High levels of assets under management and sophisticated strategies have increased the importance of sovereign funds as institutional investors. Their presence in world markets has become more pronounced. The introduction of various funds in recent years has cemented their global influence. As the number and diversity of sovereign funds expand, more are shifting into alternative assets.
In the past, these funds’ main asset allocation was to equities and fixed income instruments. However, a low interest rate environment over the past decade has led sovereign funds to search for higher yields and, in the process, turn towards alternatives.
The inclusion of alternatives in a portfolio can improve its risk-reward profile significantly. Gold, for example, has a negative correlation with equities and performs well during stock market downturns. Principal preservation, introducing a source of returns that has reduced market risk, is attained while the value of investments is protected from possible decreases in the purchasing power of the currency the asset class is expressed in.
But the inclusion of certain alternatives in a portfolio can also introduce risks such as illiquidity, complexity and cyclicality, where the asset’s value fluctuates widely according to business cycles or seasonal demand.
Nevertheless, the heterogeneous aspects of alternatives allow sovereign funds to select appropriate asset classes to suit their specific objectives. Alternative asset classes possess different correlations of returns compared with traditional asset classes. The inclusion of a wide variety of asset classes in a sovereign fund’s portfolio thus provides strong diversification benefits, especially if it is combined with more traditional asset classes such as bonds or equities.
Only gold can rival traditional investments with regards to liquidity. Measured against traditional investments, the lack of liquidity of most alternative asset classes is a significant drawback. Inclusion in a portfolio will cause diversification, but it will also create illiquidity problems.
This means alternatives require long-term investment horizons and are prone to further illiquidity in times of crisis, as was the case in the subprime mortgage crisis.
In terms of performance, different alternative assets deliver strong returns on a five-, 10- and 20-year perspective (see chart), despite uncertain market conditions. On both a 10- and 20-year basis, gold and private equity outperform. Hedge funds and commodities consistently underperform when compared with traditional and other alternative asset classes.
Sovereign funds’ general goal of safeguarding the prosperity of their home country by accumulating and increasing wealth fits well with alternatives offering diversification, a hedge against inflation and improving portfolio performance. While alternatives are not immune to risks such as illiquidity, complexity and cyclicality, their ability to provide downside protection and diversification will entice investors.
Sovereign funds should continue to consider alternatives as a new source of income. But to reap the rewards, these investors must find the right allocation strategy, monitor their portfolios well and reallocate their capital to reflect economic developments.
Dariush Yazdani is Partner at PricewaterhouseCoopers Luxembourg.