The Deutsche Bank "Asset-Liability Management Techniques for Sovereign Wealth Fund Management" Research Chair
EDHEC-Risk Institute has created a research chair in "Asset-Liability Management Techniques for Sovereign Wealth Fund Management", in partnership with Deutsche Bank, under the scientific responsibility of Lionel Martellini, Director of EDHEC-Risk Institute.
It is now widely recognized that sovereign funds represent a dominant force on international financial markets. By some estimates, the total size of sovereign wealth funds currently stands at $2.9 trillion, which amounts to approximately 60% of the world's foreign exchange reserves and exceeds the estimated size of the world's hedge fund industry (around $1.5-$2.0 trillion). The growth of sovereign wealth funds is in fact likely to continue, and is expected to reach around USD28 trillion by 2022, which is more than double the amount of FX reserves ($13 trillion), with their share in global financial asset holdings expected to grow from 2.5% in 2007 to 9.2% in 2022 (Morgan Stanley (2007)).
This rapid growth of sovereign wealth funds and its implications pose a series of challenges for the international financial markets, but also for sovereign states. The purpose of this research chair is to focus on improving our understanding of optimal investment policy risk management practices for SWFs. In particular, we ambition to analyse the optimal investment policy of a SWF in a dynamic ALM framework that will allow us to formalize the impact on the optimal allocation policy induced by the presence of risk factors affecting i) the state surplus dynamics and ii) the (implicit or explicit) liabilities the fund is facing.
Once the long-term strategic allocation has been defined, a number of implementation issues remain, in particular those related to reconciling a top-down asset allocation perspective and a bottom-up long-term security selection strategy. In fact, it is very legitimate for SWFs to seek long-term alpha opportunities, and/or consider reaching strategic stakes in selected target companies, an effort for which they are better equipped than hedge funds, which have a shorter time-horizon, or pension funds, which have lower risk budgets/margins for error and are subject to a number of short-term regulatory constraints.
This research programme will include the following developments:
- Introducing a formal dynamic asset allocation model that will incorporate the most salient factors in SWF management
- Proposing an empirical analysis of the risk factors impacting the inflows and outflows of cash for various sovereign funds, with a specific example in each of the two main categories (foreign reserve fund and natural resource fund)
- Discussing how investment banks and asset managers could design dedicated solutions for SWFs based on the financial engineering of customised building blocks aimed at facilitating the implementation of the intertemporal hedging demands related to the presence of a variety of risk factors impacting sovereign surpluses (where the money is coming from) and liabilities (what the money will be used for).
What Asset-Liability Management Strategy for Sovereign Wealth Funds?
Frédéric Ducoulombier, Lixia Loh, Stoyan Stoyanov
This publication presents the industry reactions to the EDHEC-Risk Institute study entitled “Asset-Liability Management Decisions for Sovereign Wealth Funds”. That study put forward a model to optimise the investment and risk management practices of sovereign wealth funds, which can be regarded as the extension to sovereign wealth funds of the liability-driven investing paradigm recently developed in the pension fund industry. The model suggested that the investment strategy of a sovereign wealth fund should involve a state-dependent allocation to three main building blocks: a performance-seeking portfolio, an endowment-hedging portfolio, and a liability-hedging portfolio. The objective of the current publication is to compare these research conclusions with current perceptions by sovereign investment professionals.
An Integrated Approach to Sovereign Wealth Risk Management
Sovereign wealth funds (SWFs) typically have no direct earmarked liabilities. Nor should they, as the financial asset they represent is only part of total sovereign assets, which in turn guarantee all sovereign liabilities. The objective of this paper is to incorporate the economic balance sheet of the sovereign sponsor into the optimal asset allocation problem of the SWF. This paper outlines an easy to implement solution that nests well in the literature on SWFs.
We show that economic leverage will reduce speculative demand but leave hedging demand (against fluctuations in the net fiscal position of the sovereign state) unchanged. We also show how to extend our one-period methodology to a multi-period context by solving a dynamic stochastic programme. Allowing for optimal dynamic decision making increases the amount of equity risk an SWF can take. The advantage is greatest for large values of economic leverage. Finally, we conclude that narrow tactical asset allocation ranges limit the SWF’s ability to manage its risks. [Press release announcing the publication of the research: 21/07/2011]
Asset-Liability Management Decisions for Sovereign Wealth Funds
Lionel Martellini, Vincent Milhau
This paper 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. 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.
Our results suggest that the investment strategy for an SWF should involve a state-dependent allocation to three building blocks, a performance-seeking portfolio (PSP, typically heavily invested in equities), an endowment-hedging portfolio (EHP, customised to meet the risk exposure in the sovereign wealth fund endowment streams), and a liability-hedging portfolio (LHP, 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 as separate hedging demands for risk factors impacting the investment opportunity set, most notably interest rate risk and equity expected return risk. [Press release announcing the publication of the research: 23/11/2010]
Portfolio Choice for Oil-Based Sovereign Wealth Funds
Given recent interest in the activities of sovereign wealth funds (SWFs), this paper reviews the financial economics of portfolio choice for oil-based investors. It views the optimal asset allocation problem of a sovereign wealth fund as the decision-making problem of an investor with non-tradable endowed wealth (oil reserves). Optimal portfolios combine speculative demand (optimal growth) as well as hedging demand (hedging resource fluctuation risk) and the level of risk taking should depend both on the fraction of financial wealth to resource wealth and on the oil shock hedging properties of the investments. As a novelty in the theoretical literature, it introduces background risk for a SWF in the form of oil reserve uncertainty. SWFs with great uncertainty about the size of their reserves should invest less aggressively and vice-versa. It also identifies the optimal speed of the extraction policy (oil-to-equity transformation) as a driving force for portfolio adjustments across time and presents a dynamic programming approach to approximate portfolio adjustments.
Macroeconomic Risk Management for Oil Stabilization Funds in GCC Countries
The existence of oil stabilization funds as the largest category of sovereign wealth funds relies on oil prices as a main source of macroeconomic risk for oil exporting countries. Given the often contingent spending policies of oil stabilization funds (accumulating wealth when oil prices are rising and spending wealth to support the local economy when GDP is shrinking) it is important to understand the magnitude and relative importance of oil price shocks relative to other sources of macroeconomic risk.
Using the Bernanke/Sims approach, this paper establishes oil price innovations as the most important short- and long-term economic drivers of local GDP for GCC (Gulf Cooperation Council) countries. Investment guidelines for oil stabilization funds should therefore stress the necessity to invest in assets with negative correlation to oil price movements to protect the total wealth of an oil-exporting economy. Using a Bayesian VAR, the paper projects the impact of different oil price scenarios on local GDP and hence the likely growth of oil stabilization funds.
Sovereign wealth funds make presence felt
Lionel Martellini, Vincent Milhau
"(...) It is now widely recognised that sovereign funds are a dominant force on international financial markets. Some estimates say they manage assets worth $4,000bn – or slightly more than twice the estimated size of the hedge fund industry. Post-crisis estimates suggest the total will rise to $7,000bn by the end of the decade. This rapid growth of sovereign wealth funds and its implications poses a series of challenges for the international financial markets, and also for sovereign states. In particular, an outstanding challenge is to improve our understanding of optimal investment policy and risk management practices for sovereign wealth funds. Recent academic research conducted by EDHEC-Risk Institute in co-operation with Deutsche Bank suggests it is desirable to analyse the optimal investment policy of a sovereign wealth fund in an asset-liability management framework. (...)"
EDHEC points the way for SWFs
"(...) Recent academic research, conducted by EDHEC Business School in co-operation with Deutsche Bank, suggests it is desirable to analyse the optimal investment policy of a sovereign wealth fund in an asset-liability management framework. (...)"
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