Sovereigns reign best on 3-legged stool

The optimal asset allocation for Sovereign Wealth Funds is a state-dependent allocation to three building blocks: a performance-seeking portfolio, an endowment-hedging portfolio, and a liability-hedging portfolio, according to research conducted by the EDHEC-Risk Institute.

The conclusion from the first year of research work conducted at EDHEC-Risk Institute within the Deutsche Bank research chair on asset-liability management techniques for sovereign wealth fund management, highlights the need to hedge against the risk emanating from fluctuating revenues to the fund.

The research, in an empirical application, investigates the composition of a revenue-hedging portfolio for an oil-based sovereign fund.

The paper, “Asset-Liability Management Decisions for Sovereign Wealth Funds”, proposes a quantitative dynamic asset allocation framework for sovereign wealth funds, modelled as large long-term investors that manage fluctuating revenues typically emanating from budget or trade surpluses in the presence of stochastic investment opportunity sets.

According to the research, the optimal asset allocation strategy takes into account the stochastic features of the sovereign fund endowment process (where the money is coming from), the stochastic features of the sovereign fund’s expected liability value (what the money is going to be used for) and the stochastic features of the assets held in its portfolio.

The results suggest the investment strategy for a SWF should involve a state-dependent allocation to three building blocks.

The first is a performance-seeking portfolio (typically heavily invested in equities).

The second is an endowment-hedging portfolio (customised to meet the risk exposure in the sovereign wealth fund endowment streams).

The third is a liability-hedging portfolio (heavily invested in bonds for interest rate hedging motives and in assets exhibiting attractive inflation-hedging properties, when the implicit or explicit liabilities of the sovereign wealth funds exhibit inflation indexation).

As well, there would be separate hedging demands for risk factors impacting the investment opportunity set, most notably interest rate risk and equity expected return risk.

The paper says the endowment and liability-hedging portfolio building blocks must be customised to meet the tailored needs of each specific sovereign wealth fund, but it applies the model to an oil-based sovereign fund with inflation-linked benchmarks.

The researchers conduct an empirical analysis of the oil and inflation-hedging properties of several traditional and alternative asset classes that can be ingredients within this building block using a restricted vector auto-regressive (VAR) model.

“Overall, it appears that the development of an asset-liability management analysis of sovereign wealth funds has potential important implications in terms of the emergence of new forms of financial engineering techniques for the design of customised building blocks aiming at facilitating the implementation of genuinely dedicated ALM and risk management solutions for these long-term investors,” it concludes.

A number of implementation challenges remain, the paper says, including the need to reconcile the top-down asset allocation decisions with bottom-up security selection decision.

Equity biases, such as the recent overweight to financials, need to be quantitatively measured and optimised. It suggests the use of index futures as a cost-effective vehicle for dynamic adjustment of portfolio exposure to market risk.