This publication contains the results of the first-year research work conducted at EDHEC-Risk Institute within the EDHECDeutsche Bank research chair on assetliability management (ALM) techniques for sovereign wealth fund management.
Under the responsibility of Lionel Martellini, the scientific director of EDHEC-Risk Institute, this chair examines optimal allocation policies for sovereign wealth funds (SWFs). This paper proposes a quantitative dynamic asset allocation framework for sovereign wealth funds, modelled as large long-term investors that manage fluctuating revenues typically emanating from budget or trade surpluses in the presence of stochastic investment opportunity sets. The optimal asset allocation strategy takes into account the stochastic features of the sovereign fund endowment process (where is the money coming from), the stochastic features of the sovereign fund's expected liability value (what the money is going to be used for), and the stochastic features of the assets held in its portfolio. Our results suggest that the investment strategy for an SWF should involve a state-dependent allocation to three building blocks, a performance-seeking portfolio (PSP, typically heavily invested in equities), an endowment-hedging portfolio (EHP, customised to meet the risk exposure in the sovereign wealth fund endowment streams), and a liability-hedging portfolio (LHP, heavily invested in bonds for interest rate hedging motives, and in assets exhibiting attractive inflationhedging properties, when the implicit or explicit liabilities of the sovereign wealth funds exhibit inflation indexation), as well as separate hedging demands for risk factors impacting the investment opportunity set, most notably interest rate risk and equity expected return risk.
|Research Cluster :||Finance|