Broadly speaking, there are three kinds of sovereign wealth funds (SWFs): natural resource funds such as those of Abu Dhabi and Kuwait, foreign reserve funds such as China’s and Singapore’s, and pension reserve funds, such as those we have in Australia and New Zealand.

In view of the rapid growth of SWFs, it is important to study their optimal-investment policy and riskmanagement practices. This has been the objective of the research chair set up by EDHEC-Risk Institute and Deutsche Bank in 2009.

To date, the research chair publications have adapted the asset-liability management (ALM) framework applied in the pension fund industry to the unique characteristics of SWFs and explored the management of natural resources funds. In this report, we present the results of a paper on a dynamic ALM model, developed to guide asset allocation and risk management decisions at the SWF level, and describe the results of feedback on its theoretical and practical appeal to sovereign-fund management.

By analysing the optimal investment policy of an SWF in a dynamic ALM framework, the approach formalises the effect of key inputs on optimal policy, such as the state’s investment and consumption objectives. The formal dynamic asset-allocation model developed captures the most prominent factors such as the stochastic nature of the sovereign fund’s endowment process, the stochastic properties of the sovereign fund’s expected consumption streams and, naturally, the stochastic features of the assets held in the portfolio.


Building blocks for asset allocation
In this context, our research shows that the optimal asset-allocation strategy involves three main building blocks: a performance-seeking portfolio (PSP), an endowmenthedging portfolio (EHP), and a liability-hedging portfolio (LHP), as well as hedging demands for risk factors impacting the stochastic opportunity set.

The allocation between the building blocks is dynamic and statedependent because it is a function of the investment horizon and the values of key market parameters such as volatility and equity risk premium.

The PSP building block has a standard structure and is typically invested in asset classes offering risk premia to provide the highest risk-adjusted returns. With long-term investment horizons, higher margins for error and absence of regulatory constraints, SWFs are able to seek higher risk investments than other public investment funds.


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