Unlike the PSP, EHP and LHP building blocks must be customised to meet the specific needs of each SWF. The EHP needs to be customised to hedge the SWF’s endowment streams. The endowment stream of the SWF can be related to world economic growth or commodity-price fluctuations, depending on the source of funding for the SWF, which highly impacts the composition of the EPH.
It is important to recognise that in some cases the fluctuations in the endowment stream cannot be replicated by a traded asset, which poses additional challenges unique to the EHP building block.
The LHP building block is used to hedge against interest-rate risk and/or inflation risk and is typically invested in bonds or assets that exhibit inflation-hedging properties.
Apart from the general structure of the optimal-investment policy, there is another important aspect. Even though SWFs are regarded as longterm investors, they can face a variety of short-term constraints of different types. Examples include a limit on the maximum drawdown over a given period or minimum performance requirement due to peer comparison, loss aversion or sponsor risk. As a consequence, SWFs can also benefit by implementing a dynamic riskcontrolled allocation strategy designed to meet short-term goals and constraints.
