Sovereign wealth funds (SWFs) have raised their exposure to alternative investments, including private equity, real estate, gold and infrastructure, from 19% of total AUM in 2010 to 23% by 2016, according to research by PwC.
In a report, entitled The rising attractiveness of alternative asset classes for sovereign wealth funds, PwC noted the majority of SWFs had previously followed a strategy focusing largely on fixed income, but quantitative easing and falling interest rates in developed countries had reduced the attractiveness of these products.
As a result, the share of AUM invested in this asset class fell from a peak of 40% in 2013 to 30% in 2016.
Meanwhile, in line with the strong recovery in the stockmarket since 2009, SWFs' allocation to equities increased.
Driven by the desire to diversify portfolios and the hunt for yield, SWFs have also increased their exposure to alternatives, with PwC expecting this growth to continue in the future.
However, the report warned that many alternative asset classes have a number of risks attached, with the majority being highly illiquid.
Will Jackson-Moore, global head of sovereign investment funds and private equity at PwC, said: "We expect alternatives to be prominent in SWF portfolios in the future as they can offer increased diversification, principal protection, a hedge against inflation, and an increase in portfolio performance.
"That being said, finding the right allocation strategy for these asset classes is crucial as including certain alternatives might introduce a new set of risks such as illiquidity, complexity, and cyclicality.
"SWFs should keep in mind the need for continuous monitoring of their portfolios and their investments and reallocate their capital to reflect economic developments.
"But the benefits seem to outweigh the costs, as the varied nature of alternatives provides SWFs with the ability to select an asset class specific to their investment needs."
The report (which was written with the collaboration of The World Gold Council) also identified that gold is an "excellent diversifier" when examining the correlation of alternatives' returns with the S&P 500 index, presenting the lowest correlation on a five-, ten-, and 20-year basis (0.04, -0.05, -0.07 respectively).
It found that except for commodities returns and infrastructure, all other alternative asset classes are fairly highly correlated to equities.
Private equity has the highest correlation on a 20-year basis (0.75), while hedge funds show the highest correlation on a five- and ten-year basis (0.67 and 0.81).
Regarding correlations to bonds, however, private equity serves as a good diversifier on a five-year basis (-0.23) and real estate on a ten-year view (-0.35), according to the report.
While commodities in general are not correlated to bonds, gold has the highest correlation on a five-, ten-, and 20-year basis, it found.