How Sovereign Wealth Funds Think

Sovereign wealth funds invest for citizens who are not yet born. They are state-owned pools of capital, usually built from oil revenue or trade surpluses, and together they manage trillions of dollars. Their time horizon is longer than that of almost any other investor.

Where the money comes from

Kuwait set up the first such fund in 1953 to invest its oil income. The logic has not changed. Oil in the ground is a finite asset, and a fund converts it into financial assets that can last.

Norway's Government Pension Fund Global, the largest, follows this model. Abu Dhabi, Kuwait, Saudi Arabia and Qatar do too. Singapore's GIC and Temasek, and China's CIC, were built instead from trade surpluses and reserves.

Not all funds have the same job

Much confusion about sovereign funds comes from treating these as one group. Norway's fund and Saudi Arabia's Public Investment Fund behave very differently because they were given different tasks.

Time is their main asset

A savings fund has no clients who can withdraw and few short-term liabilities. It can therefore hold volatile and illiquid assets through deep downturns.

Norway's fund kept buying shares through the 2008 crisis because its rules required rebalancing back to its equity target. That discipline, set in advance, did what human nerve might not have.

They own the market, then add to it

The largest funds are too big to pick their way to outperformance. Norway's fund owns well over 1% of all listed shares in the world, across thousands of companies. Its return is mostly the market's return.

Funds seek extra return in other ways:

• Private markets. Infrastructure, real estate and private equity pay a premium for illiquidity.
• Direct investing. Building in-house teams saves the fees paid to outside managers.
• Scale. Few buyers can write a multi-billion-dollar cheque for an airport or a toll road.

Rules protect the fund from its own government

The biggest threat to a sovereign fund is political. Governments are tempted to raid it in hard times or direct it towards favoured projects.

The best-run funds have fiscal rules. Norway limits annual government spending from the fund to its expected real return, about 3%. The capital itself is not meant to be touched.

They increasingly act as owners

With stakes in thousands of companies, large funds cannot simply sell what they dislike. They vote, engage with boards and publish their expectations on governance and climate risk. Some exclude companies on ethical grounds.

What an ordinary investor can borrow

• Define what the money is for before deciding how to invest it.
• Set rebalancing rules in calm times and follow them in a crisis.
• Spend only the expected real return, not the capital.
• Own the broad market cheaply as the core of the portfolio.

Part 14 of 15 in the series Lessons From the Masters. Next: How Billionaires Protect Money After They Make It.

Independent educational commentary, not investment advice. References to people and firms do not imply affiliation or endorsement. The picture is an illustration, not a photograph. Past results say nothing about future ones. Trading leveraged products carries a high risk of loss.