Wealth Beyond Borders: The Unfolding Challenges for Sovereign Wealth Funds
By Luciano Arvin
The emergence of sovereign wealth funds (SWFs) as global investors is one of the most significant developments of the twenty-first century. In 2000, SWFs held approximately USD 1.2 trillion in assets under their management, and as of 2024, SWFs assets had grown to USD 11.8 trillion. By contrast, the combined assets of the much more widely discussed hedge fund industry stands at USD 5.1 trillion, while private equity equals about USD 4.4 trillion. Equally impressive is the rate of return that SWFs are achieving; using the previous ten years’ average compound annual growth rates, the combined assets of SWFs will surpass those of all central banks in six years and those of all public pension funds within a decade.
However, three distinct challenges have emerged for SWFs. First, there is mounting pressure for funds to generate more social and political benefits to their home countries. Second, the rise in protectionism from sovereign investment is resulting in calls for increased regulation of SWFs. Lastly, the legal status of frozen SWF assets remains ambiguous.
WHAT ARE SOVEREIGN WEALTH FUNDS?
SWFs remain an intrigue in the world of finance. SWFs are state-controlled investment vehicles, giving them entirely different legal, institutional, and governance structures when compared to traditional institutional investors. Unlike assets held by a pension or insurance fund, they tend to have no explicit future obligations to distribute benefits or dividends. Unlike official reserves, SWFs don’t need, and lately don’t tend to be, denominated in liquid assets, namely foreign currency or public debt securities. Accordingly, they are not only free to invest with a higher tolerance for risk, but they are also able to make investments with longer time horizons.
By classifying SWFs based on the origins of their wealth, two distinct camps emerge. The first to appear are SWFs derived from the exports of oil and gas. Within this camp, the largest grouping of these funds resides in the six Gulf Cooperation Council (GCC) countries, which collectively hold over USD 4 trillion in assets. Other countries in this group with substantive SWFs include Norway, Russia, Iran, Libya, Kazakhstan, and Azerbaijan. The second camp comprises SWFs in countries that have accumulated budgetary and trade surpluses. The largest of these funds sit in Asia, specifically China (including Hong Kong) and Singapore. Other countries with large funds in this group include South Korea, Turkey, and Australia.
Throughout the 2020s, the SWFs of the first camp have grown more rapidly than those in the second. At the end of 2020, Middle Eastern SWFs and Norway’s SWF, which combined represent virtually all commodity-based SWF assets, held approximately USD 4.5 trillion. By contrast, in the same time period, Asian SWFs, which combined represent the majority of non-commodity-based SWF assets, held approximately USD 3.55 trillion. By the end of 2023, the assets of Middle Eastern SWFs and Norway’s SWF had risen to nearly USD 6 trillion, an annual growth rate of 12.77%, whereas the assets of all Asian SWFs had only risen to slightly over USD 4 trillion, an annual growth rate of only 4.34%. This difference stems from three factors: (1) the rise in the price of commodities as a result of the Russia-Ukraine war, which has resulted in commodity backed funds having greater inflows; (2) the underperformance of China in its post-Covid reopening, which has resulted in comparatively smaller inflows; and (3) the differences in the asset allocation of each group, with commodity-based SWFs garnering higher returns for their larger asset allocation in equities and private markets.
SOCIAL AND POLITICAL PRESSURE
Domestic mandates are increasingly pressuring SWFs to link their portfolio decisions to national priorities, resulting in investment turning inward to address social, political, and economic objectives. As countries reach the twilight of resource production, they are beginning to use SWFs to acquire new technology, attract foreign investment, and develop their private sectors.
This shift is best illustrated by Saudi Arabia. Historically, the Saudi Arabian Monetary Authority (SAMA) held the bulk of the country’s sovereign wealth. SAMA tended to have a conservative investment policy, which is investing in public debt instruments. Beginning in the 2010s, Saudi leaders shifted money away from SAMA to the Public Investment Fund (PIF), which entailed a concomitant shift in investment strategy to higher risk and reward investments, such as equities. In 2017, the PIF outlined four key objectives: maximizing the fund’s assets, investing in new sectors, localizing technology and knowledge, and building economic partnerships. Alongside the United Arab Emirates and Japan, this The PIF launched a USD 100 billion technology venture capital fund. It also forayed into direct investing, becoming one of the largest investors in the electric automobile manufacturer Lucid. Its reward: Lucid opened the Saudi Arabia’s first auto manufacturing plant last year. The PIF also managed to entice Foxconn into a joint venture to build an electric vehicle and semiconductor plant. Following equity investment from the UAE’s Mubadala, American pharmaceutical company National Resilience also agreed to construct a biopharmaceutical facility in the United Arab Emirates.
Although Saudi Arabia and the United Arab Emirates lead the pack in attracting investment, Other funds in the Gulf Cooperation Council countries are evolving toward more adventurous investment policy with a higher appetite for risk as well. Kuwait recently announced the creation of a separate SWF with the goals of diversifying its economy and bringing in direct foreign investment. Additionally, the Qatari Investment Authority, known for some of its showcase investments in the West, faces a recent order from the Qatari state to reorganize via royal decree. Outside of the GCC states, however, the experience is different. The SWFs of Russia, Iran, and Kazakhstan remain focused on owning assets internally, with virtually no push outwards.
In the event that China’s economy further slows down, due to the rise of a debt crisis, as has been speculated, China it might look to its funds as domestic “lenders of last resort” to be tasked with acquiring distressed assets. On the other hand, China’s push to compete with the United States in technology might pave the way for its SWFs to make direct investments in companies with specialized knowledge, to bring to China.
The change in how leaders of countries with SWFs view and value assets marks a seminal development in international finance. Formerly, assets were viewed strictly in terms of the financial value they could generate. However, in recent years, there is a growing push, from the leadership of countries with SWFs, to ensure that SWF behavior maximizes social, political and economic benefits. This trend could accelerate as potential reconfigurations of the relationship between state and citizenry in countries with SWFs might lead to greater accountability, transparency and engagement with funds now being viewed as public, rather than state, assets. Nevertheless, there is little evidence to suggest that any SWF has actively sought to leverage its investment position for political and collateral business purposes. Instead, the more probable explanation for why some companies have received SWF investment lies in the fact that some countries have designed an attractive investment environment through low taxes, cheap energy, and bourgeoning investment in both infrastructure and research and development. In addition, SWFs have received more attention than other investors because they invest in “disruptive” fields such as green energy, biotechnology, computing and artificial intelligence. Yet, characterizing these investments as solely political is simplistic. These unpredictable investments are possible because SWFs have longer time horizons than many other investor classes and can wait longer for larger returns. Ultimately, while pressure is mounting for some SWFs to generate political and social benefits, it appears that their role is passive at best, and their motivation is still primarily driven by value maximization. Whether they will become more activist and forego financial returns in favor of bringing investment back home remains to be seen.
RISE IN PROTECTIONISM
Historically, some countries impose restrictions on foreign ownership in sectors of national interest, such as defense and communications. Another question will be whether the United States or Europe will curb SWFs from purchases in industries such as technology. The U.S. Committee on Foreign Investment is reportedly increasing its scrutiny of transactions involving Middle East SWFs. The proposed Ending Tax Breaks for Massive Sovereign Wealth Funds Act would end SWFs’ historic benefit of exemption from income tax payments. The bill would also affect foreign governments without free trade agreements or income tax treaties with the United States, including all the GCC countries and China. The United Kingdom also considered a plan to tax SWFs in 2022, only to drop the plan the following year. If support gains traction for greater protectionism and increased calls for taxation, SWFs in the 2020s may look to diversify their investments toward developing nations. However, the degree to which diversification is feasible or practical remains debatable—most financial markets in developing countries do not offer the same depth, access, or efficiency as their counterparts in the developed world. Either way, the increased appetite for direct investment from SWFs, coupled with renewed calls for protectionism in target countries, sets the stage for greater contention.
Amid a rise in protectionism, Congress and the Internal Revenue Service have voiced concerns about how SWFs distort markets, evade taxes, and remain secretive about their investments. Those who argue that SWFs represent a systemic risk fail to understand the ability of SWFs to distort markets. It is worth stepping back and contextualizing the size of SWFs relative to the size of global equity markets. In 2023, the value of all SWF assets was approximately $11.2 trillion. By contrast, the value of the global equity markets in 2023 was $109 trillion. In other words, if every SWF were to allocate 100 percent of their portfolios to equities, they would control only 10 percent of the global equity market. At best, SWFs might be able to have microeconomic distortions on individual firms. In this regard, pundits’ fears are vastly overblown.
Regarding taxation, under current U.S. law, Section 892 of the U.S. tax code grants state investment, including, sovereign wealth funds, an exemption from tax. This anachronistic provision offers tax exemption for capital and portfolio investment, which remains up the bulk of SWF investment into the United States. The tax advantage for SWFs is instead limited to dividends, royalties, and certain real estate-related income. Rather than heavily penalizing SWFs, a better policy would be to reform sovereign tax neutrality, whereby state-controlled investment vehicles are no better and no worse than private foreign investors. Lastly, forcing SWFs to divulge confidential information, such as their asset allocations, benchmarks, and rates or return, while simultaneously allowing private funds to keep this information private, would compromise SWFs ability to invest in firms. Accordingly, while there may be a case for leveling the playing field, regulators should be careful to avoid unfairly targeting SWFs.
FROZEN ASSETS IN LEGAL LIMBO
What is the fiduciary duty of a nation receiving SWF investments when the investing country has been sanctioned? This issue first emerged when Libya’s SWF had its assets, the majority of which were outside the country, frozen during the 2011 civil war. In the aftermath of that civil war, assets have been slowly thawing, but the value of the Libyan fund has declined, prompting numerous lawsuits. Now, the Russia-Ukraine War is reigniting the debate in the context of Russia’s assets abroad. To be clear, very few of Russia’s SWF assets are outside of Russia, and most of the assets that are immobilized abroad instead belong to the central bank. In Libya’s case, funds have been partially kept under judicial guardianship until the country stabilized. But the Russian case raises an entirely new dimension, as Ukrainian leaders call for this money to fund the war effort and Ukraine’s reconstruction.
Deciding the fate of frozen SWF assets remains uncharted territory. If Russia’s are sold off, the financial landscape could increasingly favor "friendshoring," a tactic that states use to protect their investments and supply chains by shifting them to friendly powers. A sovereign investor fearing the loss of assets due to sanctions might pre-emptively choose to divest from their holdings in “unfriendly” jurisdictions and instead pivot to “friendly” jurisdictions. For instance, China, in a hypothetical conflict with Taiwan, might move its money from Western countries to regions like Asia, Africa, and Latin America. While the debate over frozen SWF assets remains unsettled, but the seizure or sale of sovereign funds would accelerate the friendshoring trend.
THE FUTURE OF SOVEREIGN WEALTH FUNDS
Ultimately, the ascendance of SWFs as formidable entities in the global investment landscape marks a seminal development in twenty-first century finance. The exponential growth of SWF assets underscores their pivotal role. Nevertheless, the unfolding decade presents profound challenges encompassing heightened societal expectations at home, burgeoning economic protectionism abroad, and intricate legal entanglements arising from international conflict.
The future success of SWFs requires continuous realignment and responsiveness to these challenges. Managing expectations is no easy feat, particularly for countries depending on SWFs to turn waning, transient resource booms into stable, enduring assets. Responding appropriately shifts SWFs away from their operational comfort zone and involves some risk. However, returning to investment strategies that are blind to social benefits and generate below market returns would be even riskier.
Luciano Arvin is an economist, macro trader and writer. His interests lie in the juncture of finance and politics. His previous work has been published with The Harvard International Review, HuffPost and The Diplomat. His most recent work, a monograph with the Canadian Centre for Policy Alternatives, examines the treatment of non-renewable resource revenue for the purpose of building a sovereign wealth fund in the Canadian province of Newfoundland.
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