A new report by Merrill Lynch (MER) Global Research says that assets under management in Sovereign Wealth Funds (SWFs) could grow more than four-fold by 2011, surging from US$1.9 trillion to US$7.9 trillion. The research report, titled “The overflowing bathtub, the running tap and SWFs,” states that a massive build up of reserves at central banks is fueling this rapid growth, led by China, Russia and the Middle East.

Merrill Lynch economists expect this wave of extra liquidity to benefit world financial markets. Sovereign Wealth Funds (vehicles mandated by governments to manage reserves) are likely to direct far greater allocations towards riskier assets such as equities and corporate bonds with cumulative net flows of US$3.1 trillion to US$6 trillion into these asset classes. SWFs are also likely to mandate external fund managers to invest the bulk of their assets – providing a major structural boost for the global asset management industry.

“Investors should rejoice in the more balanced global economy and the impetus that SWFs will provide to continued growth and development of global asset markets,” said Alex Patelis, head of international economics at Merrill Lynch. “The impetus from these flows underpins continued growth of global asset markets, and the use of external managers should lessen what we see as overblown fears of protectionism.”

SWF’s share of “riskier” global assets to triple

SWFs should grow annually by US$1.2 trillion in assets over the next five years, the research report says. Merrill Lynch economists expect SWFs to double or triple their share of riskier global assets (equities and non-sovereign bonds) by 2011. In 2006, government authorities controlled 5% of global assets in riskier assets. Merrill Lynch forecasts SWFs will control 16% of this segment by 2011. In the near term, the Middle East should dominate inflows into riskier assets, with Russia and Asia following.

Billions of dollars in further global asset management fees

High costs and difficulties associated with setting up internal portfolio management teams, together with the risk of a protectionist backlash, point towards extensive use of external asset managers. Merrill Lynch economists forecast a shift of US$1.5 trillion to US$3 trillion, which could generate fees of US$4 billion to US$8 billion. The research report highlights how in the case of one early adopter, Norway, internal managers are responsible for only 39% of overall risk in its US$360 billion of assets.

Merrill Lynch’s growth projections assume that central bank reserves, currently growing at a rate of US$1 trillion per year, will increase by $2.7 trillion by 2011. Even if central bank reserves remain flat, SWF assets would reach US$5 trillion.