Assets managed by official institutions have risen significantly in recent years making them a powerful force in financial markets. A recent report highlights the fact that in the face of sub-optimal returns from traditional investment strategies, official institutions are increasingly diversifying their holdings into riskier assets.
A recent report (‘The Global Public Investor 2014’ published by the Official Monetary and Financial Institutions Forum (OMFIF)) provides a fascinating glimpse of investment trends at official institutions. The report covers three broad (and sometimes overlapping) investor groups that fall within the category of global public investors. Of these three sub-groups the report covers 157 central banks, 87 sovereign wealth funds (SWF) and 156 public pension funds.
Total funds under management at these institutions are USD 29.1tn, the equivalent of 40% of world GDP. Assets under management at official institutions have, says the report, grown “unprecedentedly fast”. As a result, the same authorities that are responsible for maintaining financial stability are often the owners of the large funds that have the potential to cause problems.
Growth of assets-under-management at official institutions is in large part explained by the increase in central bank’s foreign currency reserves. This in turn reflects world economic imbalances, efforts to counter currency appreciation against the dollar and euro as well as the objective of holding asset to deal with setbacks. The combined force of central banks, sovereign funds and public pension funds brings great potential for stabilisation but paradoxically the weight of these assets also creates a new source of risk, by adding fresh liquidity and potentially generating destabilising rises in asset prices.
The weight of liquidity held by official institutions, coupled with low interest rates in developed countries, has led to ‘sub-optimal’ returns from traditional currencies and investment instruments (often short-duration bonds). So, the declining profitability of central bank’s reserve holdings has prompted a readiness to invest beyond traditional fixed income strategies. The result is increasing diversification into different sectoral and geographical investment categories. The report highlights a trend among central banks, including those in Europe, of building up equity holdings, following the patterns of sovereign and public pension funds. Investments in infrastructure, real estate, commodities and hedge funds are apparently no longer considered ‘alternative’ by official institutions.
Among the reasons cited in the report for diversification into infrastructure by official institutions is the view that expropriation of hard assets such as property is less likely than currency debasement and/or debt rescheduling of government debt. Similarly, equity ownership which promises a share of globally diversified earnings appears preferable to a debt note vulnerable to the printing press.
Should these trends continue, there is scope for official institutions to significantly contribute to promoting financial innovation. Examples include the financing of energy projects, infrastructure and other ‘alternative’ investments outside public markets or the development of new forms of securitisation to help overcome economic imbalances.
A number of official institutions have been reducing allocations to fixed income reflecting a conviction that the decades-long golden age of fixed income investing is coming to an end. For central banks managing official reserves the potential negative impact of rising interest rates on fixed income allocations means government bonds that were once viewed as representing a risk-free rate are now often seen as ‘rate-free risk’. There may well be lessons for other investors in such an analysis.