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.
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 wealth fund asset holdings in the hands of resource-rich countries, such as the United Arab Emirates and Norway. The focus of these funds is to maintain economic stability against commodity price fluctuations and ensure future generations will not be disadvantaged by the exploitation of natural resources by the present generation.
The second group relates to the foreign reserve funds, which notably include a number of Asian countries such as China, South Korea and Singapore. Their focus should be to hedge away the impact of risk factors behind these commercial surpluses, and also to generate returns that are high enough to pay off the interest on “sterilisation” bonds, which countries use to soak up excess funds from capital inflows.
The last group of funds contains the pension reserve funds for countries such as New Zealand, France or Ireland, which have set aside a portion of their pension funds and manage them separately to prepare for an ageing society.
Intuition suggests allocation policies should differ for different kinds of sovereign wealth fund, depending on the risk factors affecting their revenues and the expected use of their funds.
For example, in the case of the Norwegian fund, which is a natural resource fund set up to help meet future pension payments, the optimal allocation strategy should involve a short position in oil/gas commodity futures, or a long position in stocks of companies such as airlines that benefit from decreases in oil prices, so as to diversify away some of the risk exposure in the country’s revenues.
Additionally, it should include a long position in inflation-linked securities that will help to hedge away some of the inflation uncertainty in future pension payments.
This asset-liability management approach is the extension to sovereign wealth funds of the liability-driven investment paradigm recently developed in the pension fund industry.
In general, uncertainty in the endowment stream is not entirely spanned by existing securities. For example, in the case of sovereign wealth funds managing commercial surpluses, the endowment stream is related to worldwide economic growth, the fluctuations of which are not replicable by a traded asset. This induces a specific form of market incompleteness, which makes the dynamic asset allocation problem more complex. It also raises the challenge of designing investable proxies allowing for the hedging of unexpected changes in risk factors that would be likely to have an impact on the revenues flowing into the fund.
For example, in the case of a foreign reserve sovereign wealth fund, where revenues are related to trade balance surpluses in the sovereign country (eg, China or Singapore), the risk factors affecting the contributions to the sovereign wealth funds would be related to world economic growth, inflation differentials and changes in currency rates, among others.
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 are expected to provide the investable proxies needed for the implementation of genuinely dedicated ALM and risk management solutions for sovereign wealth funds. Lionel Martellini is scientific director at Edhec-Risk Institute, and Vincent Milhau is senior research engineer.
Source: www.ft.com
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.
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 wealth fund asset holdings in the hands of resource-rich countries, such as the United Arab Emirates and Norway. The focus of these funds is to maintain economic stability against commodity price fluctuations and ensure future generations will not be disadvantaged by the exploitation of natural resources by the present generation.
The second group relates to the foreign reserve funds, which notably include a number of Asian countries such as China, South Korea and Singapore. Their focus should be to hedge away the impact of risk factors behind these commercial surpluses, and also to generate returns that are high enough to pay off the interest on “sterilisation” bonds, which countries use to soak up excess funds from capital inflows.
The last group of funds contains the pension reserve funds for countries such as New Zealand, France or Ireland, which have set aside a portion of their pension funds and manage them separately to prepare for an ageing society.
Intuition suggests allocation policies should differ for different kinds of sovereign wealth fund, depending on the risk factors affecting their revenues and the expected use of their funds.
For example, in the case of the Norwegian fund, which is a natural resource fund set up to help meet future pension payments, the optimal allocation strategy should involve a short position in oil/gas commodity futures, or a long position in stocks of companies such as airlines that benefit from decreases in oil prices, so as to diversify away some of the risk exposure in the country’s revenues.
Additionally, it should include a long position in inflation-linked securities that will help to hedge away some of the inflation uncertainty in future pension payments.
This asset-liability management approach is the extension to sovereign wealth funds of the liability-driven investment paradigm recently developed in the pension fund industry.
In general, uncertainty in the endowment stream is not entirely spanned by existing securities. For example, in the case of sovereign wealth funds managing commercial surpluses, the endowment stream is related to worldwide economic growth, the fluctuations of which are not replicable by a traded asset. This induces a specific form of market incompleteness, which makes the dynamic asset allocation problem more complex. It also raises the challenge of designing investable proxies allowing for the hedging of unexpected changes in risk factors that would be likely to have an impact on the revenues flowing into the fund.
For example, in the case of a foreign reserve sovereign wealth fund, where revenues are related to trade balance surpluses in the sovereign country (eg, China or Singapore), the risk factors affecting the contributions to the sovereign wealth funds would be related to world economic growth, inflation differentials and changes in currency rates, among others.
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 are expected to provide the investable proxies needed for the implementation of genuinely dedicated ALM and risk management solutions for sovereign wealth funds. Lionel Martellini is scientific director at Edhec-Risk Institute, and Vincent Milhau is senior research engineer.
Source: www.ft.com
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