GLOBAL - The investment strategy of a sovereign wealth fund (SWF) should consist of three basic building blocks, including liability hedging and an endowment-hedging portfolio, according to research by the EDHEC Risk-Institute.
In its most recent paper, ‘Asset-Liability Management Decisions for Sovereign Wealth Funds’, the business school says a fund’s investment strategy should include a state-dependent allocation of three building blocks.
It believes the three buildings blocks are a performance-seeking portfolio (PSP), an endowment-hedging portfolio (EHP) and a liability-hedging portfolio (LHP), with the latter investing heavily in bonds and other assets that closely trace inflation shifts.
EDHEC said that, with sovereign assets set to increase from $3trn (€2.2trn) to $10trn in the next decade, one of the challenges that remained was to optimise their investment strategies.
Report authors Lionel Martellini, scientific director at the EDHEC Institute, and Vincent Milhau, a senior research engineer, argued that because the sovereign wealth fund is “averse to uncertainty over terminal real wealth”, it is “optimal to hedge at least partially against inflation risk” by investing in a portfolio that best replicates the fluctuations of the price index.
They added: “If an inflation-indexed zero-coupon bond is available, the inflation-hedging portfolio will be fully invested in this bond.”
The authors said the first building block of any portfolio, the PSP, was a simple high-risk/reward component found in any investment strategy, while the EHP and the LHP had to be catered to the individual needs of each fund.
They also urged SWFs to be alpha investors, noting that the long-term holding strategy of equities can be a natural source of alpha exposure.
“SWFs are better placed to benefit from any temporary mispricing opportunity than hedge funds thanks to a longer-term investment horizon, and also better placed than pension funds thanks to higher margin for error and the absence of regulatory constraints,” they said.
However, they warned that such decisions could lead to a investment bias, witnessed by recent overexposure to the financial sector.
They added: “These unintended bets on market, sector and style returns are unfortunate as they can have a very significant - positive or negative - impact on the portfolio return.
“As a result, these biases need to be quantitatively measured and optimised.”