Ready for Resilience
Welcome to the April 2023 edition of IFSWF Direct. This month we explore how sovereign wealth funds can manage the tension between portfolio resilience and efficiency. In an exclusive webinar for IFSWF members on 19 April, Chiam Swee Chiang, GIC’s Head of Total Portfolio Strategy and Matthew Leatherman, Research Director at FCLT Global, led a discussion about how sovereign wealth funds can prepare themselves for resilience and the specific tools and strategies needed.
Today’s most sophisticated investors have evolved from implementing Modern Portfolio Theory, which emphasised the creation of efficient portfolios that maximise the expected return for a given level of expected risk. Instead, they seek to optimise portfolios across three dimensions: risk, return, and resilience. Investors have moved on from focusing on efficiency because they are now faced with several disruptive structural trends, such as decarbonisation, de-globalisation, digitisation, and demographic liabilities. They need to be able to navigate the extremes of the market brought about by the impact of these disruptions, maintain financial performance in periods of market stress and reduce the volatility of short-term returns. To quote our panellists, “Never forget the six-foot man who drowned crossing a stream that was five feet deep on average.” Management can’t keep telling their stakeholders that returns will average out in the long term, as this can potentially undermine the confidence of a sovereign wealth fund’s stakeholders in its management.
The challenge for sovereign wealth fund managers is that most investors know the long-term direction of disruptions, but the short-to-medium term is still determined. Investors can’t predict the pace of these changes, and there may be periods of trend reversion. Consequently, long-term investors have to navigate this short-term uncertainty and to do so, they need operational and financial resilience. Investors must thrive during challenging times, not just when the markets perform well.
How to make a sovereign wealth fund resilient
To construct a resilient portfolio, investors need to think about both the beta perspective – the expected move in stock relative to movements in the overall market – as well as from an alpha perspective – the excess return of an investment relative to the return of a benchmark index, which enables an allocator to invest with more granularity.
Allocators should also be aware of three different investment horizons and ensure that for their allocation decisions: the long-term (e.g., 20 years), which is the anchor for their baseline risk exposure; the medium-term (10 years), the horizon to which investors allocate their capital allocation and long-term capital efficiency shift; finally there is the short-term investment horizon (three to five years), which is the tactical investment horizon. To make a portfolio resilient, investors should not try not to optimise for any single investment horizon but ensure that returns are positive and in line with the mandate for all of these periods. To do so, you need a variety of diversifying assets across the portfolio.
For example, real assets are long-term diversifiers, so if a sovereign wealth fund has allocated a proportion of its portfolio to infrastructure, it can effectively counteract inflation over the long term. However, if the fund does not have enough infrastructure exposure, the asset allocators need to consider how to handle the inflation shock in the near term by diversifying across other assets (often in public markets) that will perform over the short term to ensure the fund is resilient against brief inflation shocks.
Building a resilient portfolio takes work. It requires a deep understanding of the investment landscape, the ability to identify assets that are likely to perform well in a variety of market conditions and a sense of where their potential blind spots are. These skills enable the management team to make portfolio allocation decisions before a crisis rather than being made in a panic. This expertise requires time to build and thus needs the support of the management team and the board. However, it is not a free lunch. The expertise is expensive in both time and money to develop. Therefore, when considering the practicalities of developing a resilient portfolio, investors must understand “who is paying for lunch”.
In conclusion, long-term investors should aim to build portfolios optimally positioned on the “resilient frontier”: meeting their fiduciary duties to maximise returns with a certain level of risk while being resilient to changing expectations or guidelines. Resilience objectives can provide helpful information to help investors reach this destination. For example, frameworks have even been proposed in which ESG scores are integrated into portfolio optimisation, resulting in an ESG-efficient frontier. Identifying these frontiers allows investors to identify assets that are not only financially sound but also more resilient and have positive externalities.
