You need three different portfolios
Sovereign wealth funds are usually large long-term investors that manage revenues that typically come from a country’s budget or trade surpluses. Some estimates say they manage assets worth $4 trillion—or more than twice the estimated size of the world’s hedge fund industry. Deutsche Bank research suggests the total could reach $10 trillion within the next decade. They must also recognise the time-varying nature of the endowment process, liabilities, and the assets themselves.
An SWF’s investment strategy should include three building blocks. (The proportion of assets allocated to each of the portfolios will vary will vary dynamically depending on each country’s changing circumstances.)
Firstly there should be a performance-seeking portfolio (PSP). Typically this will invest heavily in equities. Secondly, SWFs should have an endowment-hedging portfolio (EHP) to protect against variations in revenue. Thirdly, a liability-hedging portfolio (LHP) is needed, to invest in bonds for interest rate hedging, and in assets that protect against inflation if liabilities are likely to increase in line with prices.
The first building block, the PSP, is the standard highest risk-reward component in any investor’s portfolio. But EHP and LHP building blocks must be tailored to meet the needs of each specific sovereign wealth fund. Sovereign wealth funds in oil-rich countries will have different patterns of revenue flows compared to their counterparts in countries with trade surpluses from manufacturing, such as China or Singapore. Inflation-linked benchmarks can add further complexity.
We use a restricted vector autoregressive (VAR) model to analyse empirically the hedging properties of traditional and alternative asset classes that can be used as ingredients within this building block.
Asset-liability analysis may well create demand for for new financial engineering techniques to help design these customised building blocks. The PSP-EHP-LHP approach extends the pension industry’s liability-driven investment approach to SWFs.
Challenges remain over implementation. They include the need to reconcile top-down asset allocation decisions with bottom-up selection of securities. Indeed, the asset allocation decisions analysed in our research relate to the design of the long-term strategic allocation for SWFs, with an associated optimal exposure to rewarded risk factors.
Additionally, it is legitimate for SWFs to seek alpha—returns that are higher than the market provides. They should consider taking strategic stakes in selected target companies. In fact, long-term equity holdings can be a natural source of alpha generation for sovereign wealth funds. SWFs are better placed to take advantage of temporary mispricing opportunities than hedge funds, for example, because they have for a longer-term investment horizon. And unlike pension funds, SWFs are unconstrained by regulators; they also have a bigger margin of error.
Additionally, it is legitimate for SWFs to seek alpha—returns that are higher than the broader market provides—or consider taking strategic stakes in selected target companies, or both.
However, such security selection decisions can lead to a strong bias—witness some sovereign wealth funds’ over-exposure to financial companies in recent years.
These unintended bets on market, sector, and style returns can have a very significant effect on portfolio return. That can be positive, or negative. These biases need to be measured and optimised. Alternatively, they can be adjusted through a completeness portfolio designed to fill in differences between portfolio allocation and the long-term strategic benchmark allocation. The biases of the completeness portfolio should complement and neutralise the biases of the main investments. In this context, index futures can be a cost-efficient way to adjust a portfolio’s exposure to market risk.
Our work can be extended in several directions. On the one hand, we need to understand better the composition of the endowment-hedging building block. For example, in the case of a sovereign wealth fund managing commercial surpluses, the endowment stream is related to worldwide economic growth. Those fluctuations are difficult or impossible to replicate with traded assets.
On the other hand, it is also important to account for short-term risk constraints which are faced by SWFs despite their long investment horizon. Many sovereign funds were built on the idea that they could hold on to investments for a long time. But some have had to pull back from investments abroad—even selling them at a loss—to finance investments at home. States are increasingly calling on their funds to bridge gaps in their housekeeping, or to finance economic stimulus packages. This, again, might make ill-timed divestments necessary.
This suggests that SWFs would also benefit from dynamic risk-controlled allocation strategies that are designed to help long-term investors meet short-term goals and constraints.
Finally, the approach that we propose needs to be extended towards the inclusion of other sovereign assets as well as sovereign liabilities. In particular, sovereign leverage is determined by the size of local- and foreign-currency-denominated debt—as well as contingent liabilities from pensions or industries—relative to foreign reserves and sovereign assets. That is expected to have a material impact on the best way to manage sovereign assets. •
Professor Lionel Martellini is scientific director of the EDHEC-Risk Institute and Dr Vincent Milhau is research engineer there. Deutsche Bank sponsored the research published as ‘Asset-Liability Management Decisions for Sovereign Wealth Funds,’ by EDHEC-Risk Institute.