Sovereign Wealth Funds in the New Normal

• Author: Mohamed A. El-Erian
• Position: Chief Executive Officer and co-Chief Investment Officer of the global investment management company PIMCO. This article expresses the opinions of the author, but not necessarily those of PIMCO.

SOVEREIGN wealth funds, essentially state-owned investment entities with long time horizons, are among the investors best equipped to navigate financial markets after the global crisis. Yet they too face potential challenges in steering a course through what is likely to be a multiyear, bumpy resetting of the global economy.

How sovereign wealth funds confront these challenges will speak directly to their effectiveness in investing national wealth to benefit current and future generations. It will also affect their contributions to stabilizing a fluid global economy that will experience significant multiyear changes in the systemic drivers of growth, employment, wealth, and welfare creation.

This article considers three key topics: where sovereign wealth funds stood on the eve of the global financial crisis, where they stand today, and future implications.

As the crisis broke

Three main factors defined where sovereign wealth funds stood as a group in the run-up to the most acute phase of the recent global financial crisis and the worldwide economic and sociopolitical dislocations that followed:

Each of these factors was deemed consistent with delivering higher risk-adjusted returns over time. They also reflected the then-widespread view—held both in the private and public sectors—of a cyclical and secular “great moderation” in the economic and policy realms. “Goldilocks” (as in “not too hot, not too cold”) became the one-word bumper sticker for this period.

Like virtually every sector of the financial and policy worlds, sovereign wealth funds as a whole were caught off guard by the disruption in global liquidity and funding that followed the disorderly failure of the Wall Street investment bank Lehman Brothers in September 2008. Virtually overnight, and as a cascading number of markets seized up, investors around the world were hit with dramatic repricing in all risk factors—particularly liquidity. As a result, markets around the world experienced varying, yet notable, degrees of a sudden stop.

With the global financial services sector at the center of the storm, the direct holdings of sovereign wealth funds in financial companies came under particularly intense pressure—especially as some of the funds had moved earlier to inject capital into major Western banks. Meanwhile, rather than continuing to receive large new inflows, some sovereign wealth funds found themselves under pressure to support other national (and, in some cases, regional) entities that were facing sudden and acute cash needs.

Investment returns vanished

As a result, there was a dramatic change for sovereign wealth funds during the six-month period that ended in March 2009: investment returns turned dramatically negative; cash, collateral, and counterparty management became even more acute priorities for risk management; some isolated liquidity pressures emerged; and major strategic decisions were postponed until there was greater clarity about the global financial system and where it was headed.

More generally, the seizing of global markets generally caused a pause in the longer-term evolution of asset-liability management in emerging economies—a process that had...