Sovereign investors have been allocating more of their funds to alternatives and away from core asset classes to improve returns in a challenging investment environment, but they are also moving toward in-house and co-investment opportunities. Together, these two trends give portfolio managers the chance to increase volumes, but possibly at the expense of margins, explain Nick Tolchard and Desmond Ng, co-chairs of Invesco Ltd. (NYSE:IVZ)’s Global Sovereign Group in a recent study.

Structural factors for sovereign investors

“There are both temporary and structural factors driving the growth of alternatives for sovereign investors and the structural factors make this theme particularly important,” they write. “For the asset management industry, this presents an opportunity to export its international capabilities even if providers are forced to manage a difficult trade-off between volume and margin.”

The survey found that 69 percent of sovereign investors (including sovereign wealth funds, central banks, and other government investors) have increased their holdings in real estate, and 61 percent have increased international private equity in the last twelve months relative to the size of their portfolio. Part of this shift is caused by dissatisfaction with the risk/return profiles available from equities and the impact of low interest rates on fixed income returns, but it’s also indicative of a change in its underlying strategy.

“Where sovereign investors adopt risk premium drivers such as growth, inflation, credit and liquidity, they have higher allocations to alternatives,” write Tolchard and Ng. “This is because alternative assets are often perceived as a way to achieve exposure to many of these drivers, such as property for liquidity and commodities for inflation.”

Sovereign Funds changing asset class demand

Western sovereigns allocations

Western sovereigns have allocated more of their portfolio assets to alternatives so far, but Asian and Middle Eastern sovereigns are increasing their exposure and have expressed interest in going further. “When you consider that the vast majority of sovereign investor assets are managed by sovereigns in Asia and the Middle East, the growth in sovereign alternative investments could be substantial,” write Tolchard and Ng.

SWF asset allocation by region

But this global shift will be at least partially funneled into co-investment and in-house structures instead of funds, with 36 percent of the survey’s respondents preferring them, so there will be intense competition between asset managers to get involved in these opportunities, putting pressure on margins.