It is now widely recognised that sovereign wealth funds represent a dominant force on international financial markets. By some estimates, the total size* of sovereign wealth funds currently stands at more than $3,000bn (£2,011bn, €2,264bn).
The growth is in fact likely to continue, and is expected to reach around $5,000bn in the next five years and $10,000bn within the next decade.
This rapid growth and its implications pose a series of challenges not only for the international financial markets, but also for sovereign states. One in particular is to improve the understanding of the optimal investment policy and risk management practices for sovereign wealth funds.
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.
This makes it possible to take account of risk factors affecting the state surplus dynamics (this is the “where is the money coming from” aspect), and the (implicit or explicit) liabilities the fund is facing (this is the “what is the money going to be used for” aspect).
Broadly speaking, there are three main kinds of sovereign wealth funds. The first group contains the natural resources funds, with an estimated 70 per cent of total sovereign fund asset holdings in the hands of resource-rich countries, such as the United Arab Emirates and Norway.
The focus of these funds is maintaining economic stability against commodity price fluctuations and ensuring that future generations will not be disadvantaged by the exploitation of natural resources by the current generation.
The second group relates to the foreign reserve funds, which notably includes a number of Asian countries such as China, Korea and Singapore. The focus of these funds should be to hedge away the impact of risk factors behind commercial surpluses, and also to generate higher returns than the yields they are paying to holders of local sterilisation bonds (issued to mop up excess liquidity caused by capital inflows).
The last group of funds, which accounts for a more marginal fraction of total sovereign wealth, contains the pension reserve funds for countries such as New Zealand, France and Ireland, which have set aside a portion of their pension funds and manage them separately to prepare for an ageing society.
Recent advances in dynamic asset pricing theory have paved the way for a better understanding of optimal dynamic asset allocation decisions for such long-term investors, by specifically taking into account the stochastic features of the sovereign fund endowment process (where the money is coming from), the stochastic features of the sovereign funds’ expected liability value (what the money is going to be used for), and the stochastic features of the assets held in its portfolio.
It can be shown that the optimal asset allocation strategy for a sovereign state fund involves a state-dependent allocation to three building blocks: a performance-seeking portfolio (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).
While the first building block is the standard highest risk-reward component in any investor’s portfolio, the other two building blocks need to be customised to meet the tailored needs of each specific sovereign wealth fund.
Overall, it appears that the development of an asset-liability management analysis of sovereign wealth funds has potentially important implications for investment banks and asset managers, which could implement financial engineering techniques for the design of customised building blocks aimed at facilitating the implementation of genuinely dedicated asset-liability management and risk management solutions for these long-term investors.
Lionel Martellini is professor of finance at Edhec Business School and scientific director of the Edhec Risk and Asset Management Research Centre
*Source: “Sovereign Wealth Funds, State Investment on the Rise”, Deutsche Bank Research, September 2007