September 2011

EDHEC RESEARCH: Time changes everything

ClockAsset liability models for sovereign funds must be dynamic to cater for their long-term horizons, says Lionel Martellini, of Edhec Business School. Where their money comes from and what the money is needed for are also important factors. It is now widely recognised that sovereign wealth funds (SWFs) are a dominant force on international financial markets. Some estimates say they manage assets worth $4,000bn (e2,779bn) – 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 SWFs 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. The purpose of recent research – called Asset-Liability Management Decisions for Sovereign Wealth Funds, and carried out as part of the Deutsche Bank ‘Asset-Liability Management Techniques for Sovereign Wealth Fund Management’ research chair at Edhec-Risk Institute – is to focus on improving our understanding of optimal investment policy risk management practices for SWFs.   More specifically, we aim to analyse the optimal investment policy of an SWF in a dynamic asset-liability management framework that will allow us to formalise the impact on the optimal allocation policy induced by the presence of risk factors affecting the dynamics of the state’s surplus and/or the state’s investment and consumption objectives.  New model
Recent advances in dynamic asset pricing theory have in fact paved the way for a better understanding of optimal dynamic asset allocation decisions for such long-term investors in the presence of stochastic opportunity sets.   Our ambition is to contribute to the literature by introducing a formal dynamic asset allocation model that will incorporate the most salient factors in SWF management, and in particular take 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 consumption streams, eg, in the form of an inflation-linked investment benchmark (what the money is going to be used for), and the stochastic features of the assets held in its portfolio.  We find that the optimal asset allocation strategy for a sovereign state fund involves a state-dependent allocation to various building blocks, including (i) a performance-seeking portfolio, typically heavily invested in equities, (ii) an endowment-hedging portfolio, customised to meet the risk exposure in the sovereign wealth fund endowment streams, (iii) an inflation-hedging portfolio, heavily invested in assets exhibiting attractive inflation-hedging properties, when the implicit or explicit liabilities of the sovereign wealth funds exhibit inflation indexation, as well as (iv) separate hedging demands for risk factors impacting the investment opportunity set, and most notably interest rate risk and equity expected return (or Sharpe ratio) risk. While the first building block – the performance seeking – is the standard highest risk-reward component in any investor’s portfolio, the endowment hedging building block needs to be customised to meet the tailored needs of each sovereign wealth fund.  For example, in the case of the Norwegian sovereign fund, which is a natural resource fund that has been 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, the allocation policy should include a long position in inflation-linked securities, which will help the sovereign state to hedge away some of the inflation uncertainty in future pension payments. Other researchers on asset allocation decisions for SWFs have found oil price hedging demand to be an important component of the optimal allocation decision for an oil-based sovereign fund in a static setting. Taking the problem to a dynamic setting is critically needed given that static portfolio analysis can hardly be justified for long-term investors. A first step in that direction by one researcher found that a hedging demand against shocks to the short-term risk-free rate is optimally required, in addition to the oil price hedging demand. We further extend these results by proposing a comprehensive continuous-time dynamic asset allocation model, which also encompasses a mean-reverting equity premium, an important ingredient in any long-term investment problem. Our work can be extended in several directions. On the one hand, more work is needed for a better understanding of the composition of the endowment-hedging building block. In general, uncertainty in the endowment stream is not entirely spanned by existing securities. For example, in the case of SWFs 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 impact the revenues flowing into the fund.   For example, in the case of a foreign reserves SWF, where revenues are related to trade balance surpluses from the sovereign country (eg, China or Singapore), the risk factors impacting the contributions to the sovereign wealth funds would be related to world economic growth, inflation differentials, and changes in currency rates, among others.  New horizons
It is also critically important to account for the presence of short-term risk constraints which are faced by SWFs despite their long investment horizon. Many sovereign funds were built on the idea that they could hold on to investments over long time horizons and that they could cash in a premium for investing in illiquid assets. The recent economic crisis is illustrating, however, that this strategy might not always work out. With increasing economic problems in the home country, the calls for investing in distressed assets at home become louder. At the same time, contributions to many funds are likely to decrease, given a drop in demand for natural resources and shrinking fiscal sources. As a consequence, some SWFs have to draw back from investments abroad to finance investments in their home country. Furthermore, states are calling more and more on their funds to bridge gaps in their housekeeping or to finance economic stimulus packages. This again might make ill-timed divestments necessary. These elements suggest that beyond the elements described above, SWFs would also benefit from implementing dynamic risk-controlled allocation strategies that are designed to help long-term investors meet a number of short-term goals and constraints. These insights are becoming increasingly used by pension funds, where a shift from static to dynamic liability-driven investment strategies is taking place, and they are likely to impact SWF allocation policies in the years ahead.   Finally, the approach proposed in this paper needs to be extended towards the inclusion of other sovereign assets as well as sovereign liabilities. In particular, the size of local and foreign-currency-denominated debt, as well as contingent liabilities towards pension systems or industries, relative to foreign reserves and sovereign assets will, for example, determine sovereign leverage and is expected to have a material impact on optimal sovereign asset management. • Lionel Martellini is professor of finance at Edhec Business School ©2011 funds europe

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