Considering SWF assets within wider sovereign context

Integrating a sovereign wealth fund (SWF) into total sovereign assets and liabilities, instead of focusing on SWF asset allocation in isolation, will impact optimal sovereign asset management, according to new research by the EDHEC-Risk Institute.The paper, An Integrated Approach to Sovereign Wealth Risk Management, examines the implications of moving from a SWF-centric framework to an asset-liability approach integrating sovereign assets and liabilities.

This approach “uniquely incorporates the economic balance sheet of the sovereign sponsor into the optimal asset allocation problem of the sovereign wealth fund, in a way that is similar to recent advances in corporate pension fund investing, that consider the fund an integral part of the corporate balance sheet and jointly analyse capital structure and pension fund allocation choices,” the paper states.

Importantly, it makes economic leverage an integral part of the SWF optimal asset allocation problem.

According to director of the EDHEC-Risk Institute in Asia, Frederic Ducoulombier, this offers interesting insights into optimal asset allocation given different drivers of economic risk and sheds light on the impact of sovereign leverage – determined by the ratio of existing debt and contingent liabilities to foreign reserves and sovereign assets – on optimal investment choices.

The paper, written by Bernd Scherer, professor of finance at EDHEC business school, looks at the impact on asset allocation of moving from an SWF-centric framework to an asset-liability approach integrating sovereign liabilities.

So instead of focusing on SWF assets and liabilities in isolation, the SWF is now integrated into total sovereign assets and liabilities. It argues that the size of local and foreign-currency denominated debt, relative to foreign reserves and sovereign assets will, for example, determine sovereign leverage and is expected to have a material impact on optimal sovereign asset management.

The paper acknowledges that from a bottom-up view of a SWF portfolio manager it could be argued a SWF lacks dedicated liabilities, but from a top-down view of a sovereign risk manager it does.

“In the past asset allocation for sovereign wealth funds has focused predominantly on optimal portfolio choice with non-tradeable wealth. Within that framework they allocate to a combination of minimum-variance portfolio, speculative demand portfolio, and hedging-demand portfolio,” the paper says.

By incorporating SWF asset allocation into a more holistic framework, the paper shows that economic leverage will reduce speculative demand but leave hedging policies set against fluctuations in the net fiscal position of the sovereign state unchanged.

It also shows that allowing for optimal dynamic decision-making will increase the amount of equity risk a SWF can take.

Finally, it concludes that narrow tactical asset allocation ranges limit the SWF’s ability to manage its risks.

The paper forms part of the EDHEC-Deutsche Bank research chair on asset liability management techniques for sovereign wealth fund management. Under the responsibility of the scientific director of EDHEC-Risk Institute, Lionel Martellini, this chair examines the optimal allocation policies for sovereign wealth funds.

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