Sovereign funds will grow in size and number, says Northern Trust

Though they represent a relatively recent phenomenon, sovereign wealth funds have quickly proliferated, with Asia host to the largest pool of state investment capital. And that is likely to grow, not only due to asset-value appreciation, but also to increasing contributions to existing SWFs and new ones being set up.

So say Wayne Bowers and Kevin Hardy, respectively London-based global chief executive and Hong Kong-based Asia-Pacific head at Northern Trust Global Investments.

There's a social aspect to the formation of SWFs that is vitally important in Asia in particular, says Hardy. They have a prominent role to play in contributing to retirement-scheme liabilities and much-needed infrastructure investment in the region, he adds, something others have also remarked on.

Bowers, too, points to the social change taking place in emerging markets, such as Asia, and says it's positive, as it leads to the creation of more domestic demand. Governments worldwide, though particularly in Asia and emerging states, are looking at implementing "a higher level of social safety net", he adds, which will be a major driver behind new SWFs or existing ones growing in size.

However, the decision to create one doesn't happen overnight -- there are major issues, such as where the funding will come from, what will be the fund's purpose and so on.

The capital will not only flow from the sale of commodities such as oil, says Bowers, but also from tax receipts and contributions to state pension schemes. He points to the recent announcement by Australia that it plans to raise the mandatory rate of contribution by superannuation-fund members from 9% to 12%. The same is happening elsewhere; in Sweden, for example.

India, Indonesia and Thailand appear to be prime candidates for setting up further SWFs, and there has been much discussion over whether they will and indeed should do so.

Indonesia and Thailand already have state investment vehicles, in the form of Pusat Investasi Pemerintah (Indonesia's Government Investment Unit) and Thailand's Crown Property Bureau. But neither -- with less than $1 billion and $5.2 billion in AUM, respectively -- are in the same league as the huge SWFs in China or the Middle East, or even those in Malaysia or South Korea.

Pension liabilities is one area where emerging economies may need to learn from the funding shortfalls arising in the West, and where sovereign funds can help plug potential future gaps.

Bowers feels some form of consolidation of state pension schemes in Asia is likely, such as the merging of government employee retirement schemes in some countries. Such a move would be positive for governments, he adds, as it would help increase the transparency of schemes, as well as their viability in terms of the kind of investments they can make.

Asked what progress had been made on certain issues at a May meeting of SWFs in Australia, Bowers and Hardy said they could not comment on specifics, but could speculate on the kind of discussions that may have taken place.

For example, they believe there would have been talks around the issue of where SWFs should be investing. "Is the fund there to safeguard sovereign assets?" says Bowers. "If so, perhaps it needs to diversify outside its home market." A further question is: Does it then put money into developed or emerging markets?

Of course, if the aim of the fund is to support domestic development or provide social benefits, then clearly it will have to invest in onshore assets, such as railways or telecommunications networks. If so, then it has to bear in mind that such investments are very capital-intensive and front-loaded, with a long tail of returns.

And all the while, SWFs' activities are the subject of much public scrutiny by their -- and other -- countries' populations. The former because they don't want to see their national wealth squandered and the latter because they may be concerned about another government's motives.

Bowers says one can see this as a concern in Norway where the state oil fund has been taking an aggressive stance on redressing the balance of risk within its investment portfolios.