EDHEC Encourages Sovereign Wealth Funds to Revise Investment Approach

With the growth of sovereign wealth funds likely to continue and expected to reach around $10 trillion within the next decade, a new paper by EDHEC says these investment vehicles should improve their investment policies and risk management practices.

(November 24, 2010) — A newly released paper by EDHEC recommends that sovereign wealth funds should revise their investment approach.

“While many sovereign funds were built on the idea that they could hold on to investments over long time horizons, some have had to draw back from investments abroad, even if they are marked at a loss at the time, in order to finance investments in their home country,” wrote the paper’s lead author, Lionel Martellini, a professor of finance at EDHEC Business School and scientific director of EDHEC-Risk Institute.

The report noted that the rapid growth of sovereign wealth funds, which currently have assets of more than $3 trillion, or more than twice the estimated size of the world’s hedge fund industry, pose a series of challenges for the international financial markets and for sovereign states. Specifically, the report recommended that the investment strategy for sovereign wealth funds should involve a performance-seeking portfolio (typically heavily invested in equities), an endowment-hedging portfolio, and a liability-hedging portfolio (heavily invested in bonds).

The paper, funded by Deutsche Bank and titled “Asset-Liability Management Decisions for Sovereign Wealth Funds,” found that sovereign wealth funds should divide their investments into returns-seeking and hedging portfolios tailored to their income from — and payouts to — their state sponsors. The paper compared this approach to the liability-driven investing paradigm developed in the pension fund industry, where it is perfectly recognized that hedging out the impact of risk factors on liability values is the first priority when designing asset allocation strategies, Martellini told aiCIO.

To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742