What is a Sovereign Wealth Fund?

A sovereign wealth fund is a nation's investment account, comprised of surplus funds but separate from the reserves the nation maintains for fiscal management purposes. Although the name “sovereign wealth fund” was first used in 2005, the funds themselves have existed since about the middle of the 20th century. The first such fund, the Kuwait Investment Fund, was started in 1953, before that nation had even achieved its independence from Great Britain. The determining factors of whether a nation has a sovereign wealth fund are whether it has excess cash and the political will to save it.

While most sovereign wealth funds are created as the result of a budget surplus, they can come from a variety of sources. Kuwait's, for instance, was started with excess revenues from its state-owned oil drilling enterprise. When a nation is faced with an excess of cash, it has a number of options as to its disposition, but these options essentially reduce to spending or saving. Spending can take many forms, such as capital or operational spending, paying down debt or distribution among taxpayers. Although spending is politically popular, it can sometimes be fiscally irresponsible. Nations whose economies depend largely on the export of raw materials, for example, are prudent to establish a reserve against a falling market. Others may establish a sovereign wealth fund for a specific purpose, such as the Government Pension Fund of Norway.

Sovereign wealth funds are invested, sometimes as a hedge against the nation's customary source of revenue. For example, the United Arab Emirates' (UAE) sovereign wealth fund, started in 1976, was funded with excess revenues from oil operations. Part of its portfolio is dedicated to diverse investments other than oil, as a hedge against an uncertain future in that market. Sovereign wealth funds are not immune from questionable investment decisions, though, and several lost value in the sub-prime mortgage debacle of the early 21st century.

Sovereign wealth funds are of immense strategic importance for a number of reasons. A rogue nation with a large sovereign wealth fund could use it to destabilize markets, for example. Any nation might use its sovereign wealth fund to protect or advance its own strategic interests, for example, accumulating currency or debt from certain nations so as to compromise their financial integrity or their ability to defend themselves. Many nations, expressing concern about this power of sovereign wealth funds, have enacted legislation limiting foreign investment, or requiring official approval of foreign ownership of domestic businesses above a certain percentage.

Although some sovereign wealth funds are maintained as separate entities, others are operated by their nations' central banks as part of their overall economic management strategy. Funds held and managed in this manner usually are of significant importance to the nation's economy, and significant losses to the fund, such as happened during the sub-prime lending crisis of the early 21st century, can have an impact on the nation's economy. When the fund is operated as a separate entity as an investment fund, however, the impact of the fund's performance on the nation's economy is diminished.