EFTA00812107.pdf

Invesco Global Sovereign Asset Management Study 2017 • This study is not intended for members of the public or retail investors. • Full audience information is available inside the front cover. _At t. ..1 _ : ; '. t :... , . ... .. .....• ,- . ..•,. 4,.w..o.... _ • .• . 'e,t z: : . • •• - .,. ...... : 7.r.2 — •.1- ..fir •• r ca,, Tit :t.a?:. ..:.4.-....:-• 4-::-..7: ir.s ..:>. ll'esb •••:* ..? aar ..._ .1...-r. s .- •-•••••• -• • .• • VA .1-.7crs.-s...? 413.• 6:: --....str---' • a' ' ...-... . :•:::::. • • ; • •• ••• 34,0• .4 ••:, •,, ••• . . •: Pa — 0.4e: • ""PlI ••,. • ••••••••••• • ; • 7, `. a -•• *a- a ' , 2"3 .• • ". " •• -• - •-• • • * 4114 • , • • I •a, le :••P p ••• .—•••••• •••• •• • "••:. • • • . ••••••• . • • ••••-. - •-• • • Pp. • • • . ..‘,./` EFTA00812107 Important information This document is intended only for Professional Clients and Financial Advisers in Continental Europe (as defined in the important information); for Qualified Investors in Switzerland; for Professional Clients in, Dubai, Jersey, Guernsey, Isle of Man, Ireland and the UK, for Institutional Investors in the United States and Australia, for Institutional Investors and/or Accredited Investors in Singapore, for Professional Investors only in Hong Kong, for Qualified Institutional Investors, pension funds and distributing companies in Japan; for Wholesale Investors (as defined in the Financial Markets Conduct Act) in New Zealand, for accredited investors as defined under National Instrument 45-106 in Canada, for certain specific Qualified Institutions/Sophisticated Investors only in Taiwan and for one-on-one use with Institutional Investors in Bermuda, Chile, Panama and Peru. Cover Aerial view of Midtown South. New York EFTA00812108 Introduction Key themes We published our first report on the sovereign asset management industry in 2013 following Shift from investment strategy to business model interviews with 43 sovereign investors. This year The gap between target and actual portfolio returns marks our fifth annual study with evidence-based along with declines in investment commitments are findings based predominantly on face-to-face reshaping sovereigns' strategic agendas. interviews with 97 leading sovereign wealth funds, state pension funds and central banks with assets Increasing appeal of perceived 'safe haven' markets in excess of US$12 trillion. Geopolitical uncertainty is leading to a focus on Over the past five years we've noted a number perceived 'safe haven' international markets and of factors influencing sovereigns such as low home markets. interest rates, the falling oil price and reduced funding. This year however we note geopolitical Attraction to real estate for matching and shocks in developed markets are shaping decision flexible participation making. When coupled with uncertainty over the Sovereigns are increasing allocations to high-quality end of quantitative easing, the commencement direct real estate given perceived return, matching of quantitative tightening and ongoing volatility and flexibility attributes. in currencies and commodities it's clear sovereign investors are faced with a challenging macroeconomic Environmental, social and governance (ESG) and therefore investment environment. growth dependent on performance data The first theme in this year's report addresses Perspectives on ESG are polarised with supporters the aforementioned factors and notes a continuing moving to further embed and integrate ESG in return gap between target and actual returns with investment processes while non-supporters wait asset deployment challenges limiting the ability for for evidence of investment implications. sovereigns to match strategic asset allocation targets. We note sovereigns are increasingly looking to evolve Central bank risk appetite driven by financial their business models through internalisation or market exposure investment partnerships to reduce management Central bank investment priorities and risk costs and improve placement efficiency. appetite vary according to the size of the country's Geopolitical risks have led to an increased reserves and to the level of exposure to financial concentration on perceived 'safe haven' international market shocks. markets such as the US, India and Germany as well as an increasing focus on home market allocations in an effort to reduce foreign currency exposure. We focus on real estate in our third theme, highlighting accelerated growth in the asset class. We examine the drivers for these allocations as well as setting out how and where assets are being deployed. Despite sovereigns being well placed to implement Environmental, social and governance (ESG) strategies due to their size and long-term orientation, the uptake of ESG practices by sovereigns appears to have varying success. We highlight sovereigns' polarised perspectives on ESG investing across various regions. We conclude with a theme focused on central banks. This year we have expanded and segmented our central bank sample to understand differences in strategy and pace of change with respect to investment trenches across developed and emerging markets. We hope the unique, evidence-based findings in this year's report provide a valuable insight into a fascinating and important group of investors. Alexander Millar Head of EMEA Sovereigns 8 Middle East and Africa Institutional Sales igsams.invesco.com alexander.millarginvesco.com to view more content +44 1491416180 on this year's themes 01 EFTA00812109 Sovereign segmentation is crucial to understanding Investment sovereigns attitudes and responses to external themes Investment sovereigns do not have any liabilities, Economic challenges affect sovereigns differently, allowing for long time horizons and high exposure to according to their liabilities, risk appetites, funding illiquid asset classes. Due to this investment freedom, dynamics and other factors. We use the framework return targets are high - investment sovereigns have in figure 1 to categorise sovereign investors. We will responded to falling returns by targeting greater explore the unique implications of the themes in illiquid asset exposure (to generate higher returns) this report for each of these segments. and developing internal management capability (to capture more of the value chain), however many funds are reaching limits on these allocations. Liability sovereigns Liability sovereigns are split into funds with existing outflows (current liability sovereigns) and funds with future liabilities (partial liability sovereigns). While partial liability sovereigns have similar strategies to investment sovereigns (due to their long time horizons), matching outflows is a key concern for funds with current liabilities. The return gap is therefore of particular significance to liability sovereigns and many funds expect their target rates to eventually increase as they update models to lower 'risk free' rates and increasing life expectancy. To manage these concerns, many current liability sovereigns are seeking greater exposure to high- yielding asset classes. Fig 1. Sovereign profile segmentation Sovereigns and central banks Primary objective Investment 8. liability Global sovereign profile Liability sovereigns (LIA) Sovereign investors 'Central banks have secondary frpactityobjectwes as well as primary capdal preservation objectives. They are distinct from sovereigns through thew role in local market money supply and thew regulatory function. 02 EFTA00812110  Liquidity sovereigns Central banks Liquidity sovereigns manage assets to stimulate Central banks are 'lenders of last resort' - managers economies that are highly dependent on commodity of a large foreign reserves portfolio to bail out prices during a market shock. Due to the unpredictable financial institutions of public importance. Due to and sudden nature of outflows, liquidity sovereigns the importance of maintaining reserves to sufficiently have extremely short time horizons and prioritise cover such requirements, preservation of capital portfolio liquidity above investment returns. Despite is of greatest importance. Central banks also have low yields of government bonds, liquidity sovereigns high levels of public accountability and disclosure, are unable to seek higher returns from alternative encouraging risk aversion through short time horizons asset classes due to the inherent liquidity risk. and highly liquid investments. While other sovereigns invest in home market assets, central bank reserve Development sovereigns managers hold the majority of their assets in foreign The asset and geographic allocation of development securities, increasing the importance of currency sovereigns is driven by the requirement to encourage exposure relative to other sovereigns. local economic growth (rather than investment Unlike sovereign investors, central banks have return). Development sovereigns take large (often objectives outside of reserves management, including controlling) stakes in companies of economic local market liquidity management and maintenance significance in order to grow their presence in of currency pegs. Since these external factors have the local market. While other sovereigns adjust influence over the foreign reserves, in this study we allocations to maximise their asset growth and yield, consider central banks separately from sovereign development sovereigns consider their success investors. However, as many government bonds have in economic metrics such as GDP growth and job negative yields, certain central banks have looked to creation, working closely with their investments to invest in non-traditional asset classes (e.g. equities) grow long-term strategic assets. This means that to preserve their capital, closer aligning their foreign development funds are relatively unreactive to reserves investment strategy to that of sovereign return shortfalls and asset allocation trends. wealth funds. Funding challenges and the low return environment have unique implications for each sovereign segment. N., Investment & liquidity Investment & development Capital preservation Liquidity sovereigns Development sovereigns Central banks- (Lie) (DEV) (CB) 03 EFTA00812111 Shift from investment strategy to business model The gap between target and actual portfolio returns along with declines in investment commitments are reshaping sovereigns' strategic agendas. EFTA00812112 EFTA00812113 The outlook for macro policy and for the geopolitical Sovereigns face a continuing 'return gap' environment remains uncertain These dynamics suggest a continuation of the Our fifth annual cycle of interviews Look place 'lower rates, lower return' environment over at between January and March 2017. In speaking with least the next 24 months. While the lower return leading sovereign investors and central banks (with environment has been a consistent theme in past assets in excess of US$12 trillion) we identified a years, in 2017 the implications are compounded, number of critical themes that shaped interview with low interest rates the factor of greatest responses. Unsurprisingly, we noted that the outlook importance to both strategic and tactical asset for macro policy and the potential for further allocations in figure 2. Risk asset valuations have geopolitical shocks dominated discussions. inflated over a number of years, while the near- - Sovereigns see the end of OE (Quantitative uniform tilt to alternatives such as infrastructure Easing) without a clear indication as to the form or has resulted in supply challenges and delays. timeframe for further OT (Quantitative Tightening). In 2016, all sovereign profiles displayed a While the US has begun to raise interest rates, the return gap (figure 3), driven by the low interest rate Federal Reserve is engaged in parallel measures environment, however this shortfall was greatest that may reduce the quantum and pace of further among investment sovereigns. Traditionally, liability increases; and there is uncertainty whether and sovereigns have hedged fixed income against when other major markets will follow suit inflation (due to the focus on matching outflows - The bifurcation of the US and other developed to beneficiaries), while investment sovereigns have markets (notably the UK, Germany and Japan) left their Inflation exposure open. This has led to had significant implications for currency rates, investment sovereigns having the greatest return challenging sovereign geographic allocations gaps, as developed economies return to growth - Political change in developed markets (notably and inflation rises. While liquidity and development Brexit and the US election) created volatility in sovereigns are also suffering from low interest sovereign portfolios, challenging the robustness rates, respondents noted that investment returns of sovereign risk models. As policy changes are were of secondary importance, relative to liquidity worked through governments (e.g. the terms of and development objectives. Furthermore, liquidity Brexit and US corporate tax reform), there will be sovereigns noted that their long-duration fixed wider implications for long-term geographic and income assets had increased in value as rates fell. asset allocation Against this, sovereigns are challenged by fixed - Emerging markets face various macro challenges, return targets, which are typically set to match with commodity prices recovering slowly (e.g. oil, potential liabilities and do not adjust to market natural gas and copper) and an increasingly unstable conditions. Despite return challenges, we do not political outlook in Brazil and South Africa see a concurrent shift in investment activity year-on-year (as we go on to explore). The challenges of the return gap are most severe among investment sovereigns. 06 EFTA00812114 Fig 2. Importance of macroeconomic conditions to strategic and tactical asset allocation • Importance to SAA ■ Importance to TAA 8.1 Low interest rates 9.1 7.4 US election 8.5 7.1 Commodity prices 6.6 6.9 Brexit, EU break 7.5 6.5 Stock market volatility 7.5 5.7 Terrorism 5.9 5.6 War in Syria 5.5 5.5 Emerging market 6.9 5.1 Climate change 7.0 5.0 Chinese volatility 6.1 Sample is based on sovereign investors and excludes central banks. SAA =Strategic Asset Allocation. TAA=Tactkal Asset Allocation. Sampte=20. Fig 3. Past year returns and target returns (% AUM) • Past year returns ■ Target returns 4.1 Sovereign sample 57 6.1 2.6 Investment sovereigns 12 6.3 4.9 Liability sovereigns 27 6.0 2.4 Liquidity sovereigns 3.3 4.6 Development sovereigns 11 7.7 Sample is based on sovereign investors and excludes central banks. Sample size shown in grey. Data is not weighted by AUM. 07 EFTA00812115 Fig 4. Expected time (years) to deploy assets ■ 2016 ■ 2017 Infrastructure Private equity Real estate Hedge funds 4 2.4 2.3 2 1.7 SS Sample is based on sovereign investors and excludes central banks. Sample: 2016=21, 2017=35. 08 EFTA00812116 Deployment challenges are limiting sovereign Risk of fund withdrawals is slowing further ability to match targets illiquid asset investment In previous reports, we observed sovereigns' return The ability of sovereigns to respond to the return gaps, driven by low Interest rates and challenging gap is being limited by the increasing likelihood of targets for fixed income allocations. We have also withdrawals. Over the past three years, governments noted how appetite for alternatives has grown as have responded to economic volatility by reducing sovereigns seek greater returns from private markets. new funding to sovereigns and, in some cases, In last year's report, we demonstrated that high levels drawing down from sovereign reserves, as seen of competition in infrastructure and private equity in figure 5. were causing sovereigns to shift deployment of real While previously only liability sovereigns assets towards real estate. experienced regular drawdown of funds (in the form Competition for infrastructure and private equity of outflows to beneficiaries), an increasing propensity deals has accelerated in 2016, with deployment for government withdrawals is encouraging times increasing across alternative asset classes investment and liquidity sovereigns to consider the (figure 4). While the growth in these times is small, liquidity of their portfolio. Liquidity sovereigns were it is significant: sovereigns are increasingly dependent comfortable in their ability to withdraw from their on their alternative investments to generate yields, portfolio at short notice, however, many sovereigns however, growing levels of undeployed capital for stated that liquidity management was an entirely alternative investments are being held in cash and new objective, with certain investment sovereigns money market funds, so that sovereigns can respond responding by creating tactical allocations to cash quickly when real asset opportunities arise. These and money market funds. This has led to conflicting highly liquid investments offer limited returns, liquidity requirements: sovereigns have to manage particularly in comparison to sovereign targets for withdrawal risks by shortening time horizons while real asset investments, causing further growth in simultaneously seeking to access illiquidity premia the return gap. to generate greater returns. Fig 5. Expected new funding and cancelled Investments (%AUM) • New funding • Cancelled investments Sovereign sample Investment sovereigns Liability sovereigns Liquidity sovereigns Development sovereigns 2015 2016 2017 2015 2016 2017 2015 2016 2017 2015 2016 2017 2015 2016 2017 37 56 58 9 10 10 17 26 27 14 6 8 7 14 13 0 Sample is based on sovereign ewestors and excludes central barks. Sarrcle sizes shown in grey. Data is not weighted by AUM. Periods shown reflect past year new funding/cancellations. 09 EFTA00812117 Fig 6. Change in past year allocations by asset class (% citations) ■ Decrease ■ Stay the same ■ Increase Global equity 2013 52 24 24 2014 20 46 34 2015 12 52 36 2016 20 55 25 2017 13 63 23 Home market equity 2013 40 30 30 2014 18 41 41 2015 23 50 27 2016 25 57 18 2017 23 67 10 Global bond 2013 55 27 18 2014 25 64 11 2015 22 63 16 2016 23 65 13 2017 17 69 13 Home market bond 2013 42 25 33 2014 45 45 10 2015 53 47 2016 36 57 7 2017 25 73 3 Sample is based on sovereign investors and excludes central banks. Sample: 2013=22, 2014=36, 2015=33.2016=44, 2017=60. 10 EFTA00812118  Uncertain market direction has challenged response to return gaps through asset allocation Political change across developed markets challenges high conviction geographic allocations outside a small number of perceived 'safe haven' markets. Similarly, the staggered shift to OT is creating uncertainty over sovereign forecasts for asset class performance. Additionally, in many cases allocations to illiquid assets were approaching restrictions put in place by investment boards, with little room to further tilt to risk classes. Such uncertainty over investment strategy means that very few sovereigns are willing to adjust strategic asset allocations, and internal restrictions are a challenge to those that are seeking to change. This can be seen in figure 6, in which an increasing number of sovereigns state they have 'frozen' asset allocations to traditional asset classes. A focus on business model to drive implementation efficiency and liquidity premium capture As willingness to take active positions in geographic and asset allocation decreases, the effects of the return gap are compounded. Sovereigns are unable to respond to growing shortfalls through asset allocation alone, and are instead looking at how to evolve their business models to drive more efficient realisation against portfolio objectives, notably through internalisation or investment partnerships to reduce management cost and improve placement efficiency. However, sovereigns acknowledged that any changes to business models carried trade-offs against execution and investment risk: - Many respondents have struggled to reach target alternative allocations and the shift to internalise or move to co-investment or operating partnerships may create further constraints - Over-investing in privately listed assets puts sovereigns at risk of future valuation adjustments while utilisation of alternative deployment models (working directly with operating partners) has implications for governance processes and disclosure - Reducing intermediation while potentially improving line-of-sight to placement also reduces external objective inputs to asset selection and valuation - Finally, the tilt to internalisation may not be consistent with geographic diversification objectives, and there is some evidence of an increasing 'home market' bias despite stated objectives to the contrary While the motivation for business model changes is clear and aligned, there is an acknowledgement amongst participants that not all sovereigns will be successful in executing, with the potential for risk or investment shocks where execution is unsuccessful. As willingness to take active positions in geographic and asset allocations slows, sovereigns must engage with investment boards to include consideration of market conditions (as well as potential outflows) in their return targets to continue to work towards their long-term objectives. With limited scope to act through allocation sovereigns are focused on alternative levers. ll EFTA00812119 Increasing appeal of perceived 'safe haven' ma Geopolitical uncertainty is leading to a focus on perceived 'safe haven' international markets and home markets. • EFTA00812120 Construction of subway system extension, New Yak EFTA00812121 Sovereigns are targeting markets offering security g 7. Attractiveness of markets to sovereign investors and growth Traditionally sovereigns have grouped countries by economic development or geographic region to form their overall geographic allocations. Indeed, last year, we highlighted increased allocations to North America, based on perceptions of the US as a 'safe haven' for sovereign assets, driven by the strength of its currency and positive tax changes for international investors. While at a high level, sovereigns have been unwilling to adjust regional allocations (as outlined in theme 1), idiosyncratic geopolitical risks are causing sovereigns to reweight to countries within these allocation bands. In developed markets, uncertainty over global interest rates is shifting this focus to identifying markets to shelter assets (as shown by the increased attractiveness of the US and Germany in figure 7), with Brexit and the US election cited as the factors of fastest growing importance to asset allocation (growing importance cited by 82% and 68% of sovereigns respectively). Similarly, emerging markets sovereigns are identifying countries with the greatest potential for long-term economic growth. is based on sovereign investors and excludes central banks. on a scale from 1 to 10 where 10 is the most attractive. Rating scored as of O1 of the given year. 2015=26. 2016=44. 2017=58. Sovereigns are seeking greater exposure to perceived 'safe havens' within each key region. 14 EFTA00812122 15 EFTA00812123 Growth of the US for both returns and protection Currency strength The attractiveness of the US has been driven by underlies optimism interest rate rises (with expectations for further raises for the US. this year) and bond yields lagging in other developed markets (figure 8). There is also market confidence of a 'pro-business' corporate tax regime following Trump taking office in January 2017, causing sovereigns to note the growth potential of US equity markets (with 40% of sovereigns expecting to increase North American allocations in 2017), as other developed market stocks remain flat. Currency strength underlies this optimism (USD up 3% against EUR and 20% against GBP in 2016'), with some sovereigns deliberately targeting dollar exposure through their international investments. Liability sovereigns noted the dual benefit of the open currency position, both eliminating hedging costs and generating additional returns relative to home market currency. In our 2015 sovereign study, we highlighted the attractiveness of real estate investments in developed markets. Under FIRPTA (Foreign Investment in Real Property Tax Act), sovereign appetite for real estate investment in the US has further grown. Most notable, however, is the growing optimism around the potential for new infrastructure deals in the US following political campaigning suggesting an investment opportunity of US$1 trillion. Despite positivity, sovereigns in Europe and Asia noted that successful US real estate investments gave no guarantee of similar opportunities within infrastructure. Many respondents were concerned about growing protectionism in the US, questioning if it might both limit access to infrastructure and real estate investments for foreign sovereigns and would have long-term economic implications as foreign relations are strained. 'Source: XE currency data. Data from 01January 2016-01 January 2017. Fig 8. 10-year government bond yields US UK Germany Japan 2.5 1.3 0.2 0.0 Source: US - US Treasury Resource Center, UK - Bank of England Data, Germany - Bundesbank