Chinese sovereign funds such as Safe Investment Company and CIC should consider dumping and even shorting US retail stocks during US economic downturns, if they want to adopt an integrated asset and liability management process when making investment decisions, according to a new paper by the Edhec-Risk Institute
The Edhec-Risk Institute in Singapore has recommended that Chinese sovereign entities hold no exposure to the stocks of US retail companies or that they short such stocks to hedge against appreciation of the renminbi as well as hedging a fall in US consumer demand.
In its paper, 'An integrated approach to sovereign wealth risk management', the institute outlines a model that takes into account assets and liabilities of a sovereign sponsor to achieve the optimum investment allocation for sovereign wealth funds. The idea is to minimise risks associated with liabilities of a country, which may be unwittingly duplicated or overlooked by the fund entity, says report author Bernd Scherer.
The paper offers the example of China, where the sovereign has a large exposure to the US retail market via exports. This means a slowdown or recession in the US economy would lead to a cutback in spending by the US consumer for Chinese goods, negatively impacting Chinese companies.
China's largest sovereign wealth funds are Safe Investment Company and China Investment Corp.
However, while some sovereign funds agree in principle with the approach, they see practical difficulties around governance. "Conceptually, I think this is the right approach but practically, the entity doesn't necessarily have a full view of the assets and liabilities of the country – for example sovereign assets are managed by several entities, while the liabilities are managed by different entities," says Eric Hong, an official at Malaysian sovereign fund Khazanah in Kuala Lumpur.
Hong adds that while Khazanah has real financial liabilities, it doesn't look at asset and liability management (ALM) as systematically as he would like. "We need to approach investments from an ALM standpoint, not separating the two. If the methodology can be simplified then we could adopt this," he says.
A source at another sovereign fund in Asia says it faces a similar hurdle. "As we only manage a limited portion of the nation's reserves according to guidelines from our central bank, our risk management focuses on portfolio management rather than overall sovereign wealth management," the source says.
Khazanah, like Temasek of Singapore, is part of a growing category of sophisticated sovereign-supported funds that issue debt in the form of bonds and so already have a need to look at ALM from their own institution's perspective. It might then be a natural step to move to looking at sovereign ALM.
"Using an ALM framework to manage the fund's assets and debts makes sense, but there is no guarantee that this management will be optimal at the fund level if other liabilities and future contributions are disregarded, let alone at the sponsor level as other state assets and liabilities are ignored in the process," says Frédéric Ducoulombier, director for Asia at the Edhec-Risk Institute in Singapore.
The integrated ALM approach is similar to recent advances in corporate pension fund investing that consider the fund an integral part of the corporate balance sheet and jointly analyse capital structure and pension fund allocation choices.
"This latest work shows the impact of the state's economic leverage on the optimal policy of the fund; it reduces speculative demand (allocation to the performance portfolio) but leave hedging demand (against fluctuations in the net fiscal position of the sovereign state) unchanged," says Ducoulombier. "It also shows the benefits of adopting a dynamic asset allocation approach and its impact on the risks the fund can take. It underlines the costs in terms of risk management of imposing narrow tactical asset allocation ranges."
Source: www.risk.net
The Edhec-Risk Institute in Singapore has recommended that Chinese sovereign entities hold no exposure to the stocks of US retail companies or that they short such stocks to hedge against appreciation of the renminbi as well as hedging a fall in US consumer demand.
In its paper, 'An integrated approach to sovereign wealth risk management', the institute outlines a model that takes into account assets and liabilities of a sovereign sponsor to achieve the optimum investment allocation for sovereign wealth funds. The idea is to minimise risks associated with liabilities of a country, which may be unwittingly duplicated or overlooked by the fund entity, says report author Bernd Scherer.
The paper offers the example of China, where the sovereign has a large exposure to the US retail market via exports. This means a slowdown or recession in the US economy would lead to a cutback in spending by the US consumer for Chinese goods, negatively impacting Chinese companies.
China's largest sovereign wealth funds are Safe Investment Company and China Investment Corp.
However, while some sovereign funds agree in principle with the approach, they see practical difficulties around governance. "Conceptually, I think this is the right approach but practically, the entity doesn't necessarily have a full view of the assets and liabilities of the country – for example sovereign assets are managed by several entities, while the liabilities are managed by different entities," says Eric Hong, an official at Malaysian sovereign fund Khazanah in Kuala Lumpur.
Hong adds that while Khazanah has real financial liabilities, it doesn't look at asset and liability management (ALM) as systematically as he would like. "We need to approach investments from an ALM standpoint, not separating the two. If the methodology can be simplified then we could adopt this," he says.
A source at another sovereign fund in Asia says it faces a similar hurdle. "As we only manage a limited portion of the nation's reserves according to guidelines from our central bank, our risk management focuses on portfolio management rather than overall sovereign wealth management," the source says.
Khazanah, like Temasek of Singapore, is part of a growing category of sophisticated sovereign-supported funds that issue debt in the form of bonds and so already have a need to look at ALM from their own institution's perspective. It might then be a natural step to move to looking at sovereign ALM.
"Using an ALM framework to manage the fund's assets and debts makes sense, but there is no guarantee that this management will be optimal at the fund level if other liabilities and future contributions are disregarded, let alone at the sponsor level as other state assets and liabilities are ignored in the process," says Frédéric Ducoulombier, director for Asia at the Edhec-Risk Institute in Singapore.
The integrated ALM approach is similar to recent advances in corporate pension fund investing that consider the fund an integral part of the corporate balance sheet and jointly analyse capital structure and pension fund allocation choices.
"This latest work shows the impact of the state's economic leverage on the optimal policy of the fund; it reduces speculative demand (allocation to the performance portfolio) but leave hedging demand (against fluctuations in the net fiscal position of the sovereign state) unchanged," says Ducoulombier. "It also shows the benefits of adopting a dynamic asset allocation approach and its impact on the risks the fund can take. It underlines the costs in terms of risk management of imposing narrow tactical asset allocation ranges."
Source: www.risk.net
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