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Sovereign wealth funds must consider 'implicit liabilities', says EDHEC

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  • Sovereign wealth funds must consider 'implicit liabilities', says EDHEC

GLOBAL - Sovereign wealth funds (SWFs) must consider their implicit liabilities, according to a survey by the EDHEC-Risk Institute, which saw respondents arguing that liability-driven investment (LDI) approaches used within the pensions industry should be implemented by the funds.

Gathering responses to a previously published research paper on the issue of liability management within SWFs, EDHEC found that 70% of respondents were in favour of an asset liability management (ALM) framework, as it would allow for a better understanding of each fund's optimal investment policy, as well as risk management practices.

"More than half of the respondents (56%) agree there is a lack of dedicated ALM and risk management solutions for SWFs," said the paper, written by EHEC-Risk Institute Asia director Frédéric Ducoulombier and research engineer Lixia Loh.

"In particular, respondents think such issues have not been given much practical consideration or priority."

The survey, with respondents from sovereign wealth, state reserve and sovereign development funds, as well as central banks, found that 89% agreed that implicit liabilities should be managed, with the authors dismissing as a "common misconception" that such vehicles did not have explicit liabilities.

"In addition," the paper added, "the respondents agree that extending the liability-driven investing (LDI) paradigm developed in the pension fund industry to SWFs provides a better understanding of the optimal investment policy and risk management practices."

However, only 55% of all respondents agreed with EDHEC's initial assessment that a SWF investment strategy should consist of three building blocks - a performance-seeking portfolio (PSP), an endowment-hedging portfolio (EHP) and a liability-hedging portfolio (LHP) - as set out by the initial research.

"The respondents who do not agree that the building-block investment approach is appropriate for them feel that it may oversimplify asset allocation decisions," the paper said.

"They claim the investment strategy should be specific to the SWF's strategic investment objectives."

The authors added that these concerns could easily be allayed by allowing individual sovereign vehicles to customise the building blocks according to their own investment approach.

The research added: "Another obstacle mentioned by some respondents is that the ALM approach is generally viewed as a country-level approach, while SWFs may be managed separately from the rest of the state's asset and liabilities.

"This indicates there is a need to engage multiple stakeholders in the management of state assets and liabilities, as well as a need to conduct further research into solutions tailored to particular models of corporate governance.

"In fact, integrated ALM does not require giving a single entity control of all assets and liabilities."

The authors insisted the integrated ALM policy only required the mandate to be changed so that sovereign assets and liabilities outside of its jurisdiction were taken into account when designing investment strategy.

It concluded: "The general opinion expressed by the respondents is that the dynamic ALM approach has the potential to add value to SWF investment and risk management practices, and it should be explored by investors and their solution providers."

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