Additionally, it is legitimate for SWFs to seek alpha opportunities, and/or consider reaching strategic stakes in selected target companies. In fact, long-term equity holdings can be a natural source of alpha generation for sovereign wealth funds given that SWFs are better placed to benefit from any temporary mispricing opportunity than hedge funds thanks to a longerterm investment horizon, and better placed than pension funds thanks to higher margins for error and the

absence of regulatory constraints. Eventually, however, such security selection decisions can lead to a strong bias, such as overweighted exposure to financials. These unintended bets on market, sector, and style returns are unfortunate as they can have a very significant, positive or negative, impact on the portfolio return. As a result, these biases need to be quantitatively measured, and optimised. Alternatively, these biases can be adjusted for in a multi-factor setting through a completeness portfolio designed to fill in differences between portfolio allocation and the long-term strategic benchmark allocation. In this context, index futures can be used as cost-efficient vehicles for dynamic adjustment of portfolio exposure to market risk.




The research that we have done 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 a 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 impact the revenues flowing into the fund. For example, in the case of a foreign reserves sovereign wealth fund, where revenues are related to trade balance surpluses from the sovereign country (for example, 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.

A first step in the direction of a formal analysis of the magnitude and relative importance of oil price shocks relative to other sources of macroeconomic risk for oil stabilisation funds has been taken by Scherer (2009), and this work needs to be extended to foreign reserve funds. On the other hand, 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 sovereign funds have to draw back from investments abroad, even if they are marked at a loss at the time, to finance investments in their home country.

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