Limitations of Sovereign Wealth Funds

Although sovereign wealth funds have been lauded as investment vehicles to ensure the

prosperity of the nations given their size and horizon, there are three major limitations.


First, incentives may not be so aligned between the sovereign wealth fund professionals

and the nation. The investment horizons are quite long at least ten years, and the

investment professionals who engaged in the investment may be gone by then or off the

hook by simply saying no one can predict the future. Also, sovereign funds are large and

do not face immediate redemption, which may lead professionals to take either

excessive risks or be less careful in the due diligence, since the consequences are not

as severe compared to a fund that might face immediate withdrawals in case of

underperformance. Plus, sovereign wealth fund professionals also face a revolving door

problem, where they could get paid more by funds, leading to conflicts of interest.


Second,sovereign wealth funds are extremely huge. Such size gives a lot of leveraging

power during investment negotiations but it is also a huge obstacle. Given the size,

sovereign wealth funds cannot invest in assets that are too small. For instance,

sovereign wealth funds cannot invest much in small stocks because it may literally buy

up a huge portion of the small stock market, becoming a market itself. In addition, the

sovereign wealth fund cannot be nimble, it takes a long time to unwind positions. If they

sell or buy too quickly the market might move too much and quickly, resulting in losses.

Hence, it lacks investment flexibility.


Third,  sovereign wealth fund may be affected by politics. Sovereign wealth funds are

generally independent and immune from politics but when things go bad politicians will

demand certain changes in strategies, which may be either suboptimal or catastrophic.


Overall, sovereign wealth funds are a good attempt to utilize the nations' capital more

efficiently; however, it is important to be aware of their limitations. In essence, sovereign

wealth funds may help with the nation's prosperity (a bit) but it is no gold-egg laying

goose.




*From Snapshot Serengeti