Sovereign wealth funds, state-controlled investment entities funded by government cash surpluses, are casting an increasingly long shadow over global markets, causing no small concern among those whose livelihoods or incomes are closely tied to foreign-exchange movements.

Some of these funds have been around for many years, some are new kids on the block. Some are transparent in their goals and operations, others less so. In general, sovereign wealth funds are unlikely to be a force of instability in markets, most observers say, as they aren’t expected to behave like speculators. Then again, currency investors would do well to keep a wary eye on the opaque funds.

“Currency investors should be aware - not afraid - of sovereign wealth funds,” said Michael Maduell, president of the Sovereign Wealth Fund Institute, a research organization based in Roseville, Calif.

SWFs are undeniably a formidable presence in markets and their financial muscle is expected to bulk up further, thanks to a steady rise in their number as well as assets under control.

Estimates vary, depending on who’s doing the counting, but there are currently about 40 national SWFs that manage a combined total of nearly $3.7 trillion, according to the SWF Institute’s Web site, http://www.swfinstitute.org/funds.php. Some forecasts indicate that figure could grow to $12 trillion by 2015, due in part to more countries establishing such funds.

Their increased influence and size is one reason why the International Monetary Fund is developing a code of best practices for SWFs. The U.S. has already reached agreement with officials from Abu Dhabi and Singapore on sets of principles for both the funds and their recipients.

But while $3.7 trillion is a huge amount and far beyond the cumulative total for hedge funds and other short-term speculative players, it’s dwarfed by estimates that indicate $53 trillion in existing assets is “under management of mature market institutional investors,” according to the Norwegian Ministry of Finance.

So if currency markets aren’t spooked by the presence of big institutional investors, why do SWFs carry such an ominous aura? In part, it’s because they are generally seen as wanting to put their money into non-dollar assets, which would by definition hurt the greenback. Currencies are like any other commodity - when demand goes down for them, so do prices.

Variation Of Diversification Theme
This is a variation on the diversification-of-reserves theme that’s been haunting the dollar for quite a while. Some investors are very worried that central bank sales of dollars will trigger a crash-and-burn tailspin for the U.S. currency. So far, evidence at hand shows it’s an exaggerated fear and an unlikely future scenario.

Take the example of the two countries with the world’s biggest reserves, each with over $1 trillion. China has SWFs. Japan doesn’t, but has been taking steps to reduce the levels of its foreign reserve holdings.

“There has been no net dumping of dollar-denominated assets in recent months, and in fact we have seen an increase in total dollar holdings,” wrote Win Thin, senior currency analyst at Brown Brothers Harriman in New York, in a note.

His comments came following the release on 15 May of U.S. capital flow data for March by the Treasury International Capital system.

“It is clear that there has been no sign that either China or Japan are decreasing dollar holdings, but rather the data shows diversification by the two within U.S. securities,” he stated.

Japan’s total U.S. dollar holdings have increased $43.5 billion since June 2007 to $1.234 trillion, according to TIC data cited by BBH analysts. China’s total U.S. dollar holdings have risen $77.5 billion since June 2007 to $988 billion at the end of March, the same report said.

Perhaps some of the unfounded concern comes from a lack of familiarity with the operation of SWFs. One of the stated goals of some SWFs is to use excess reserves to obtain a better rate of return than possible through passive placement in U.S. Treasurys, but that doesn’t necessarily mean all U.S. assets will be shunned. Nor does it mean that the management of a country’s overall reserves will require a shift away from the dollar.

SWFs, Central Banks Aren’t Hedge Funds
Central banks aren’t hedge funds. Their mandate is to preserve their nations’ foreign reserves, not to maximize the returns on them. Although SWFs have more leeway regarding risk, they aren’t considered bold investors. They’re aiming for a somewhat higher yield than is possible with the most conservative investments, but they aren’t betting on extraordinary returns, either.

It’s also important to note SWFs haven’t suddenly jumped out from a financial market closet to become a bogeyman for forex players. The oldest SWF, belonging to Kuwait, has existed since 1953 and two of the largest, those of Abu Dhabi and Singapore, have been around for more than 30 years. According to most analysis in the public and private spheres, SWFs have so far shown themselves to be stable, long-term investors and absolutely not day traders.

The structure, nature and even national origin of these funds also contribute to their scariness. SWFs draw their funding from one of two sources: 1) commodity-related income, such as from oil; or 2) non-commodity income, usually resulting from current account surpluses and foreign-exchange policy. The Chinese, Singaporean and South Korean funds would be examples of the second category.

A handful of major funds, belonging to Abu Dhabi, Norway, Singapore, China, Saudi Arabia and Kuwait, account for about four-fifths of all SWF assets. While there’s a great deal of rumbling over the Chinese and Middle Eastern SWFs, nobody appears too worried about Norway or Singapore - even though Norway’s Government Pension Fund - Global is the world’s second-largest SWF with $380 billion under management.

Much of benign opinion regarding the Norwegian and Singaporean funds stems from their transparency, limited goals and the fact they are ultimately responsible to democratically elected governments. The goals and operations of many other funds are deemed as much more mysterious.

Any time you can’t see what’s behind a door, you’ll wonder what’s lurking there. And that’s why investors should be aware of the transparent SWFs, but perhaps beware of the opaque ones.