SWFs to alter allocations for a more optimal portfolio

Sovereign wealth funds (SWFs) may allocate substantially more to equities if they consider
correlations between natural resources and financial assets in portfolio optimisation, according to State Street’s Vision Report, which also suggests SWFs consider becoming more active share owners as a consequence of the financial crisis.

As an end note to the Vision Report, recent research by State Street Global Markets shows a more holistic asset allocation approach for SWFs that incorporates a broader definition of assets and liabilities, including both the investment portfolio and the commodity wealth of countries in a total portfolio optimisation process, dramatically alters the asset allocation.

The analysis of a particular SWF, showed when the mineral wealth in the ground was included in the total portfolio allocation, the existing portfolio was rendered sub-optimal.

While the portfolio optimisation without the oil wealth called for a rather conservative mix of fixed income and some equity investments, the “total portfolio” optimisation called for a nearly 100 per cent equity allocation for the SWF’s investments.

However, as the relative weight of oil decreases and the financial portfolio increases over time the optimal allocation within the “asset portfolio” will shift from predominantly equity to a much more balanced mix of equity and bonds.

The Vision Report, Sovereign Wealth Funds Emerging from the Financial Crisis, also outlined other creative asset-liability modelling may include exploring whether some foreign assets currently residing in a domestic-debt-funded SWF might be optimally swapped against debt with the local government pension fund. This could move SWFs that are reluctant holders of reserves to shrink their balance sheets, while helping the pension fund expand its foreign allocation without significant market impact.

Meanwhile the report also suggested SWFs may consider more active involvement in their shares in which they invest, but to do so in a politically acceptable and market-friendly way, they need to consider joining forces with two other groups of market participants – other institutional investors, and activist hedge funds.

Issues that may force the alignment of interests among activist hedge funds and institutional investors like SWFs including composition, competence and independence of boards of directors, executive pay, merger and acquisitions.

“It is not unreasonable to expect that SWFs will gradually evolve to more closely resemble their large institutional peers in terms of active ownership and shareholder rights,” the report says.

Many SWFs were shying away from precisely such involvement when they decided to forego board representation and voting rights as they invested heavily in Western financial firms and banks in 2007 and early 2008.

The State Street Vision Report – written by John Nugee, head of State Street Global Advisors

Official Institutions Group; Andrew Rozanov managing director and head of Sovereign Advisory at State Street Global Markets; and George Hoguet, managing director and global strategist at State Street Global Advisors – examines how SWFs have weathered the financial crisis and how the current cliemate may affect their future behaviour.

It said SWFs are re-examining their investment choices and assumptions, including how they determine adequate reserve levels, the role of the state in local economies and attitudes toward riskier assets.

According to Rozanov one of the immediate consequences of the financial crisis is many SWFs that were moving into riskier assets in search of higher yields and diversification benefits have put these plans on hold and started to build large liquidity buffers.

This de-risking of investment programs has led to an increased appetite for traditional reserve assets, such as the US dollar and SU government paper.

Longer term one of the implications is that SWFs may need to consider the amount of dollar liquidity they need in times of distress.

SWFs are likely to conduct a thorough analysis of their asset allocation, portfolio construction and risk management approaches and assumptions. A new generation of risk models will emerge that use more robust scenario analysis.