IFSWF Direct | How SWFs Manage Long-Term Risk
IFSWF Secretariat
Welcome to the March 2023 edition of IFSWF Direct. This month we have a special edition exploring how sovereign wealth funds, as long-term investors, approach risk management.
We recently conducted our annual report on institutional investor flows in partnership with State Street, which included interviews with nine IFSWF members that invest in international financial markets. As part of the research, we asked these institutions what significant risks they saw facing their portfolios. These interviews gave us a valuable glimpse into what potential risks sovereign wealth funds have identified and how they are navigating current obstacles.
Managing Long-Term Risk in an Uncertain Envrionment
Since the global financial crisis of 2008 – when many sovereign wealth funds were relatively young institutions and sometimes responded in line with market fluctuations – they have developed a more professional view of managing risk, focusing on long-term strategic challenges. These issues are the most important for them as long-term investors with a fiduciary duty to steward their governments’ assets. As a result, over the past three years of uncertainty, our yearly research project with State Street has revealed that since the beginning of the market ructions spurred by the COVID pandemic, sovereign wealth funds have been focused on their long-term strategy and have kept to their benchmarks, even at times of immense market uncertainty. Even in recent weeks, sovereign wealth funds told us that they are “able to look through” the short-term market volatility and dislocations caused by the failure of Silicon Valley Bank and the bailout of Credit Suisse and have remained focused on what they see are the key risks to their long-term returns. However, they are keeping an eye on related “systemic, financial plumbing and reputation risks” as part of their portfolio management considerations.
Overall, sovereign wealth funds believe that we are entering a period of prolonged high and volatile inflation, which has the potential to damage global growth and even draw the economy into recession. They were also concerned about the impact of central banks’ responses to a new era of higher inflation. They noted that a new regime of tighter monetary policy, particularly in developed markets, was a significant risk to consider when evaluating their liquidity needs.
Although these foreseeable risks were at the top of their minds, the members we surveyed also had an eye on more unpredictable, asymmetric risks, particularly in terms of geopolitical conditions, consumer behaviour, and global issues such as climate change. Such “unknown-unknowns” are possibly the most concerning for sovereign wealth funds. As one told us, these “have the potential to cause lasting and possibly permanent change” to the global economy and financial markets.
Sovereign wealth funds are increasingly adopting new, cutting-edge tools and techniques to manage these risks. For example, some emphasise diversification and portfolio hedging in addition to traditional active management strategies. Moreover, many funds employ sophisticated techniques such as algorithmic trading, artificial intelligence, and machine learning to aid their decision-making. By leveraging these new tools, they are better able to analyse market data, identify and take advantage of opportunities, and manage portfolio risks more effectively. They are also able to identify potential risks earlier, allowing them to act proactively and limit losses. This is particularly beneficial in volatile markets such as those in 2020, when having the ability to anticipate and quickly respond to changes is essential.
Some sovereign wealth funds use derivatives to hedge risk and manage their portfolios, while others invest in more passive strategies such as index funds and exchange-traded funds. Additionally, some also use alternative investment strategies such as commodities, currencies, and hedge funds to diversify their portfolios and reduce the overall risk profile.
In the current investment environment, which is the most uncertain since the global financial crisis, sovereign wealth funds continue using their portfolio allocations to balance risk. Since 2016, we have been observing that sovereign wealth funds with a savings or diversification mandate increase their allocations to private assets. Roberto Marsella, Head of Private Assets at Generali Investments Partners, believes this trend will continue due to “the intrinsic characteristics of real assets and private markets, such as the opportunity for portfolio diversification due to a low correlation with liquid markets and a good degree of inflation hedging and value reserving. In the specific case of sovereign wealth funds, investing in these asset classes enables them to access a range of sectors and geographies that they would otherwise be unable to unlock.” He also believes that there will be “renewed interest in infrastructure investments, driven by their ability to provide stable cash flows, less correlated returns and a hedge against inflation.”
Some of the sovereign wealth funds we spoke to are also introducing new tilts towards the technology and healthcare sectors, which align with the trends, such as the energy transition and revolutions in mobility and digitisation that Marsella is observing “changing the face of infrastructure investing, which – since the global financial crisis – has gradually shifted from traditional infrastructure to a wider definition of perimeter.”
In conclusion, sovereign wealth funds are meeting the more uncertain investment environment by looking through the short-term noise and leveraging new tools, strategies and technologies to manage their risk exposures. That said, as all sovereign wealth funds are different and have unique mandates and risk appetites, the strategies they use will vary significantly and are often tailored to the specific needs and goals of the individual fund. By leveraging the right combination of strategies, funds are able to make informed decisions and invest in assets that are most likely to generate the desired returns while also managing risk appropriately.
The full report, Post-Inflation Realities: Evidence from Institutional Investor and Sovereign Wealth Fund Activity, will be published in April.
