Today, hedge funds are the bogeyman for every financial hiccup in the global financial system. Yet the impact of George Soros and company soon may be dwarfed by an even more secretive group of international investors flush with the cash that swings global markets. Who is this mysterious group? The rapidly growing group of sovereign wealth funds (SWFs) -- government-sponsored entities funded by the growing foreign exchange reserves of countries that range from Norway to China.

Awash in petrodollars and revenues from the commodities boom, the assets of SWFs may be already as high as $2.5 trillion. That number is growing by almost another $500 billion annually. Contrast that with the entire hedge fund sector's assets of $1.6 trillion. Morgan Stanley estimates that the size of SWFs could swell to $12 trillion by 2015. That's about the size of the U.S. GDP in 2005. How and where this massive -- and secretively managed -- pool of funds is to be deployed will have huge implications for financial markets in the decades to come.

Sovereign Wealth Funds: Bigger and Better Than Hedge Funds

For such a high-powered group, SWFs have a remarkably low profile. That's because they have emerged virtually overnight as their assets have exploded thanks to high commodities prices and large trade surpluses. In the 1970s, developing countries' foreign exchange reserves typically stood at 6-8% of GDP. Since the Asian financial crisis of 1997, this average has mushroomed to an average of 30%. Governments traditionally held a reserve of financial assets to prop up domestic currencies and support banks in times of crisis. Since they were emergency funds, the financial assets had to be both safe and liquid. That meant the governments kept holdings in precious metals, and later, in U.S. Treasuries.

That situation has changed in a blink of a financial eye. In the Middle East and China -- official reserves are now so astronomically high that governments can no longer justify the need for liquidity to manage currencies or unexpected economic crises. The success of Singapore's Temasek has inspired the global SWF club of countries -- including the likes of Botswana, Australia, Iran, Brunei and Kazakhstan -- to take a more active approach to investing foreign reserves.

Central bankers have begun to diversify financial holdings from precious metals, bonds, dollars and bank deposits into high-yielding, if less liquid, investments. Oil-producing countries, in particular, are keen to develop highly sophisticated national endowments to replace shrinking revenues from dwindling natural resources. Norway's giant $300 billion Government Pension Fund announced last month it would increase its exposure to global equities from 40% to 60%. Russia's finance ministry has split the country's $108 billion stabilization fund in two, with one half mandated to invest more in domestic and international equities.

The result? SWFs could rapidly become #1 players in the global financial market place. The implications are both unclear and frightening. There is no precedent for such a wall of money to find its way into global financial markets. Consider that the world's entire supply of shares is $55 trillion. Bonds account for a similar amount. SWF assets alone could account for a substantial percentage of this.

And as Andrew Rozanov of State Street Bank -- a regular attendee at the London Junto speaker series that I organize for investment professionals -- pointed out in the Economist this week, SWFs enjoy a natural advantage over hedge funds. Their ability to retain funds in perpetuity, combined with the lack of pressure to produce short-terms profits, allow the SWFs to exploit the benefits of volatility and liquidity unavailable to traditional hedge funds. That's the same kind of advantage that university endowments at Yale, Harvard and Stanford enjoy -- and which have allowed them to rank among the best-performing investment organizations in the world.

Sovereign Wealth Funds: China as the 800-Pound Gorilla

With $1.2 trillion in foreign-exchange reserves -- and the pool growing by more than $1 billion every day -- China is the potential 800-pound gorilla of the SWF world. With a current account surplus of $400 billion this year, China's reserves could expand to $1.6 trillion next year -- matching the size of the entire hedge fund industry alone. That amount could double again within four years.

Like most other central banks, China's assets have been largely parked in U.S. Treasury bonds. But China has recently announced the establishment of its own SWF -- the China Investment Corporation -- with a kitty of up to $300 billion. Its first investment? A $3 billion investment in the upcoming IPO of Blackstone, the New York-based private-equity firm. China's investment signals the dawn of a new age for Chinese investment abroad -- and one that will impact global capital markets for decades to come.

Sovereign Wealth Funds: The Great Unknown

The growing importance of SWFs and diversification into other markets is beginning to attract both worry and criticism.

First, there is the impact on U.S. Treasury bonds. The IMF estimates that central bank buying has depressed yields on long-term U.S. Treasury bonds by between 30 and 100 basis points. Sudden portfolio adjustments by, say, China's SWF, could lead to a collapse of U.S. bond prices, making it more expensive for the United States to finance its debt.

Second, there is the issue of transparency. Few SWFs give details of their operations. If monitoring the currency and asset compositions of official reserves is difficult, tracking the investments of SWFs is nearly impossible. Only Norway provides anything close to transparency. The Abu Dhabi Investment Authority (ADIA) seems to be the model for most SWFs. ADIA has a reputation as a highly professional organization with a diversified portfolio and a cadre of talented managers. Yet despite managing $875 billion, there are next to no public details on AIDA's operations. It makes the most secretive hedge funds look like an open book.

Without disclosure, funds can hide strategic objectives behind a veil of secrecy. Financial returns, political objectives, and securing strategic resources are all meshed together in an impenetrable web. China's deal with Blackstone is already raising red flags. Consider that CNOOC, China's state-controlled oil company, was blocked from acquiring Unocal for U.S. national security reasons. Yet by purchasing a stake in Blackstone, China will be able to bypass restrictions that might prevent it from having a stake in Unocal-style deals in Europe and America. Today's Darth Vaders of the global financial landscape, hedge funds may one day seem quaint and harmless in comparison.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru

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