Sovereign wealth funds have become an increasingly important group in the hedge fund space in recent years, largely due to the resources available to them and hence their ability to deploy large sums of capital. These investors typically have higher risk profiles than other institutional groups and therefore tend to build more sophisticated hedge fund portfolios. Despite accounting for less than 1% of all active hedge fund investors on Preqin’s Hedge Fund Investor Profiles online service, sovereign wealth funds represent 11% of all institutional capital invested in hedge funds.
It has been noted, however, that the Volcker Rule, due to come into effect in July 2015, may have an impact on sovereign wealth fund allocations to hedge funds going forward. The Volcker Rule essentially places restrictions on banks and bank holding companies in terms of proprietary trading and investments in hedge funds and private equity. Through the legislation’s broad definition of a bank holding company, several sovereign wealth funds could be caught up in the legislation as a result of their involvement with US-based banks.
China Investment Corporation (CIC) is one such institution that may find it hard to maintain its current hedge fund exposure. CIC is a large allocator to hedge funds, with a current allocation to the asset class of approximately $23bn, and represents a significant proportion of sovereign wealth funds’ net commitment to hedge funds. CIC’s dilemma stems from its controlling ownership in several Chinese banks, effectively classifying it as a bank holding company. More specifically it has ownership stakes in Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Nanyang Commercial Bank of Hong Kong, all of which have operations in the US. These holdings may prohibit CIC from investing in hedge funds based in the US, or non-US funds with US stakeholders. Its existing activity in the asset class includes a number of US-based managers, including Blackstone, Capula, Morgan Stanley and Oaktree, all of which could be affected.
Singapore’s sovereign wealth fund, Temasek Holdings, may also fall into a similar situation to CIC due to its controlling interest in DBP Bank, which also has operations in the US. Temasek’s dilemma is likely to be more muted, however, due to its preference for Asia-based managers. Although if any of its non-US managers have US backers then it may be forced to redeem them.
Theoretically, there are a number of options for sovereign wealth funds whose investments in hedge funds look likely to be affected by the Volcker Rule. One option may be to operate funds in separate accounts with external managers that do not take part in proprietary trading. Although this may be difficult to achieve in practise, as the fund would have to follow a separate strategy to the main fund, as well as having justification for its existence. It remains to be seen how the final version of the law, which is still being adapted, will affect the sovereign wealth funds caught up in it and there may still be an exemption which allows these investors to continue investing in hedge funds.
Despite these issues caused by the Volcker Rule, they seem to be isolated incidents and sovereign wealth funds will remain important for the hedge fund industry moving forward. It is interesting to analyse the effect that this ruling could potentially have on not just sovereign wealth funds, but potentially other large foreign investors with holdings in large US banks. This could be an extraneous effect the legislators try to clear up as the Volcker Rule continues to be revised.