Yield-seeking sovereign wealth funds set to target new asset classes

Low yields in traditional asset classes are prompting powerful sovereign wealth funds to reassess their asset allocation, according to Patrick Thomson, global head of Sovereigns at JP Morgan Asset Management.

Speaking at the Davos economic forum, Thomson said the very low level of yields in asset classes historically used by sovereign and central bank investors – 10-year US Treasury yields are currently trading below 2% – is leading to a readjustment of portfolios.

Sovereign wealth fund assets are now thought to stand at around $5trn.

“Diversification and the search for yield have become more important objectives for these investors, where in the past their focus has been on traditional assets such as US Treasuries and other government bonds. Now they are forced to build more diversified portfolios.”

He sees four sectors set to benefit through 2013: emerging markets, Europe, private markets and alternatives, and co-investments. “Emerging markets equities and debt, high yield and credit have attracted many institutional investors globally seeking that extra yield.”

He predicted that growth in emerging economies will account for 70% of global economic growth this year. Emerging markets are growing at more than four times the pace of developed markets (DM) (average EM GDP growth from 2008-2011 at 5.6% compared to flat DM GDP growth).

“The dynamics and fundamentals have convinced sovereign investors to increase their exposure to emerging markets to take advantage of this positive growth,” Thomson added.

China remains a focus following recent developments around qualified foreign institutional investors (QFII). In April, the Chinese government increased the total quota for QFIIs to $80bn from $30bn.

Only six foreign investors in China (all sovereign wealth funds) have quotas as large as US$1bn allowing them to invest directly in the Chinese securities markets. These are Qatar Holding, Kuwait Investment Authority, Hong Kong Monetary Authority, Norway’s Norges Bank, Government of Singapore Investment Corporation and Singapore-based investment firm Temasek Fullerton.

Institutional fund flows into emerging market debt (EMD) stand at 40 times the levels of 2009, according to data provider EPFR, reaching positive net inflows of $36bn in 2012. Emerging market equity funds added US$29bn in net flows in 2012, while the high yield debt sector has seen significant interest from institutional investors, adding $26bn in net fund flows in 2012 – a massive 13 times the levels seen in 2008.

Sovereign investors remain concerned over growth prospects in Europe, recently highlighted by the German government forecast for 2013 GDP being cut to 0.4% from 0.7% in 2012.

However, European equity markets in 2012 performed better than expected (MSCI Europe up 16.4%, DAX up 29.1%). “We observe strong interest in European corporates via direct stakes (such as in energy and utilities businesses), infrastructure and core real estate,” said Thomson. “In addition, sovereign wealth funds are looking for European companies with a large presence in the emerging world (such as some Spanish corporates that are active in Latin America), which provide them with exposure to this source of potential earnings growth.”

Driven by the desire to secure yield without taking too much equity risk, the appetite for mezzanine debt, senior loans, private equity, real estate and infrastructure investments remains strong.

Year-end 2011 assets under management for global alternatives reached record levels of US$6.5trn, having grown more than seven times faster than traditional asset classes during the prior five years. “Alternative investments remain compelling thanks to their diversification strength and healthy returns,” Thomson explained.

“Many sovereign investors can take advantage of the change in risk appetite of pension funds and insurance companies, who are facing significant challenges due either to their funding status or to new regulations such as Solvency II or the IORP Directive. As these traditional sources of long-term capital continue to dwindle, sovereign investors, who typically have much longer horizons, can benefit from the opportunities that arise in non-traditional assets.”

Lastly, a growing investment theme for sovereign institutions during the last five years is their increase in direct deals and co-investments. With prices compressing to low levels, sovereign investors increased their appetite for co-investing and partnering either with asset managers or other sovereign wealth funds. Co-investments provide additional control over structuring ownership of the asset and more flexibility around the exit options.

Direct investments by sovereign wealth funds in 2012 totalled $57.3bn – four times higher than in 2006. While in 2007 European direct investments represented 20% of total sovereign direct deals, by 2011 the figure stood at 43%. The value of European direct deals more than doubled during those four years, growing from $15.5bn to $34.4bn.

Real estate remains a major targeted sector for direct deals, with the value of deals growing by 36.4% in 2012 compared to 2011, as sovereign wealth funds seek to diversify from fixed income and global equity markets. London enhanced its position as the most attractive city in the world for cross-border property investment, garnering $10bn of deals in the first half of 2012, a 30% increase from the same period in 2011.

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