11/25/2013 03:38 pm ET Updated Jan 25, 2014

How Do Governments Invest

We all want to know. How do governments invest globally these days? New practices are emerging.

We have come a long way since sovereign wealth funds' controversial investments in distressed financial and infrastructure companies in the U.S. and Europe. Indeed, their investment behavior has changed in recent years and new trends are emerging. Markets' followers have to understand these trends better to improve their interaction with the unique sovereign funds community.

As the trends below demonstrate, sovereign funds' investing becomes a 'new normal' in national institutional investment. While sovereign funds have traditionally served as quiet, passive and isolated investors, they are now becoming more collaborative, better diversified, philanthropic and transparent about their operations.

First, most funds have dramatically increased their investment in real assets, such as real estate. This asset class fits the nature of the sovereign wealth funds as long term investors and solves the ultimate problem of over-exposure to correlated assets. The U.S. economic recovery, for example, allowed many funds to open offices in the U.S. and invest in recovering real estate assets and large oil and gas projects. The Norwegian Sovereign Fund announced end of last year that they would like to invest a third of their 5% real estate assets in the U.S. market. Many funds do and will follow.

Second, sovereign funds are moving towards a 'co-investing' model, by which investments are led by a consortium of sovereign financial institutions, where each fund brings different financial capability, networks, and specific knowledge. This new model is driven by the political pressure and financial need to diversity the risk, the growing size of real expensive assets or projects, foreign policy considerations that support cross-border collaboration, and the fact that governments realized that developing the know-how internally might be sometimes too pricey or complicated. Several sovereign funds, for example, have joined forces to co-invest in International Finance Corporation's private equity funds.

The role of sovereign funds in international forums has facilitated the process of bringing funds together and creating co-investment opportunities. The World Economic Forum put together a sovereign group to create a dialogue on long-term investing as a solution to the failed short-term view of financial markets. The IMF has established a secretariat, which will institutionalize the sovereign funds community around common issues of concern and interest, such as risk management, talent management, working with OECD countries, and, yes, improving co-investing operations.

Third, while sovereign funds have significantly increased their investment in real assets, such as infrastructure and real estate, funds around the world are simultaneously investing in the future of innovation. As countries invest tremendously in developing culture of innovation and entrepreneurship, as one of the global financial crisis' biggest lessons, sovereign financial resources are perceived as a way to invest in venture capital firms and companies to create a local ecosystem that fosters innovation. Also, investing in such foreign firms would enable national governments to bring this intellectual property in the future back to the home country. The Malaysian government is a case in point, where the government is using the sovereign fund to foster innovation at home and abroad.

Fourth, historically, sovereign funds focus on liquid and stable currencies, such as the U.S. dollar and the euro. Yet, political instability and depreciation opened the door to new currencies, such as the Canadian Dollar and the Australian Dollar. Moreover, many sovereign funds increase their Chinese Yuan holding in light of the fact that more and more assets are tied to the Yuan currency.

Fifth, sovereign funds look at philanthropy as an integral and critical component of their investment operations. Several existing sovereign funds establish their own foundations as part of the need to become part of the main stream of institutional investing. It also allows governments to support goals that promote national goals outside of the financial goals of the particular funds. Qatar Foundation for Education is a good example. This trend needs to be understood as part of the larger trend, according to which sovereign funds are more vocal on corporate boards and in international scene as active shareholders.

Finally, many sovereign wealth funds, like institutional investors in general, have developed mixed feelings about their interaction with external asset managers. On one hand, many times the size of the assets and the broad mandate allow funds to explore high number of external managers. At the same time, many of the fund managers in recent years underperformed, charged high fees, and were not transparent enough about their operations. It is important to remember that within the sovereign funds context there are additional elements. Global citizens want to make sure that their national funds are building their own internal capacity and know-how. Paying high fees for underperformed and secretive managers do not match national interest and good public finance principles. Thus, several sovereign funds are working extensively to develop certain capacities in house. The impact on potential external managers is clear. Being competitive and open is the way to go.

A version of this article was published on OMFIF Nov Bulletin.