What Is a Sovereign Wealth Fund (SWF)?

A sovereign wealth fund (SWF) is a state-owned investment fund or entity which comprises of pools of money derived from a country's reserves. Reserves are funds set aside for investment to benefit the country's economy and its citizens. The funding for an SWF comes from central bank reserves which accumulate because of budget and trade surpluses, official foreign currency operations, money from privatizations, governmental transfer payments and revenue generated from the exporting of natural resources.

Sovereign Wealth Funds Explained

In general, funds tend to prefer returns over liquidity, making them more risk tolerant than traditional foreign exchange reserves, according to the non-profit Sovereign Wealth Fund Institute. Foreign exchange reserves are assets that are held on reserve by a central bank in foreign currencies, used to back liabilities and influence monetary policy.

As per the Institute's description, the traditional classification of sovereign wealth fund includes

  • Stabilization funds
  • Savings or future generations funds
  • Pension reserve funds
  • Reserve investment funds
  • Strategic Development Sovereign Wealth Funds (SDSWF)

The acceptable investments included in each SWF vary from country to country. Countries with liquidity concerns limit investments to only very liquid public debt instruments. In some cases, sovereign wealth funds will invest directly in domestic industries.

Some countries have created SWFs to diversify their revenue streams. For example, the United Arab Emirates relies on oil exports for its wealth. Therefore, it devotes a portion of its reserves to an SWF that invests in diversified assets which can act as a shield against oil-related risk. The amount of money in an SWF is substantial. According to the World Economic Forum, as of 2018, the UAE's fund was worth about US$683 billion. The Forum also finds that Norway’s sovereign wealth fund, the largest in the world, has exceeded US$1 trillion since 2017.

There is a concern that SWFs have political influence. Some of the most significant sovereign wealth funds, except for Norway, are not entirely transparent about their investments and corporate governance practices, which leads some to think they are for political, not financial motives.

Key Takeaways

  • A sovereign wealth fund is a state-owned investment fund that is used to benefit the country's economy and citizens.
  • Funding comes from central bank reserves, currency operations, privatizations, transfer payments, and revenue from exporting natural resources.
  • Funds tend to prefer returns over liquidity and are therefore more risk tolerant than traditional foreign exchange reserves.
  • Acceptable investments in each SWF vary from country to country.

Real World Examples

Countries will create SWF to match the needs of their population. Acceptable fund investments will vary with the country's liquidity, debt, and projected growth needs. For instance, Norway's SWF is the largest in the world, as of 2018. It invests money generated from sea-based oil drilling revenues and then pays gains out as a dividend to its population or for incentives such as the purchase of electric vehicles.

1.3%

The estimated ownership of Norway's sovereign wealth fund in all global stocks. The $1+ trillion fund is worth about $200,000 per Norwegian citizen.

Japan's Government Pension Investment Fund

Japan faces the dilemma of a growing elderly population combined with a dwindling labor force and negative government bond yields. The nation designed its public pension system to have contributions from the working populace support its elderly citizens. As global market conditions change, Japan's Government Pension Investment Fund retooled its investment strategy to grow assets earmarked for pension benefits.

In 2014, GPIF officials announced a radical shift away from domestic bonds to global equities. The massive $1.1 trillion SWF reduced its domestic bond allocation targets from 60% to 35% and also expressed its intent to increase global and domestic equity from 12% each to 25%. Japan sets its sights on improving portfolio returns to compensate for shrinking subsidization from the working populace.

China Investment Corporation

The China Investment Corporation, a $940 billion SWF as of late 2018, manages a portion of the nation's foreign reserves. The Chinese Ministry of Finance established the CIC in 2007 by issuing special bonds. The fund targets equity, income and alternative investment strategies such as hedge funds. As hedge fund returns have lagged common stock indices since 2009, CIC managing director Roslyn Zhang expressed disappointment in 2016 over poor performance and exorbitant fees.