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LONDON (Reuters) - The world's biggest sovereign wealth funds may see their bumper profits of 2012 diminish this year as recent diversification into high-growth emerging markets starts to produce disappointing returns.
Their long-term horizon may allow many sovereign funds, which globally control $5 trillion of oil and other windfall assets, to weather losses. But the sheer size of these funds may increasingly limit the window of opportunities even when emerging markets recover.
SWFs have piled into emerging markets, crucially via public equity and debt markets, which are cheap to invest in and big enough to absorb sizeable investments, rather than potentially higher-yielding private equity deals, which are often too small and labor-intensive to discover real gems.
According to Thomson Reuters data, the world's top 38 sovereign funds which globally invest nearly $900 billion in listed public equities allocate more than a third of the total to emerging markets at $383 billion, up 18 percent from mid-2012.
Emerging Asia and the Middle East, where many of these funds originate, grab the biggest shares of this pie at $227 billion and $140 billion respectively.
These assets, which benefited from cheap money from advanced economies, helped many SWFs clock up double-digit profits in 2012. But good times may be ending as emerging economies struggle to attract capital flows from the recovering West.
Early indications of that come from Norway, whose $760 billion sovereign fund allocates 10 percent of its equity portfolio in emerging markets.
Its emerging equity investments lost 5.9 percent in the second quarter, with the overall fund returning just 0.1 percent in the three months.
"(SWFs) are the ones who got involved but they were not in private equity. They owned public equities and bonds. That's the big distinction," said Stephen Jen, managing partner of London-based hedge fund SLJ Macro Partners.
"Because institutional infrastructure is so fragile and non-transparent in emerging markets, it's much better, risk-adjusted, for you to have a bigger presence in the company that you invest in. I can see with private equity how people make money in emerging markets if they are careful."
Just as many SWFs boosted their allocation, emerging markets suffered a sell-off. The benchmark MSCI emerging equity index .MSCIEF has lost 1 percent since January, while its developed counterpart .MIWO00000PUS gained nearly 19 percent.
Abu Dhabi Investment Authority said in May it is reducing target exposure to developed stocks to 32-42 percent from 35-45 percent. Its exposure to emerging stocks remains unchanged at a band of 10-20 percent.
Azerbaijan's $34 billion oil fund raised its emerging weighting to 13 percent last year from 9.5 percent and also added the Turkish lira and Russian rouble to its portfolio.
Similarly, funds from Singapore and Russia have said over the past year that they had boosted emerging assets at the expense of developed investments.
"They believe that emerging markets deliver performance over the long run in excess of the broader market ... They are willing to have an emerging market tilt, and the implicit assumption is they think they can weather the times when emerging markets do badly," said Andrew Ang, adviser to Norway's SWF and professor at Columbia Business School in New York.
"But emerging markets have a premium and it's not free lunch."
In the past three years, developed stocks have gained nearly four times more than their emerging cousins.
According to Institutional Investor's Sovereign Wealth Center, the 10 largest SWFs had around a quarter of their entire portfolio of various asset classes in emerging markets in 2012.
In principle, sovereign funds would be better off chasing illiquid but higher-yielding assets than passively investing in an index because they invest long-term for future generations.
In reality, however, digging out undiscovered gems in private or direct deals requires considerable groundwork and resources in a transaction which rarely exceeds $500 million, especially in emerging markets.
Public markets are bigger and liquidity makes them cheap to invest in. Market capitalizations of MSCI emerging equities stand at around $3.8 trillion, although they are tiny compared with the developed markets' $28.8 trillion.
According to CityUK, direct investments in all markets by sovereign funds fell to a six-year low of $57 billion in 2012, 46 percent below the peak level three years earlier.
SWFs have spent around $500 billion in direct investments since 2005, but they account for less than 5 percent of overall portfolios.
"There are economies of scale of being big. Those investment strategies involve passive indexing. Traditional active management is extraordinarily difficult if you have masses of money," said Ang, who is also a research associate at the U.S. National Bureau of Economic Research.
"In private deals, agency issues become of the first order. You need skills. Information is very poor. You can get screwed everywhere."
Editing by Stephen Nisbet