EDHEC-Risk publication proposes an optimal investment strategy for sovereign wealth funds
23 November 2010
The publication proposes a formal analysis of the optimal investment policy 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 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 that the investment strategy for a sovereign wealth fund should involve a state-dependent allocation to three building blocks:
· a performance-seeking portfolio (typically heavily invested in equities);
· an endowment-hedging portfolio (customised to meet the risk exposure in the sovereign wealth fund endowment streams); and
· 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 fund exhibit inflation indexation).
This work highlights in particular the need for a hedge against the risk emanating from fluctuating revenues to the fund. In an empirical application, the composition of a revenue-hedging portfolio for an oil-based sovereign fund is investigated.
This analysis has important potential implications in terms of the emergence of genuinely dedicated ALM and risk management solutions for sovereign wealth funds.
© EDHEC
