Given the diverse requirements and profiles of SWFs, their investment objectives, risk tolerance and time horizons vary over a considerable range. Some of this variation reflects differences in fund liabilities. The exception is those funds that have open-ended liabilities – whether these are contingent, fixed or mixed. For most funds, however, return enhancement is a high priority. SWFs generally seek to earn returns greater than they would achieve on foreign exchange reserves which are primarily invested in short term deposits, US Treasury bonds and other sovereign instruments. Diversification is another leading priority.

According to a recent article in Central Banking , fully 80 per cent of the sovereign investors surveyed had diversified their portfolios in the past two years by adding a new asset class, including corporate bonds, equities, gold and other real assets. What will be the impact of SWFs on global asset prices? To begin with, we should be cautious of partial equilibrium models. Many factors shape incremental asset supply and demand and, hence, prices. However, it is clear that SWFs may represent an important source of additional demand for financial assets. As pure conjecture based on the asset allocation of a typical pension plan, we can speculate that over time the collective asset allocation of SWFs will be approximately 60 per cent equities, 30 per cent bonds and 10 per cent alternatives.

Capital market theory holds that the world market portfolio is the most efficient. The international capital asset pricing model is not perfectly robust, but it provides a good starting point for analysis. As part of our thought experiment, we formulate a working hypothesis that SWFs will, over time, reduce their incremental purchases of US Treasuries, sell a portion of their existing US Treasuries, and reallocate to global equities and global bonds in proportion to world market weights.

Estimates of the size of the world’s capital markets vary. The average of figures compiled by the McKinsey Global Institute, Goldman Sachs and Merrill Lynch placed the total stock of investable global equities at about US$33 million, global government bonds at US$21 trillion, and private sector bonds at US$24 trillion.

IMPACT ON EQUITY VALUES

SWFs currently control nearly US$3 trillion in assets and are projected to invest about US$5 trillion in the next five years. If, today, they were to collectively allocate 60 percent of this capital to the FTSE Global All Cap Index, they would own about 5.2 percent of each of the 8,009 companies in the index.