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Investment Management - October 22, 2010

Asset-Liability Management Decisions for Sovereign Wealth Funds

It is now widely recognised that sovereign wealth funds (SWFs) are a dominant force on international financial markets. By some estimates, the total size of sovereign wealth funds currently stands at more than $3 trillion, more than twice the estimated size of the world’s hedge fund industry (around $1.5 trillion of assets under management) but only a seventh of the global investment-fund industry (around $21 trillion of assets under management). While total assets managed by sovereign wealth funds have fallen substantially after 2008 because of collapsing asset values during the financial crisis, with cash withdrawals from sovereign funds also expected to increase due to the need to inject liquidities into weakening economies, the growth of sovereign wealth funds is in fact likely to continue, and is expected to reach around $5 trillion in the next five years and $10 trillion within the next decade.1

The rapid growth of sovereign wealth funds and its implications pose a series of challenges for the international financial markets and 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. 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.

While the first PSP building block is the standard highest risk-reward component in any investor’s portfolio, the EHP and LHP building blocks must be customised to meet the tailored needs of each specific sovereign wealth fund. In an application to oil-based sovereign funds with inflation-linked benchmarks, we conduct an empirical analysis of the oil- and inflation-hedging properties of several traditional and alternative asset classes that can be used as ingredients within this building block using a restricted vector autoregressive (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. The PSP/EHP/ LHP approach can in fact be seen as the extension to sovereign wealth funds of the liability-driven investing (LDI) paradigm recently developed in the pension fund industry.

In terms of implementation, a number of challenges remain, including the need to reconcile the top-down asset allocation decisions with bottom-up security selection decisions. Indeed, the asset allocation decisions analysed in this paper relate to the design of the long-term strategic allocation for SWFs, with an associated optimal exposure to rewarded risk factors. Additionally, it is legitimate for SWFs to seek alpha opportunities, and/or consider reaching strategic stakes in selected target companies. In fact, long-term equity holdings can be a natural source of alpha generation for sovereign wealth funds given that SWFs are better placed to benefit from any temporary mispricing opportunity than hedge funds thanks to a longer-term investment horizon, and also better placed than pension funds thanks to higher margin for error and the absence of regulatory constraints. Eventually, however, such security selection decisions can lead to a strong bias, such as a recent overweighted exposure to financials. These unintended bets on market, sector, and style returns are unfortunate as they can have a very significant, positive or negative, impact on the portfolio return. As a result, these biases need to be quantitatively measured, and optimised. Alternatively, these biases can be adjusted for in a multi-factor setting through a completeness portfolio designed to fill in differences between portfolio allocation and the long-term strategic benchmark allocation. In this context, index futures can be used as cost-efficient vehicles for dynamic adjustment of portfolio exposure to market risk.

This research was produced as part of the "Asset-Liability Management Techniques for Sovereign Wealth Fund Management" research chair at EDHEC-Risk Institute, sponsored by Deutsche Bank.


  1. Source: “Sovereign wealth funds, state investment on the rise”, Deutsche Bank research, September 2007.