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Optimal investment strategies for Sovereign Wealth Funds

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A presentation with some facts about sovereign wealth funds and some theory supporting the design of optimal strategies of SWFs. I present in detail the example of an oil stabilization fund with a …

A presentation with some facts about sovereign wealth funds and some theory supporting the design of optimal strategies of SWFs. I present in detail the example of an oil stabilization fund with a critical discussion of a model outlined by the IMF staff. This should be viewed as a modest introduction to the subject and a work in progress as I will develop this topic more in depth in the coming months.


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  • 1. Sovereign Wealth Funds Alexandre Kateb Presentation at the EDHEC Risk and Asset Management Center Nice, 7 May 2009
  • 2. Outline
    • SWFs : key facts and figures
    • Investment strategy for SWFs
      • General considerations
      • The case of a stabilization fund
  • 3. Context
    • The last global expansion cycle (2002-2007) has been accompanied by a substantial accumulation of capital and current account surpluses in some emerging countries : commodity exporting countries (e.g. OPEC, Russia, Argentina,..) and manufacturing goods exporting countries (China and ASEAN countries)
    • While in previous expansion cycles much of the wealth was generally spent (e.g. on public investment programs) or managed as FX reserves held by the central banks, we are now witnessing the growth of distinct public investment bodies, the so called « Sovereign Wealth Funds » (SWFs)
    • Many questions were risen about the transparency, governance, and political motivations of these expanding asset management vehicles
    • In the wake of the financial crisis, SWFs appeared as the white knights called at the rescue of ailing western financial institutions and corporates
    • However, the central challenge for SWFs remains how to invest optimally their funds, consistently with their specific constraints and policy objectives
  • 4. SWFs : key facts and figures
    • Definition of SWFs :
    • SWFs = Sovereign Wealth Funds
    • No universally agreed definition (IMF, OECD, US, Europe, …)
    • Minimum consensus :
    • « A state investment vehicle which is funded by foreign exchange assets and which manages these assets separately from official reserves  »
    • Distinctive features :
    • A distinct public investment body (not a simple fiscal account)
    • Separated from the Central Bank’s ordinary FX Reserve Fund
    • Predominantly invested in foreign currency assets
    • Targeting an average annual return superior to the risk-free return
    • No explicit liabilities (no debt committed to foreign or domestic entities)
    • In practice, some of the distinctive features of SWFs may be relaxed
  • 5. SWFs : key facts and figures
    • Types of SWFs (by primary objective) :
    • ََ The IMF has identified 5 types of SWFs based on their main objective (IMF):
    • stabilization funds , where the primary objective is to insulate the budget and the economy against commodity (usually oil) price swings
    • savings funds for future generations , which aim to convert nonrenewable assets into a more diversified portfolio of assets
    • reserve investment corporations , established to increase the return on FX reserves
    • development funds , which typically help fund socioeconomic projects or promote industrial polices that might raise a country's potential output growth
    • contingent pension reserve funds , which provide for contingent unspecified pension liabilities on the government's balance sheet
    • In practice, a SWF can shift from one category to another or can be included in two or more categories depending on policy objectives and circumstances
  • 6. SWFs : key facts and figures
    • Type of SWFS (by source of funds)
    • There are basically two types of SWFs based on their funding sources :
    • Commodity funded SWFs : ~ 65% of total AUM by SWFs
      • Funded from FX proceeds of commodity export revenues
      • Main examples : OPEC/GCC related SWFs, Norway’s PF-Global, Russia’s SWF
    • Non-commodity funded SWFs: ~ 35% of total AUM by SWFs
      • Funded from the transfer of surplus CB FX reserves
      • Main examples : Singapore’s GIC, HKMA’s Investment Portfolio, China’s CIC, Korea’s KIC
    • The importance of non-commodity funds is expected to rise in the coming years as China and other countries with structural current/capital account surpluses will face increasing pressures to shift a larger share of their FX reserves to higher yielding investments
  • 7. SWFs : key facts and figures
    • Assets under management by SWFs
    • Current estimates : USD 3000-4000 bn
    • Future estimates 2015 : USD 8000 bn (IFSL) to 15000 bn (Morgan Stanley)
    • In any case, AUM by SWFs represent only a small share of global financial assets under management, but their importance is growing.
    Source : Aizenman (2008)
  • 8. SWFs : key facts and figures
    • Transparency and governance
    • Truman (2008) proposed a useful “scoreboard” for comparing the management practices of SWFs by identifying 4 categories :
      • Structure : clarity of objective, source of funding, and investment strategy
      • Governance : independence of investment strategy, corporate responsibility
      • Transparency/accountability : reporting on activities and performance, public disclosure of investment portfolios
      • Behavior : the nature and speed of adjustment of the SWF portfolio,
    • T he ideal SWF that emerges from this survey (cf. appendix) is the public investment fund that has long term objectives other than strictly currency stabilization, explicitly or implicitly linked to some intertemporal allocation and/or distributional objective
    • The real picture is sharply contrasted with overall scores ranging from 94/100 for the Alaska Permanent Fund) and 92/100 for Norway’s Global Fund to 9/100 for QIA (Qatar Investment Authority) and for ADIA (Abu Dhabi Investment Authority)
    • => There is still a lot of progress to be done in the area of transparency and governance of SWFs
  • 9. SWFs : key facts and figures
    • International policy initiatives
    • The international debate over SWFs lack of transparency has resulted in a number of international initiatives to define best practices and to draw a code of conduct
    • The OECD Investment Committee has adopted a report on recipient country policies in relation to SWFs, which was endorsed by OECD ministers in early June 2008.
    • The International Working Group of Sovereign Wealth Funds ( IWG ) was established at an I MF-sponsored meeting of 26 countries with SWFs in early May 2008
    • The IWG agreed in September 2008 on a set of G enerally A ccepted P rinciples and P ractices (GAPP) more commonly known as the Santiago Principles
    • The GAAP are underpinned by the following guiding objectives for SWFs:
      • To maintain a stable global financial system and free flow of capital and investment
      • To comply with all applicable regulatory and disclosure requirements in the countries in which they invest
      • To invest on the basis of economic and financial risk and return-related considerations
      • To have in place a transparent and sound governance structure that provides for adequate operational controls, risk management, and accountability.
    • => It remains to be seen whether there will be any tangible convergence among SWFs operational practices on the basis of these general standards
  • 10. Investment strategy for SWFs: some general considerations
    • Investment policy and risk management : survey results
    • A survey conducted in 2008 by the IMF on behalf of the IWG shows a broad range of practices among SWFs on investment policy and risk management
    • Policy objective : generally no explicit liabilities, though some SWFs explicitly aim to cover expected future pension expenditures.
    • Funding and withdrawal rules are usually tied to the source of the funds
      • Stabilization funds : revenue contingent deposit and withdrawal rules
      • Reserve investment corporations : reserve adequacy requirements
    • Some keep capital and returns while others pay out targeted annual dividends
  • 11. Investment strategy for SWFs: some general considerations
    • Investment policy and risk management : survey results
    • Investment objectives : some funds maximize returns relative to a benchmark, others have absolute return objectives . O ne SWF explicitly states that it uses an asset-liability approach .
    • Investment strategies vary from traditional to more advanced
      • SWFs that are not separate legal entities have relatively traditional asset allocations, mostly limited to highly rated government securities
      • Other SWFs use more alternative asset classes, with benchmarks including 40% –70 % equity, 4%–10 % private equity funds, 13%–40 % fixed income, 2%–5 % infrastructure, 2%–5% commodities, and 8%–10% real estate.
  • 12. Investment strategy for SWFs: some general considerations
    • Investment policy and risk management : survey results
    • Risk measures : the most common risk measures and methods to manage financial risks are credit ratings, value-at-risk models, tracking error, duration, and currency weights. Some SWFs indicate that overall risk levels are subject to stress testing
    • Most SWF respondents note that they are not allowed to borrow or use leverage
    • However, several SWFs point out that they invest in certain asset classes that use leverage (e.g. private equity and multi-strategy funds) or employ derivatives for the purpose of protecting the value or return of their investments
  • 13. Investment strategy for SWFs: some general considerations
    • The importance of risk management
    • The financial crisis has brought into light the importance of risk limits even for SWFs that are only concerned with long term returns, as drawdowns have been severe
    Source : Setser (2009)
  • 14. Investment strategy for SWFs: some general considerations
    • The limits of traditional risk management
    • The crisis has also evidenced the limits of the traditional risk management tools (volatility, VaR, tracking error) used by many SWFs
    • Most model-based risk systems estimate risk on the basis of historical relationships.
    • When these relationships change significantly in a short space of time, the model will not be in a position to provide reliable estimates of future risk
    Source : Norway’s Government Pension Fund – Global, 2008 Annual Report
  • 15. Investment strategy for SWFs: some general considerations
    • Asset Liability Management
    • Asset/Liability management(ALM) addresses the problem of an investor who faces a sequence of liability payments in the future, and wants to construct a portfolio of securities that allows him to meet these liabilities under a variety of plausible scenarios
    • From all feasible portfolios he wants to choose the one that optimizes some optimality criterium
    • Both the size of the liability payments and the security returns may depend on the state of the world in the future
    • Although SWFs have no explicit liabilities they have implicit liabilities arising from their policy objectives => An ALM framework could be adapted to assess the investment strategy of SWFs
  • 16. Investment strategy for SWFs: some general considerations
    • Liability Driven Investment and the separation theorem
    • According to EDHEC the optimal asset allocation strategy for a sovereign state fund should involve a state-dependent allocation to three building-blocks :
      • a performance-seeking portfolio (heavily invested in equities)
      • a liability-hedging portfolio (heavily invested in bonds for interest rate hedging motives, and in assets exhibiting attractive inflation-hedging properties).
      • an endowment-hedging portfolio (customised to meet the risk exposure in the sovereign wealth fund endowment streams)
    • This result is derived from EDHEC’s research on the Liability Driven Investment (LDI) strategies recently developed for Pension funds. Cf. Martinelli (2006)
    • From an academic perspective , it can be regarded as an example of the fund separation theorem (Markowitz for the static version, Merton for the stochastic one)
    • Although this approach seems compelling, it remains to be seen how it can be successfully implemented in practice to construct the « ideotypical » funds that fit the specific liability and endowment patterns of SWFs (e.g. by creating specific contracts/securities)
    • => This can be an area of fertile collaboration between research and the industry
  • 17. Investment strategy for SWFs: some general considerations
    • The Stochastic Programming Approach
    • Stochastic programming models can be used to solve financial optimization problems under realistic market imperfections and trading restrictions
    • A key issue for the successful application of these models is the construction of event trees with a limited number of nodes which stand for different scenarios
    • Thus, an important question is therefore to what extent the approximation error in the event tree (i.e. the time/state « discretization ») will bias the optimal solutions of the model. Yu et alli (2003) review different methods for constructing event trees and accounting for approximation errors.
    • => One suggestion could be to combine the former « three funds » approach with scenario-based stochastic programming, the latter providing consistent rules for periodic (annual or semi-annual) allocation shifts between the three funds
  • 18. Investment strategy for SWFs: some general considerations
    • Depending on their policy objective, SWFs face different implicit liabilities that command specific optimality criteria
    Type of fund Implicit liabilities Optimality criteria Stabilization funds Non-commodity structural deficit Fiscal sustainability and macro stability Long term savings funds (future generations funds) Replacement cost of an exhaustible resource Intergenerational equity, Economic diversification Reserve investment corporations Sterili zation costs (through domestic bonds) Return in excess of the sterilization liabilities Contingent pension reserve funds Contingent unspecified pension liabilities Intertemporal funding ratio
  • 19. Investment strategy for SWFs: the case of a stabilization fund
    • The net worth approach to fiscal stabilization
    • Da Costa and Ramon (2006) describe a simple model that captures the dynamics and the steady-state equilibria values (as GDP ratios) of debt, nonfinancial and financial assets, and net worth of the nonfinancial public sector under alternative fiscal-investment fund rules.
    • The framework is based on the new «  en vogue  » comprehensive net worth approach to governement’s assets and liabilities that has been endorsed by the IMF since 2001
    • Their model can be used to analyze economies with depletable resources, a related financial asset fund (oil fund), and a fiscal rule. The analysis is applied to the Norwegian oil fund , and the model is used to project key variables such as the debt and financial assets ratios.
  • 20. Investment strategy for SWFs: the case of a stabilization fund
    • The net worth approach to fiscal stabilization
    Source : Da Costa (2006)
  • 21. Investment strategy for SWFs: the case of a stabilization fund
    • The net worth approach to fiscal stabilization
    • The set of identities below captures the essentials of the net worth approach :
    • Where :
    • GOBP : Gross Primary Operating Balance
    • A NF t , A F t : End-of period stock, respectively of, Non Financial (NF) and Financial (F) assets
    • D t : End-of period outstanding domestic and external debt expressed in local currency.
    • i : Effective nominal interest rate paid on end-of previous period debt
    •  t D ,  t F  t NF : Percentage change in a price index, respectively, for debt (D), Financial assets (F),
    • Non Financial assets (NF)
    • INV NF t , INV F t : Net purchase of Non financial assets (investment) and Financial Assets
    •  : Average depreciation rate of Non Financial Assets
  • 22. Investment strategy for SWFs: the case of a stabilization fund
    • The net worth approach to fiscal stabilization
    • The motion law of the net worth ratio could be derived from this sytem :
    • Where the equations (1) – (3) are expressed in terms of GDP and  F ,  NF are the return rates, respectively, on Financial and Non Financial assets
    • T he authorities can set independently the values of the policy-determined variables— inv NF t , inv F t , and gobp —to obtain specific values of the endogenous variables— d t , a NF t and a F t
    • Reciprocally, i nverting the above system will determine the values of gopb, inv NF t , inv F t that lead to the desired steady-state levels for the debt ratio, nonfinancial, and financial ratios
  • 23. Investment strategy for SWFs: the case of a stabilization fund
    • The case of Norway’s oil fund
    • Norway set up an oil fund in 1991 to facilitate the decoupling of oil revenue inflow from oil revenue use, and reduce the undesirable “Dutch disease” effects by investing the fund’s resources in foreign financial assets.
    • Intergenerational equity is also one of the motivations for building such a fund, as it accumulates proceeds from extracting a depletable resource
    • All the proceeds of oil revenues are saved in the oil fund. The fiscal rule entails that only the return of the oil fund can be used to finance the structural, non-oil operating deficit and up to a predetermined cap. Any excess of deficit over the cap has to be financed with public debt.
    • In theory, the structural non-oil deficit can be set at a level such that it could be financed by the oil fund’s yield given by its long-term trend rate of return ,  F estimated at 4 percent, inflation adjusted
    (financing equation)
  • 24. Investment strategy for SWFs: the case of a stabilization fund
    • The case of Norway’s oil fund
    • In this case, under certain simplifying assumptions, Da Costa and Ramon (2006) exhibit t he following motion law of the debt and asset ratios :
    • For simplicity, the authors assume that all financial assets correspond to the oil fund, which on period t yields an actual rate of return of ρ F t , and that non-oil, nonfinancial assets are zero. The latter constraint can be relaxed without compromising the stability of the model as long as the government follows a golden fiscal rule warranting the stability of the debt ratio
    • In the steady-state terminal phase, by definition, the oil nonfinancial asset has been depleted . This implies that the financial assets ratio is zero as the source of funds is tarished. Consequently, the total structural operating budget must be balanced.
    with
  • 25. Investment strategy for SWFs: the case of a stabilization fund
    • The case of Norway’s oil fund
    • Alternatively the authorities may decide that they want to keep the financial asset ratio constant in terms of GDP, in order to compensate the future generations for the depletion of natural resources
    • When the oil nonfinancial assets have been totally depleted, the government limits the financing of the structural deficit to an amount given by
    If the long-term average of these two rates (financial return, GDP growth) were about the same, the non-oil structural operating budget has to be balanced on average to keep the financial assets ratio constant at a policy-determined level.
  • 26. Investment strategy for SWFs: the case of a stabilization fund
    • Li mitations of the model and potential extensions
    • Although Da Costa and Ramon provide a useful framework of thought, their model presents several limitations :
    • It does not explicitly take into account the stochastic nature of the different parameters , especially the rates of return on the financial assets (oil fund), on non financial assets (oil revenues) and the interest rate
    • It does not provide any criteria for « path optimization » of the stock of financial and non financial assets, and accordingly it defines no rules for assessing « penalty costs » in case of divergence from this optimal path
    • It is too restrictive as it does not explicity account for the dual objective of most oil funds (i.e. macroeconomic stabilization AND intergenerational equity), including Norway’s oil fund => An intertemporal utility function is missing
    • The conclusions do not apply to a wide range of developing countries where commodity revenues play a substantial role in closing the fiscal gap. In effect, these countries need much more flexibility than the stringent rules followed by Norway
    • => Research still needs to be done on designing a macro/financial framework for assessing the optimal funding policy and investment strategy for commodity-funded SWFs (fiscal policy rules + financial planning programs)
  • 27. Selective bibliography
    • Aizenman Joshua and Reuven Glick, Sovereign Wealth Funds : Stylized facts about their Determinants and Governance, NBER WP No. 14562, December 2008
    • Da Costa Mercedes and V. Hugo Juan-Ramon, The Net Worth Approach to Fiscal Analysis: Dynamics and Rules , IMF WP/06/17, January 2006
    • Kern Steffen, SWFs and Foreign Investment Policies – An update , DB Research, October 2008
    • Martinelli Lionel, Managing Pension Assets : from Surplus Optimization to Liability-Driven Investment, EDHEC Risk and Asset Management Center, Working Paper, March 2006
    • Maslakovic Marco, Sovereign Wealth Funds 2009 , IFSL Research, March 2009
    • Mitchell S. Olivia, John Piggott, and Cagri Kumru, Managing Public Investment Funds: Best Practices and New Challenges , NBER W P No . 14078, June 2008, Revised August 2008
    • Setser Brad and Rachel Ziemba, GCC Sovereign Funds : Reversal of Fortune, Council on Foreign Relations , Working Paper, January 2009
    • Truman Edwin M., A Blueprint for Sovereign Wealth Fund Best Practices , Peterson Institute for International Economics, Policy Brief Number PB08-3, April 2008
    • Yu Li-Yong, Xiao-Dong Ji, Shou-Yang Wang, Stochastic Programming Models in Financial Optimization: A Survey , Advanced Modelling and Optimization, Volume 5, Number 1, 2003
  • 28. Appendix 1 : most important SWFs by AUM Source: IFSL (2009)
  • 29. Appendix 2 : difference between SWFs and other investment vehicles Source : SWF Institute
  • 30. Appendix 3 : a scoreboard for assessing SWFs management practices Source : Truman (2008)