Sovereign investors are adapting their portfolios to the new macroeconomic environment, characterised by sticky inflation and rising geopolitical and climate risk, according to the eleventh annual Invesco Global Sovereign Asset Management Study.

The swift rise in interest rates and sharp correction in listed asset prices led most sovereign wealth funds to report negative returns for 2022, and the vast majority (86%) anticipate inflation to be higher in the coming decade than in the last. In response, many are fundamentally rethinking the way they invest in fixed income and private assets, alongside a renewed interest in emerging markets.   

Invesco's study, which has become the leading bellwether for sovereign investor activity, is based on the views of 142 chief investment officers, heads of asset classes and senior portfolio strategists at 85 sovereign wealth funds and 57 central banks, who together manage $21 trillion in assets.  
Rethinking fixed income 

Fixed income is the asset class sovereigns are most likely to increase in their strategic asset allocation over the next 12 months, with a 28% net allocation intention surpassing infrastructure (25%), private equity (21%), listed equities (15%), and real estate (9%).

However, fixed income's failure to shelter portfolios from the 2022 asset price correction has changed the way sovereign investors perceive the asset class.

Rather than a ‘set and forget' position for diversification purposes, they now favour a more active and tactical approach, creating value by actively rebalancing across different fixed income segments and utilising a wide range of strategies, similar to listed equities. Alternative fixed income segments can therefore play a greater role, with private credit, high yield and infrastructure debt seen as the most attractive options. 

Historically categorised as private equity by many sovereign investors, private credit has now matured into a distinct asset class, often supported by dedicated investment teams. Investors have been attracted by the funds' favourable risk-return profiles and high liquidity levels, as well as the transparency of the holdings and good levels of diversification within funds, as most are large-scale and invest in a wide range of issuers. 

"Although average returns in 2022 were negative, there was significant variation within these results", said Rod Ringrow, Head of Official Institutions at Invesco. "The better performers were those that recognised the risks posed by inflated asset prices and were willing to make substantial portfolio changes. The key lesson from 2022 was that sovereigns need to be prepared to demonstrate greater flexibility and responsiveness to market conditions."
Increased appetite for emerging markets 
The higher interest rate environment has prompted a renewed appetite for emerging markets. 
In recent years, as developed markets' asset prices soared amid negative real rates, many funds found little need to pursue the extra research and risk associated with large emerging market allocations. However, the normalisation of higher rates looks set to change this, and many sovereign investors commented on increased resilience, institutional strength, and stability in key emerging markets. 71% of sovereigns expect emerging markets to either match or better the performance of developed markets over the next three years. 
Almost a third (29%) of investors intend to increase their allocations to Emerging APAC in 2023, making it the joint most popular region alongside North America, and well ahead of Developed APAC (15%), Developed Europe (14%), and the Middle East (8%). At 22%, Latin America was the second most popular region overall. 
India continues to be seen as a leading market: 76% of investors see it as an attractive opportunity for emerging market debt in 2023, well ahead of its closest competitor, South Korea, at 56%. Mexico (51%), Brazil (49%), Indonesia (44%) and South Africa (41%) have all seen significant year-on-year increases in their perceived attractiveness.2 
A more selective approach to private assets
Sovereign investors remain interested in private assets, with infrastructure seen as the overall most attractive asset class over the next five years, ahead of fixed income, private equity, and listed equity. 
Within infrastructure, there is considerable interest in renewable energy generation: 81% of sovereigns see it as an attractive area, followed in second by energy transmission and supply (65%). This was in part caused by the war in Europe and energy crisis that followed, which triggered a global surge in renewable infrastructure demand. 
The valuation correction in 2022 revealed performance disparities across private assets, which has brought about a more selective approach. Investors are now more cautious about highly leveraged deals, with almost half of sovereign wealth funds reporting being dissuaded from recent real estate (48%), private equity (49%) and infrastructure (43%) deals due to unappealing debt structures.  
Real estate is currently perceived to be the least attractive private asset segment, mainly due to challenges in the office and retail sectors. Many sovereign wealth funds heavily exposed to these sectors have sought diversification in areas such as industrials, healthcare and data centres, which have risen in popularity due to the growth of digital technologies and remote work. 
The price correction has had little impact on the attractiveness of private equity, with just 13% of sovereign investors seeing private equity as less attractive than before. More than a third (34%) see it as more attractive, and the majority (53%) observe no impact. 
"Challenges notwithstanding, for many sovereigns the global economy remains fundamentally resilient and expected returns across asset classes are higher than in recent years", continued Ringrow.  
"This year's data, however, reveals a misalignment between sovereign wealth funds and central banks on interest rate expectations over the next two years. Sovereign wealth funds are far more likely to expect real interest rates to trend downward, albeit remaining higher than in the last decade, while central banks are more likely to expect them to trend upward. This further underscores the importance of a watchful and flexible approach."
A new generation of sovereign wealth funds  
The last decade has seen a surge in new sovereign wealth funds: since 2012, 27 new funds have been created, with Africa (11) and APAC (7) accounting for the majority.  
Most are development funds, set up to drive economic growth and diversification. Many funds are also focused on the energy transition and, for some, this has become the leading development objective. In total, 65% of funds with development objectives aim to facilitate the energy transition, making it the most commonly held objective, ahead of employment (59%), GDP growth (57%) and social objectives, such as health and education (57%).  
The challenge for new funds is building credibility alongside their more-established peers. Demonstrating strong levels of governance will be key, alongside fact-finding partnerships with other funds and experienced asset managers to help build on their skills and knowledge.
Leading the energy transition 
Sovereign investors are now more resolute than ever in their ambitions to fund the energy transition. Respondents asserted that the ramifications of climate change (66% of citations) and the financial cost of the energy transition (53% of citations) are two of the three most significant risks to global growth over the next decade, behind only rising geopolitical risk. 
Between 2017 - 2023, the number of sovereign wealth funds with ESG policies grew from 46% to 79%, and from 11% to 59% for central banks. The increasing significance of ESG initially stemmed from climate-driven long-term risks to returns - in 2020, ‘improving returns' and ‘reducing risk' were primary motivations for adopting ESG policies. The Russian invasion of Ukraine, however, underscored the importance of energy security and prompted even greater urgency, with this year seeing the fastest rate of ESG adoption among both sovereign wealth funds and central banks. 
"With the energy transition taking precedence, we see sovereign investors concentrating more on green infrastructure and green bonds," said Ringrow. "Those sovereigns with extended investment horizons are increasingly considering direct investments in green infrastructure as a means of maximising impact. In particular, investment, liability, and development sovereign wealth funds all deem ‘direct investment in green infrastructure' as the most crucial method for financing the energy transition."