Managing Abu Dhabi's $627 Billion Sovereign Wealth Fund (ADIA), Presentation at Harvard University


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Aaron-Micael Beydoun has estimated the depletion of Abu Dhabi's oil reserves in 93 years in a course on investment management at Harvard University. Managing the USD 620 Billion of the Emirate's sovereign wealth vis-à-vis the Abu Dhabi Investment Authority, ADIA, he has proposed the following: Although an optimization of financial assets has established the portfolio strategic asset allocation, this ignores that underlying commodity asset i.e. oil, that forms the majority of client’s implied existing portfolio. Since the oil that forms the bulk of implied national wealth is highly volatile, then traditional portfolio investment risk management that only includes invested financial assets may not properly account for total wealth risk. Therefore, so as to properly account for national wealth risk, we recommend a strategic asset allocation that broadens the asset base to include the non-monetized commodity asset i.e. oil so as to properly account for national wealth risk.

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Managing Abu Dhabi's $627 Billion Sovereign Wealth Fund (ADIA), Presentation at Harvard University

  1. 1. Abu Dhabi Investment Authority (ADIA)Harvard University: Aaron N. Beydoun
  2. 2. Abu Dhabi Investment Authority• ADIA was created in 1979 to preserve and maintain the real value of the Emirates’ wealth for future generations. While Abu Dhabi has a healthy overall trade surplus, the Emirate has a deep non-oil trade deficit that has reached as high USD 21 Billion. With limited potential for further increases in oil production in light of production levels already close to capacity, client recognizes the need to diversify away from carbon economy. The fund is currently valued at USD 627 billion. UAE Proven Reserves (000 barrels) 98,000,000 Abu Dhabi Reserves (000 barrels) 92,120,000 Daily Production (000 barrels) 2,700 Years till Depleted 93 Source: Abu Dhabi National Oil Company
  3. 3. United Arab Emirates: HydrocarbonEconomy
  4. 4. United Arab Emirates: InvestmentPrerogatives• Abu Dhabi is focused on diversifying its local economy and is investing aggresively. The following core sectors that have been recognized by the Emirate as priority, are planned to grow at an aggregate annual rate exceeding 7.5%. The objective is to help Abu Dhabi achieve a neutral non-oil trade balance by 2030.
  5. 5. Investment Policy Statement• Return requirement: Since the portfolio comprises total national wealth, it must also incorporate total national wealth risk. If the Investment Committee were to value the portfolio value exclusively looking at financial assets under management, it would ignore the underling commodity asset that forms the majority of the Emirate’s implied existing portfolio. Therefore, to more accurately account for total national wealth risk, the portfolio receives a discounted cash flow from existing wealth through the monetization of oil..• Risk tolerance: To reconcile the portfolio’s considerable ability to accommodate risk and client’s apparent preference for lower risk, the overall risk tolerance is described as “average”. The target VAR at a 1% risk threshold is 1.6% monthly. The target standard deviation is 3.75%. The target Sharpe ratio is .79.• Time horizon: long-term, multi-stage.• Investment approach: ALM (asset-liability management).
  6. 6. Investment Policy Statement: Time Horizon Stage 1: Carbon Economy 2012 - 2030 Stage 2: Neutral Economy 2030-2104 Stage 3: Post-Carbon Economy 2105 - Beyond
  7. 7. Investment Policy Statement: ReturnObjective• The investment portfolio must replace oil that supports more than 60% the National Budget. Oil is expected to deplete by 2105. The portfolio must also fund the National Deficit (about U$20 billion annually), until 2030. Using an ALM Discounted Cash Flow method, a discount rate of 8.081% will effectively immunize the perpetual national liability. Discount Rate 8.081% Management costs 0.075% Expected inflation 2.1% Required rate of return 10.4%
  8. 8. Investment Policy Statement: DCF RequiredReturn
  9. 9. Immunizing Portfolio vis-à-vis Liabilities• ALM approach: client currently receives an average of USD 62 billion from oil, we must meet that liability by 2105 when production will end.• Cash-flow matching: client must satisfy the average government budget deficit of USD 20 billion through 2030.• The discount rate or minimum required return that satisfies our first liability is 8.082% and the liquidity requirement of 3% satisfies our second liability.
  10. 10. ADIA Investment Partners• The portfolio is considered a U.S. domestic fund, by practice.• Money managers include: Blackrock, Alliance Bernstein, PIMCO, J.P. Morgan, Lazard, Morgan Stanley, Nomura Asset Management, in addition to less known managers such as Piedmont Ventures (Durham, NC USD 3.4 Billion), Rigel Capital Management (Seattle, WA USD 516 Million), Taiyo Pacific Partners (Kirkland, WA USD 2 Billion).• ADIA is currently investing in at least 240 distinct funds.
  11. 11. Capital Market Expectations: InvestmentThemes• Central bank easy-money policies likely to translate into inflation risk. Policymakers are pumping liquidity into the global economy to cushion against private-sector deleveraging and austere government policies in heavily indebted markets. With interest rates near historic lows inflation likely to increase as the global economy recovers, we anticipate increased riskiness holding long-term fixed-income assets and recommend a greater weighting in short and intermediate-term fixed-income securities in the strategic asset allocation.• Slow growth and contagion risks depress prospects. Deleveraging and slow economic growth will continue to hinder equity returns in many countries. We see better growth opportunities in emerging-market economies with favorable demographic trends and lower-debt levels. U.S. corporate profits continue positive trajectory with a greater proportion of profits coming from overseas. We believe the U.S. is the global benchmark for equity expectation as it is the largest and most developed national equity market.
  12. 12. Capital Market Expectations: U.S.Corporate Profit
  13. 13. Capital Market Expectations: U.S. Large-Caps
  14. 14. Capital Market Expectations: InvestorHoldings Real Year Deposits Bonds Equities Estate 1999 Q4 41.7% 14.5% 9.4% 34.4% 2005 Q4 56.5% 14.6% 10.0% 18.9% 2012 Q1 44.6% 20.8% 12.3% 22.3% 1982-2012 AVG 50.4% 19.9% 10.6% 19.1% Source: Federal Reserve, Wells Fargo
  15. 15. Capital Market Expectations: Forecasts Asset Class Geometric Return Annual Standard Deviation Downside RiskCash alternatives 3.49% 1.50% 1.05%Short-term taxable fixed income 3.98% 2.25% 0.34%Intermediate-term taxable income 4.38% 5.00% -3.51%Long-term taxable fixed income 4.57% 9.50% -9.86%Short-term tax-exempt fixed income 2.73% 2.25% -0.91%Intermediate-term tax exempt fixed 3.15% 4.50% -3.98%incomeLong-term tax-exempt fixed income 3.47% 9.50% -10.95%International fixed income 4.70% 8.00% -7.62%High-yield fixed income 7.23% 15.00% -14.54%Emerging-market debt 6.91% 13.50% -12.93%Real estate investment trust (REIT) 7.34% 16.00% -15.67%Large-cap value 7.87% 16.20% -15.41%Small-cap growth 9.09% 22.00% -20.97%Small-cap value 8.86% 21.00% -20.08%International equity 8.26% 18.25% -17.49%Emerging-market equity 9.97% 25.50% -23.84%Commodities 7.29% 18.00% -18.13%Gold 5.21% 13.00% -13.94%Source: Wells Fargo,adjusted based on CMEs
  16. 16. Asset Class Correlations Foreign U.S. U.S. Lg Cap U.S. Lg Cap U.S. Mid Cap U.S. Mid Cap U.S. Sm Cap U.S. Sm Cap Industrialize Emerging U.S. High Non-U.S. Commoditie Investment Cash Real Estate Growth Value Growth Growth Growth Val d Mkts Mkts Stks Yield Bonds Bonds s Grade bonds StocksU.S. Lg CapGrowth 1 0.848 0.896 0.74 0.856 0.718 0.582 0.517 0.189 0.528 0.005 0.023 0.124 0.444U.S. Lg CapVal 0.848 1 0.778 0.899 0.743 0.844 0.586 0.537 0.23 0.577 -0.008 0.052 0.141 0.588U.S. Mid CapGrowth 0.896 0.778 1 0.776 0.98 0.792 0.558 0.559 0.125 0.562 -0.019 -0.019 0.162 0.515U.S. Mid CapVal 0.74 0.899 0.776 1 0.767 0.957 0.536 0.512 0.212 0.62 -0.015 -0.002 0.15 0.678U.S. Sm CapGrowth 0.856 0.743 0.98 0.767 1 0.805 0.539 0.56 0.097 0.581 -0.036 -0.035 0.161 0.541U.S. Sm CapVal 0.718 0.844 0.792 0.957 0.805 1 0.516 0.517 0.16 0.644 -0.032 -0.013 0.157 0.701ForeignIndustrialized Mkts 0.582 0.586 0.558 0.536 0.539 0.516 1 0.667 0.17 0.398 0.288 0.052 0.181 0.389StocksEmergingMkts Stks 0.517 0.537 0.559 0.512 0.56 0.517 0.667 1 0.036 0.432 0.025 0.003 0.201 0.343U.S.Investment 0.189 0.23 0.125 0.212 0.097 0.16 0.17 0.036 1 0.382 0.447 0.237 -0.107 0.157Grade BondsU.S. HighYield Bonds 0.528 0.577 0.562 0.62 0.581 0.644 0.398 0.432 0.382 1 0.082 0.01 0.039 0.499Non-U.S.Bonds 0.005 -0.008 -0.019 -0.015 -0.036 -0.032 0.288 0.025 0.447 0.082 1 0.229 -0.076 -0.001Cash 0.023 0.052 -0.019 -0.002 -0.035 -0.013 0.052 0.003 0.237 0.01 0.229 1 -0.163 -0.05Commodities 0.124 0.141 0.162 0.15 0.161 0.157 0.181 0.201 -0.107 0.039 -0.076 -0.163 1 0.159Real Estate 0.444 0.588 0.515 0.678 0.541 0.701 0.389 0.343 0.157 0.499 -0.001 -0.05 0.159 1Source: Morningstar
  17. 17. Asset Class Correlations: Crude Oil Consumer Consumer Health Technolog S&P 500 Energy Financials industrials Materials Telecom Utilities Oil Gold Dollar Long Bond Disc. Staples Care yS&P 500 0.64ConsumerDisc. 0.53Consumer Staples 0.50Energy 0.69Financials 0.51HealthCare 0.56industrials 0.59Materials 0.61Technology 0.59Telecom 0.24Utilities 0.26Oil 0.64 0.53 0.50 0.69 0.51 0.56 0.59 0.61 0.59 0.24 0.26 1.00 0.43 -0.52 -0.46Gold 0.43Dollar -0.52Long Bond -0.46 Source: Bespoke Investments
  18. 18. Key Investment Sectors of 2030 Initiative• Energy: Abu Dhabi is making significant investments in refining facilities outside the Emirate, including in Asia, North Africa, and Europe.• Chemicals: Already positioning itself with highly successful fertilizer, ethylene, and polyethylene ventures. Emirate is capturing larger share of hydrocarbon value chain and is investing in companies with valuable know-how.• Other core segments Abu Dhabi is concentrating on include metals and mining, aviation, aerospace, defense, pharmaceuticals, biotechnology, and life sciences. There are already large existing investments in hotels, restaurants, media, and financial services. Investing in foreign companies provides Abu Dhabi with invaluable know-how and further perpetuates their goal of diversifying their economy and reducing their non-oil trade deficit.
  19. 19. Management Mechanism: Equities• Equities capital market expectations: Deleveraging and slow economic growth dampen equity prospects. Still, one of the most durable trends in last 60 years has been the ability of U.S. corporations to increase profits vis-à-vis successive financial crises and a changing global economy. As profits grow, return potential on assets tied to those profits grows.• Equities strategy: Invest in companies that have considerable exposure to emerging and developing markets. Given client’s IPS and risk/return objective, there is an inclination to invest in companies with a proven track record and that trade in more liquid, transparent, and regulated markets e.g. U.S..• Management selection criterion: Identify managers that excel at market oriented management focused on value investing alpha generating strategies with at least 7-10 years of sound returns surpassing benchmarks.
  20. 20. Management Mechanism: Fixed-Income• Fixed-income capital market expectations: Given current asset holdings many funds have an above-average allocation to deposits and fixed-income assets given overall macro environment and at the behest of central bank easy-money policies. Risk of inflation in the future leads us to be inclined towards short and intermediate-term fixed-income instruments.• Fixed-income strategy: Given clients unique risk/return profile and our subsequent ALM approach to the portfolio construction, we recommend increased investment in high-quality debt.• Management selection criterion: Since much of the portfolio is entrenched in Fixed-Income we require Active Management in the form of Enhanced indexing by matching primary risk factors. This type of management gives the portfolio flexibility, while also managing cost. The fund manager will need to have strong prior returns versus benchmark over an extended time period (7-10 years).
  21. 21. Management Mechanism: Alternatives• Alternative investment capital market expectations: Given rising inflation in key emerging markets, namely China and Brazil, and the likelihood of rising inflation in the U.S. due to Federal Reserve policies, alternative investments will allow the Investment Committee to better hedge the portfolio.• Alternative investment strategy: Invest in real estate, commodities, and natural resources. Real assets, particularly farmland, have outperformed inflation during the last 15 years. The Investment Committee has invested in farmland from Argentina to Iowa.• Management selection criterion: Since alternative investments are less transparent in terms of available information than bonds or equities they can offer greater potential for adding value through management. We selected managers based on past performance (7-10 years performance beating benchmark).
  22. 22. Resampled Efficient Frontier # Port # Return Risk Assets 27 9.1% 8.3% 55 28 9.3% 8.8% 54 29 9.6% 9.5% 55 30 9.8% 10.2% 56 31 10.0% 11.1% 55 32 10.3% 12.0% 56 33 10.5% 13.0% 55 34 10.7% 14.1% 54 35 10.9% 17.2% 54
  23. 23. Group Bounds: Minimum/Maximum Optimized Allocation Fixed-income: EmergingEquities: U.S. Small Cap 5% 20% 2% 10% Markets Fixed-income: Mortgage-Equities: U.S. Large Cap 5% 25% 1% 10% backedEquities: Emerging Market 1% 20% Fixed-Income: High-yield 4.0% 10% Fixed-income: Non-Equities: International Developed 2% 15% 7.0% 12% governmentEquities: Telecom (Hedge) 5% 10% Alternatives: Private Equity 10% 25%Fixed-income: U.S. Treasuries 2% 7% Alternatives: Natural Resources 3% 7%Fixed-income: U.S. Government 2% 10% Alternatives: Hedge Funds 5% 15%BondsFixed-income: TIPS 2% 10% Alternatives: Real Estate 5% 7%Fixed-income: MUNIS 2% 10% Alternatives: Commodities 5% 9%Fixed-income: Inv.-grade Short 2% 10% Alternatives: Real Assets 2% 7%DurationFixed-income: Inv.-grade Long 2% 10%Duration
  24. 24. Portfolio Comparison with StrategicAllocation Optimized Allocation Fixed-income: EmergingEquities: U.S. Small Cap 14.0% 9% 2.0% -4% Markets Fixed-income: Mortgage-Equities: U.S. Large Cap 8.0% -7% 1.0% -2% backedEquities: Emerging Market 2.0% -3% Fixed-Income: High-yield 4.0% -1% Fixed-income: Non-Equities: International Developed 2.0% -3% 7.0% 4% governmentEquities: Telecom (Hedge) 5.0% 3% Alternatives: Private Equity 12.1% 6%Fixed-income: U.S. Treasuries 2.0% -3% Alternatives: Natural Resources 2.0% 0%Fixed-income: U.S. Government 5.9% 1% Alternatives: Hedge Funds 5.0% 3%BondsFixed-income: TIPS 2.0% -2% Alternatives: Real Estate 7.0% 5%Fixed-income: MUNIS 2.0% -3% Alternatives: Commodities 5.0% 2%Fixed-income: Inv.-grade Short 2.0% -5% Alternatives: Real Assets 7.0% 2%DurationFixed-income: Inv.-grade Long 2.0% 0%Duration
  25. 25. Portfolio Comparison with StrategicAllocation Strategic Allocation Optimized Allocation Difference Equities 32.0% 31.0% -1% Fixed-Income 45.0% 29.9% -15% Alternatives 20.0% 38.1% 18%
  26. 26. Recommendation• Although an optimization of financial assets has established the portfolio strategic asset allocation, this ignores that underlying commodity asset i.e. oil, that forms the majority of client’s implied existing portfolio. Since the oil that forms the bulk of implied national wealth is highly volatile, then traditional portfolio investment risk management that only includes invested financial assets may not properly account for total wealth risk. Therefore, so as to properly account for national wealth risk, we recommend a strategic asset allocation that broadens the asset base to include the non- monetized commodity asset i.e. oil so as to properly account for national wealth risk.
  27. 27. Portfolio Risk vis-à-vis National Wealth Risk• We recommend that the client’s portfolio optimization include returns and volatility from oil prices in conjunction with investable financial asset classes. Consequently, we introduce the investment criteria of a highly volatile asset i.e. oil in deriving an overall optimal portfolio that is more suitable for the sovereign wealth of the Emirate. To account for changes in national wealth vis-à-vis oil, we include oil prices in the form of benchmark indices e.g. Arab Light Crude, Brent Crude, and iPath S&P GSCI Crude Oil Total Return. However, oil is only considered an anchor asset; the optimizer is set to maximize risk- adjusted returns by allocating optimal weights in any asset class except oil. With oil returns and volatility added, the optimal portfolio will allocate more towards low-risk equity and high-quality fixed- income. Thus, investing in less volatile asset classes will moderate the high volatility of oil prices. As oil reserves are gradually depleted, client can proportionally allocate a higher percentage to higher-risk asset. This can be simulated by gradually detaching the anchor asset i.e. oil from the optimization.
  28. 28. Monte Carlo Simulation• The optimizer pushes the optimal portfolio down the efficient frontier to safer equities and more fixed income. Oil Volatility Portfolio Optimal 9.46% PortReturn Optimal 9.17% PortRisk
  29. 29. Monte Carlo Optimal Portfolio
  30. 30. Risk Management: Governance Statement• Identifying loss exposures to the entire portfolio using VAR measurements, variance-covariance methods to determine the relationship between asset movements, and measuring market risk (beta) against benchmark asset classes (beta).• Independently managing asset classes, having fund managers responsible for managing the risks inside of their respective portfolios, and only actively managing assets where we have specialized knowledge. Still, there will be a dedicated Risk Director who will monitor and aggregate portfolio positions.• Maintaing a minimum 3% i.e. USD 20 Billion of assets in cash and cash equivalents to mitigate liquidity risk and meeting average National Deficit.• Managing financial risk using all disposable analyses and financial instruments such as option, futures, and forward contracts.• Monitor the portfolio’s risk and make monthly adjustments when necessary according to VAR, standard deviation, and Sharpe ratio measurements.
  31. 31. Risk Management: Market, Currency,Liquidity,• Market Risk• The Investment Committee will maintain a monthly VAR at 99% confidence i.e. USD 6.3 Billion.• Optimize the portfolio’s standard deviation by identifying non-correlated assets. The target standard deviation of the portfolio is 3.75%.• Calculate the key risk metrics on a monthly basis; asset/portfolio standard deviation, Sharpe ratio, and changes in bond duration. The target Sharpe Ratio is .79• Liquidity Risk• Maintain a minimum of 3% in cash and cash equivalents i.e. meet budget deficit.• Limit the use of leverage based on asset class.• Currency Risk• The Investment Committee has appointed a currency overlay manager.• Given the fact that transactions are executed in multiple currencies, namely
  32. 32. Risk Management: Political Risk• Political Risk• There are two Directors dedicated to working with the Abu Dhabi National Oil Company (ADNOC) and the government concerning National Wealth risk. The Emirates’ internal and external fundamentals must constantly be monitored e.g. war, politics vis-à-vis Iran, Arab Spring, etc.• Portfolio decisions have political implications and much as the client is an institution, investment behavioral tendencies come into play because of politics.• Other Risk• Corridors will be used to established minimum/maximum weights for asset classes.• Utilizing financial instruments to immunize the portfolio and prevent default risk e.g. CDS’s.
  33. 33. Performance vis-à vis S&P 500: + 3.10%
  34. 34. Performance vis-à vis DJIA: + 2.86%
  35. 35. Performance vis-à vis NASDAQ: + 6.77%
  36. 36. Performance vis-à vis Composite: + 2.71%
  37. 37. 5 Month Performance: + $30.1 Billion(5.29%) Emerging Mkts Debt Fund $31,349,994,625 Natural Resources ETF $6,266,859,607 Other $44,666,685,801 Large-Cap Stock $151,138,553,413 Small-Cap Stock $216,635,421,910 Mid-Cap Stock $61,856,858,517 Long/Short Equity ETF $18,384,634,021 Intl Real Estate ETF $1,112,084,614 Intl Income ETF $12,539,999,274 Infl Protected ETF $12,540,683,654 Corp Debt BBB Rtd ETF $10,457,095,723 Emerging Mkts Debt ETF $12,540,004,606 Commodities ETF $6,270,557,768
  38. 38. Trade Execution: Strategies• Passive strategies: The majority of the assets will be invested by external managers, particularly in asset classes the Investment Committee feels it has a competitive advantage in manager selection. Further, and given the large size of the portfolio and it’s long-term strategic outlook, transactions will occur infrequently and only when asset class corridors are exceeded. Consequently, transaction costs will be minimized and will also be cleared through large brokerage houses that can provide advantageous fee structures.• Active strategies: A key investment objective is to reduce market impact when trades are executed. Given the high-profile nature of any SWF and the large positions taken, trade orders which are greater than 1% of the float of a traded asset are partitioned and executed over several days, whether through internal or external managers. Further, limit orders are used when appropriate to obtain the most cost-efficient pricing.
  39. 39. Dynamic Asset Management: Policy• Capital Market Expectations are reviewed annually and asset classes are optimized using mean-variance.• The portfolio is monitored monthly on the first trading day of each month. If securities within an asset class exceed policy corridors by 3% they are sold and the proceeds are used to purchase assets in a separate asset class with the most underweight being first.• Performance of alternative assets, particularly private equity allocation, will utilize the Internal Rate of Return (IRR).
  40. 40. Abu Dhabi Investment Authority (ADIA)Thank you