Sovereign wealth funds create headlines as cash-rich foreign nations look to make larger and more focused investments in the modern economies of the United States and Europe. It is becoming increasingly important to understand these funds because of the increasing amount of money they hold and the power and influence this can wield. So, what are these funds? Read on to familiarize yourself with one of the largest and fastest-growing pools of capital in the world.

What Is a Sovereign Wealth Fund?
A sovereign wealth fund is simply an investment fund managed by a government or other organization on behalf of a nation or sovereign state. The capital that flows into sovereign wealth funds can come from any number of sources, but the most common are foreign currency reserves (budget and banking surpluses) and excess profits from the sale of natural resources and commodities. Crude oil profits in particular have been a huge benefactor to sovereign wealth fund assets. (For some more background on these funds, see An Introduction To Sovereign Wealth Funds.)

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On the whole, sovereign wealth funds don't have boilerplate restrictions on what can or can't be owned, much like with hedge funds in the United States, but foreign stocks, bonds, derivatives and currencies are all fair game.

Many of the big-story headlines you may have read about SWFs relate to their efforts to buy large stakes in financial corporations like Citigroup (NYSE:C), Merrill Lynch, Morgan Stanley (NYSE:MS) and Blackstone Group (NYSE:BX). But with these investments, and the attempts to make others, sovereign wealth funds have incited feelings of protectionism within the countries where these banks and other investments are located. (To learn more about protectionism, read What Is International Trade? and The Basics Of Tariffs And Trade Barriers.)

Who Are the Major Players?
There are dozens of sovereign wealth funds in existence, and many have been around since the '80s and '90s. The growth in assets and the intent of fund managers to diversify away from just holding currency reserves or gold is what sets apart the old SWFs from the newly created ones. In the interest of seeking higher returns and diversification, many SWFs invest in global assets like stocks and bonds, and they invest in multiple currencies.

According to data compiled by the International Monetary Fund (IMF) in early 2008, the current aggregate value of SWFs are in the neighborhood of US$2-$3 trillion, which is already more than is held by the world's hedge funds (US$1.7 trillion). It should be noted, however, that the use of leverage within hedge funds gives them much more buying power than their net asset values alone. (To learn about the IMF, read What Is The International Monetary Fund?)

The top five largest SWF by assets (data as of February 2008)
  1. Abu Dhabi Investment Authority (UAE) - $875 billion
  2. Norway Government Pension Fund (Global) - $380 billion
  3. Government of Singapore Investment Corporation - $330 billion
  4. Saudi Arabia 1 (no official fund name) - $300 billion
  5. State Administration of Foreign Exchange (China) - $300 billion
Three of the top five funds have gained their heft thanks to exploding oil profits, with the exception of Singapore and China, which were running high current account surpluses in the mid-2000s. (To learn more about current accounts, see Understanding The Current Account In The Balance Of Payments.)

What Stronger Presence Means to the Global Economy
Once people understand just where these funds are coming from, they tend to either get really upset and scared, or they see it as a natural extension of free markets, globalization and the increased wealth being generated in areas of the world that have long been considered the weaker "bit players" on the global stage. (For further reading on globalization, read The Globalization Debate.)

There are genuine geopolitical concerns about what a large sovereign wealth fund could do to a potential adversary nation. Imagine what several hundred billion non-regulated dollars in concentrated wealth could do - under a malicious hand, it could perform a hostile takeover of strategic financial, industrial or infrastructure assets. It could also erode a nation's currency in the foreign exchange markets. In a worst-case scenario, a sovereign wealth fund is a large pool of hidden assets, with no shareholders (or regulations), which could be ruled by a dictator.

The Sanguine Side
While the size of these assets compels us to not ignore the issue, it is not necessary to take a defensive stance. Several precedent-setting events have already taken place, and these have served to help increase the amount of discussion and regulation being created by international security and monetary authorities like the Securities and Exchange Commission (SEC) and the IMF.(For more on the SEC read, Policing The Securities Market: An Overview Of The SEC.)

Global Examples of Action and Reaction

Asia
In the 1980s, many Japanese companies began purchasing prized real estate assets in cities like New York, and many feared that it was the first wave of an impending financial takeover from across the Pacific. But alas, in this case Japan bought at the top of a real estate bubble, and quickly took big losses on their investments. No effort to disrupt the U.S. economy took place.

North America
In the United States, the Foreign Investment and National Security Act of 2007 was passed to beef up existing statutes, which date back to the 1980s and outline what the government can do to step in and block investments from foreign countries that may pose a threat to national security. The U.S. government did just that in 2006, stepping in to block an existing deal for Dubai to purchase a British port operator with significant assets in U.S. ports.

Europe
On the other side of the pond, in 2008 Germany enacted a law that requires parliamentary approval for any foreign acquisition amounting to more than 25% of the voting rights in any individual company. This may be a model for other countries going forward, as voting rights are deemed more important than common stock holdings without voting rights.



Transparency Is the Answer
One of the most important aspects to consider going forward is transparency. As long as these funds' holdings are known to the public (even if only once or twice a year), a rogue nation won't be able to gang up on the assets or currency of a neighbor for political gain. Such trends would quickly become obvious, and market forces would dictate a swift resolution. (For more, see Show And Tell: The Importance Of Transparency.)

The chart below provides information about how transparent various large sovereign wealth funds are, as well whether their investments are targeted passively (such as investing in U.S. Treasury Bonds, index funds) or targeted strategically (individual companies, alternative assets):


The relative size of each circle represents the size of the fund; bigger circles for larger assets. As you can see, most of the large circles are in the upper-left corner, where transparency is lower than average and strategic focus is higher than average. It should be the goal of current and future monetary authorities to encourage sovereign wealth funds to open their books up more and promote some level of transparency. The rankings are based on data from the Sovereign Wealth Fund Institute, a nonprofit, nonpartisan group that provides research, news, and statistics about the structure and leadership behind SWFs.

Parting Thoughts - Remember the Invisible Hand
The markets with the most safety and liquidity are still located in the G7 economies like the U.S., Europe and Japan. Until that reality changes, those nations will see capital inflows across all asset classes coming from the sovereign wealth funds. The vast majority of that capital will be completely harmless, and only serve to strengthen all parties involved. For the small number of potential conflicts that may arise, we are beginning to see the makings of a framework to assess and defuse these risks before they escalate to larger economic or political issues.

On the whole, more sovereign wealth fund capital is a good thing for U.S. investors, simply because it increases the long-term demand for financial assets. Sovereign wealth funds also give U.S. companies greater access to capital, thus lowering the cost to obtain it.

Investors should keep watching for unruly behavior, but at the end of the day should trust capitalism to do its job. Remember the moral of the "invisible hand" metaphor from Adam Smith: Capitalism inspires investors to seek out their own self-interest, which in turn tends to help, not hurt, the (global) community. (For more on the invisible hand, see Adam Smith: The Father Of Economics.)