Sovereign Wealth Funds (SWFs) have been the subject of heated debate in recent months as foreign funds have swept in to take large stakes in iconic US firms. More than $3.3 trillion in capital is managed under these funds, a substantial portion of which comes from the Middle East and China. Aside from the political and geopolitical issues these entities raise, the mind-boggling amount of capital manipulated by these funds has economists wondering about their effect on the global economy and financial system.
Morgan Stanley believes that SWFs can be broken down into three distinct categories and that each type of fund will have a different effect on the investment landscape:
…it may be useful to consider three different types of SWFs, based on the sources of the accumulation of official reserves/SWFs: (1) oil and other commodities; (2) goods or C/A surpluses; and (3) capital inflows. The sources of ‘funding’ of the rise in official foreign assets will likely dictate the risk-return profile of the investment portfolio of the central banks/SWFs in question.
The first type of fund has the highest risk profile because the wealth being managed has no associated liability. The second and third type have lower risk profiles because the reserves are financed through the issuance of government bonds:
Specifically, Type 1 SWFs should have the highest risk-return profile because they essentially have no distinct liabilities. Type 2 SWFs should have a marginally lower risk-taking appetite than Type 1 SWFs because of the domestic bond liabilities…Type 3 SWFs, however, should have the lowest risk-taking appetite and therefore should have rather modest – and even negative – effects on the overall risk profile of the financial markets. Depending on the relative size of these three types of SWFs/reserves, the world’s risk-return balance may be altered in different ways.
The aggregate effect on global markets depends, therefore, on the relative mix of the types of funds. Morgan Stanley conlcudes that because much of the wealth in SWFs is associated with Type 1 funds, the world’s risk profile has therefore become more risky:
Whether SWFs raise the world’s risk-return profile depends on the sources of the SWF/reserve assets. Oil-based SWFs should have the biggest impact on the world’s risky assets, followed by goods-trade surplus SWFs. SWFs based on capital inflows should have minimal – and possibly even negative – effects on the world’s aggregate risk-taking preference. The net effect depends on the relative size of these three types of SWFs. Since Type 1 and Type 2 funds are huge, SWFs should raise the world’s risk-return profile.
With more and more capital invested in riskier and riskier securities, the chance of turmoil and dramatic unwinding rises a notch. So as SWFs grow in both size and number, don’t be surprised if the market becomes a wilder and more volative beast than it used to be.