EDHEC: SWFs and Their Implicit Liabilities

A new survey by EDHEC-Risk Institute lets managers of the sovereign wealth funds – and those who manage other, related institutions such as central banks or state development funds – speak for themselves about the strategies SWFs pursue. The responsive state-affiliated investment managers, mostly from Middle Eastern and East Asian vehicles, say that they believe SWFs can benefit from a liability-driven investment model, but they worry about models that are too general, inadequately customized to their needs.

Sovereign Wealth Funds (SWFs), investment funds controlled by nation states as instruments of policy, have had and continue to have an enormous impact on the financial world, with current assets under management close to $5 trillion. This has motivated a good deal of scholarly research. EDHEC-Risk Institute and Deutsche Bank jointly established a research chair for that purpose in 2009, and publications of that research chair have since adapted the asset-liability management (ALM) framework to the characteristics of SWFs.

The ALM Framework

The ALM framework was first developed in the context of pension funds. The idea was that the board of a fund should formulate guidelines that balance the assets of a pension between a performance-seeking portfolio on the one hand and a liability-matching portfolio on the other.

In a 2010 EDHEC publication,  “Asset-Liability Management Decisions for Sovereign Wealth Funds,” Lionel Martillini and Vincent Milhau proposed the application of the ALM approach to SWFs. Specifically; they said that an optimal investment policy for an SWF would involve these building blocks: a performance seeking portfolio (PSP); an endowment-hedging portfolio (EHP); and a liability hedging portfolio (LHP). The allocation of a SWF’s available capital among these three baskets would vary according to the investment horizon and the values of certain key market parameters, notably volatility.

After the publication of that paper, EDHEC-Risk called for market participants to share their reactions to its ideas. This month, EDHEC-Risk has published a new report – an assessment of the responses they received. This is “What Asset-Liability Management Strategy for Sovereign Wealth Funds?’ by Frédéric Ducoulombier, Lixia Loh, and Stoyan Stoyanov.

SWFs are distinct from pension funds at least in this sense, there are broadly speaking no explicit liabilities. There is no ongoing schedule of payments an SWF is responsible for making, for example. Nonetheless, there are clearly implicit liabilities. On this the point nearly all (92 percent) of survey respondents concurred, saying that implicit liabilities, arising from the objectives of the fund, must be taken into account in managers’ plans.

These authors distinguish among three types of SWF: natural resource funds, foreign reserve funds, pension reserve funds. The mandate of the resource funds is “typically to maintain economic stability against commodity price fluctuations and to invest for future generations.” The second type of SWF, foreign reserve funds, created by countries with current account surpluses, will seek to hedge the risk factors that threaten such surpluses. The final group, pension reserve funds, are separate entities from the state pension operations – but each is a hedge against the expected or perhaps the unexpected costs of the aging of cohorts in a population.

Forex and Liabilities

To grasp implicit liabilities, consider the case of foreign reserve funds more specifically. Typically, such a fund is run by a state with a managed exchange rate regime. The fund may purchase foreign currencies, often U.S. dollars, with the local currency (often newly expanded for this purpose). The idea is to prevent the appreciation of its own currency. Then it or the associated central bank issues local-currency denominated debt, which helps to sterilize what would otherwise be the inflationary effect of the dollar purchasing campaign.  This creates an expansion of the sovereign’s balance sheet on both the assets and the liabilities side.

Though the sovereign’s balance sheet in such a situation isn’t explicitly on the books of the SWF, it isn’t something the SWF can ignore. As Ducoulombier, Loh, and Stoyanov write, “[I]t is not clear that the assets under management represent net sovereign wealth because both the assets of the fund and the liabilities in terms of local debt on the side of the state grow.”

Seventy percent of the respondents agreed that ALM provides an improved understanding of the optimal investment and risk management policies for SWFs.

As you can see from the Exhibit above, reflecting EDHEC’s survey results, 15 percent “strongly agree” with that statement, while another 55 percent agree sans phrase.  Since the remainder professed no opinion, 0 percent disagreed (strongly or otherwise).

Many respondents, though, are concerned that ALM oversimplifies their asset allocation decisions.  Ducoulombier et al. think this concern is misdirected, that the three-basket approach of ALM is consistent with a thorough customization to “the particular constraints and objectives of each SWF,” and they remark that these responses show the need for further educational efforts.

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