Official Institutions Group

Elliot Hentov, PhD

Head of Policy and Research, Official Institutions Group, SSGA and
Jeremy De Pessemier
Investment Strategist, Investment Solutions Group, SSGA
ssga.com/oig

Nothing
Lasts Forever
Imagining the Life Cycle of a Sovereign
Wealth Fund
Nothing Lasts Forever: Imagining the Life Cycle of a Sovereign Wealth Fund

The proliferation of Sovereign We believe this assumption to be not only flawed but
analytically unhelpful as it restricts free thinking on any
Wealth Funds (SWFs) across the fundsinvestment strategies. As a permanently ongoing

globe is a fairly recent phenomenon concern, bureaucratic inertia and intellectual rigidity can
replace analytical rigor. In other words, there is a paradox
with more than half of todays SWFs wherelong-term oriented funds use short-term metrics as

having been created in the 21st guidance. In this respect, funds expecting to exist forever
maynot maximize their stakeholders interest, as they seek to
century. Nonetheless, despite the emulate annual or medium-term targets instead of long-term

relative youth of these institutions, goals. Among investment professionals, this typically takes the
shape of measuring fund performance to select benchmarks,
the default assumption is that they established indexes or peer performances but what if these

will be permanent features of their are all incorrect reference points?

respective government operations. In this paper, we are suggesting a thought experiment for funds
to reframe their goals by focusing and rearticulating their core
mission. For example:

What is the ultimate purpose of the fund?

How would success be measured?
What time frame is appropriate for the funds mission?
How could one quantify the liabilities of a SWF?

The last point is especially relevant, as all investors have

liabilities. SWF liabilities may be implicit and/or undefined,
butthey exist. The development of a portfolio solution should
reflect a thorough understanding of these liabilities and their
associated risks.

By addressing these questions and others, we aim to devise

analternative prism to build a customised benchmark
applicable to different types of fund. We simulate this exercise
with a simplified case study of an intergenerational SWF.

Sovereign Wealth Funds

A Historical Phenomenon
The term Sovereign Wealth Fund continues to be frequently
used as a catch-all for government-owned investment funds that
are each highly idiosyncratic. The most accepted taxonomy of
different SWF types is the International Monetary Fund (IMF)
classification of five groups:

1. Stabilization Funds,
2. Pension Reserve Funds,
3. Reserve Investment Corporations,
4. Savings Funds,
5. and Development Funds.

2
In practice, most institutions are a combination of the different In contrast, savings and development funds (sometimes also
SWF functions listed above. In a purist view, of these five types, called strategic funds) tend to be unencumbered national
only number two and three in Figure 1 constitute the pure savings, geared toward intergenerational savings or long-term
SWF model, i.e. national savings that can be deployed beyond economic transformation without explicit liabilities of any kind.
immediate government policy objectives. In contrast, They are also designed to ultimately absorb national savings in
stabilization funds are rainy day funds for governments to tap the domestic economy, whether as part of active development
in periods of stress. Hence, they simply represent enlarged fiscal policies or through intergenerational dividend receipts from
buffers and need to meet certain characteristics, notably on savings held abroad.
liquidity and risk, in order to fulfil their purpose. Pension
What led to the creation of such national savings? The two
reserve funds are a financially effective tool for governments to
mostcommon sources are the earnings of natural resource
make explicit pension liabilities otherwise unstated and to build
extraction or non-commodity exports which generate balance of
a reserve to service these liabilities. Reserve investment
payments surpluses. In economic terms, these economies
corporations are responsible for managing a share of foreign
produce national savings as their income is greater than their
exchange reserves that appears to be in excess of the routine
ability to consume or invest. Economic theory would predict
management of a countrys external balances. In this regard,
this to be temporary with structural forces ultimately pushing
they are just an extension of a central banks reserve
consumption or investment up and reducing savings.
management, albeit with a higher risk tolerance and
longertimehorizon. Put simply, nothing lasts forever. Even natural resource
bonanzas have an expiration date. Even with technological
advances, some energy deposits are finite and lead to host
Figure 1: Taxonomy of Sovereign Wealth Funds
countrys declining resource production over time. For example,
(IMF Definition)1
UK oil production began in 1976 and peaked in 1999, declining
Type Purpose Examples
since then despite rapid innovation in the offshore oil sector.
Stabilization Rainy Day Fund for shock Russia: Oil Stabilization Fund Countries with larger proven reserves have longer time periods,
absorption or smoothen out Chile: Economic and such as Kuwait that could maintain current production for
revenue cycle for government Stabilization Fund
(typically commodity-dependent)
another 89 years.2 Nonetheless, even that is finite and poses a
time limit, not to mention the potential premature loss of
Saving Intergenerational Savings Fund UAE: Abu Dhabi Investment
Authority (ADIA) relevance due to environmental or technological progress.
Canada: Alberta Trust Fund Similarly, East Asian countries export-led surpluses also reflect
Development Channel for Kazakhstan: Samruk-Kazyna a time period specific to rapid industrialization. It is therefore
Economic Development also reasonable to assume that it characterizes a particular
Pension Reserve Funds established to service New Zealand Super Fund developmental phase that will end. Given that these surpluses
contingent pension liabilities Australia Future Fund depend on deficits elsewhere in the global economy, they are to
Reserve Funds split off from central banks China: China Investment be viewed as temporary.
Investment to achieve higher returns than Corporation (CIC)
regular foreign reserves
In sum, all of the trends leading to the creation of national
savings are temporary and have an expiration date. Therefore,
Source: State Street Global Advisors (SSGA) Research using IMF classification. the product of these savings the respective SWFs could also
consider themselves as a historical phenomenon with a time-
sensitive purpose, i.e. they also have a life cycle during which to
accomplish their mission and may not be permanent.

State Street Global Advisors 3

Nothing Lasts Forever: Imagining the Life Cycle of a Sovereign Wealth Fund
Thought Experiment: Savings Fund for
Intergenerational Transfers
Countries benefiting from natural resource booms recognize
the good fortune of the generation that enjoys the tailwind of
boosted incomes. As a result, most of the savings SWFs today
consider themselves vehicles for intergenerational transfers.
Therefore, the ideal fulfilment of a SWF mission would be to
share the earnings from natural resources equitably across
generations. The strategic asset allocation should be tailored
tothis unique liability risk profile, funded status, return target,
desired future funding status and expected funding volatility.
The framework should also allow de-risking in certain scenarios
and re-risking in others, as markets, liabilities andinvestment
objectives evolve.
In our experiment, fictional country Generania suddenly
discovered oil a generation ago and significant oil production
began 20 years ago and has now receded. Of the total earnings,
Generanias government spent 1/3 over the course of 20 years
aspart of economic development programs and regular
government budgeting. The remaining 2/3 was deposited in
theSWF. In detail, Generanias SWF has total assets under
management (AUM) of $24 billion and is due to make
annualtransfer payments to the government of $1 billion,
starting thisyear. Thereafter, transfer payments increase with
an annual inflation increase of 2.5%. Fund should last for
40years.
Figure 2: Current Average Asset Allocation of
Commodity-based SWFs
Generania SWF Average Asset Allocation
Private Markets
19.0%
Cash and Fixed Income
Equites
38.4%
Source: Elliot Hentov How Do SWFs Invest? A Glance at SWF Asset Allocation,
SSGA Research, December 2015, p.3.
The above chart is for illustrative purposes only.
4
Briefly disregarding the fact that the SWF accrued positive
average return during this period, the basic arithmetic
proposition would hold that the fairest objective of the
SWFwould be to spread the remainder over the course of the
coming 40 years in a manner that treated future generations
equally. How should the SWF approach its investment if it
assumes no further deposits from the host government and
aims to disburse its entire original principal (inflation-adjusted)
over the 40 year period?
Under this payout scenario, SWFs would face similar issues
toother long term investors, particularly endowments. If
endowments want to maintain their assets over the long term,
they have to be prudent in their investment assumptions i.e.
estimate their future returns to determine how much to spend
each year: pay out too much and their funds will dwindle away.
In this way, an endowment fund has both a growth and an
income component. The key difference between an endowment
and SWF however, is that the former is a permanent, self-
sustaining source of funding i.e. most endowments are designed
to keep the principal amount intact while each year, a share of
the value of the fund is paid out to support the funds purpose.
Figure 3: Expected Distribution of Generic Portfolio
Returns over 40 Years
USD (Billions)
100
80
60
42.7%
40
20
0 0 10 20 30 40
10th Percentile 25th Percentile Median
75th Percentile 90th Percentile
Source: SSGA Research as of 31 August 2016.
The above estimates based on certain assumptions and analysis made by SSGA.
There is no guarantee that the estimates will be achieved.
For Illustrative purposes only
In our experiment, Generanias SWF current investment
strategy exactly matches the average asset allocation of
commodity-based sovereign wealth funds, as depicted in
figure2. In this regard, we estimated it to be the following:
42.7% in Cash & Fixed Income, 38.4% in Equities and 19% in
private markets, mainly alternatives related to private equity
and real estate.
Based on this allocation, we simulated the performance of an
average portfolio using proxy indices as shown in figure 3.3 The
goal was to identify the median life expectancy of Generanias
portfolio given our long term expected volatility and return
forecasts. Figure 3 shows the distribution of expected returns of
such a generic portfolio, with the median return giving the SWF
a life cycle of 33 years, i.e. seven years short of its 40-year target.
In this example, the challenge for the Generania SWF would be
to extend its expected life cycle by about 20%. This could be
attempted by mimicking liability-driven investing and taking
stock at a defined point. For example, if median performance
took place over the first 20 years, then the strategic asset
allocation could be re-risked. After 20 years, we simulated the
effects of shifting all fixed income exposure into public equities,
while leaving the private equity share unchanged (with the
assumption that this would be illiquid to alter at that point).
Figure 4: Expected Distribution of 40-year Portfolio
Returns after Re-Risking after 20 years
USD (Billions)
100
80
60
40
20
0 0 10 20 30 40
10th Percentile 25th Percentile Median 75th Percentile 90th Percentile
10th Percentile (re-risk) 25th Percentile (re-risk) Median (re-risk)
75th Percentile (re-risk) 90th Percentile (re-risk)
Source: SSGA Research as of 31 August 2016.
The above estimates based on certain assumptions and analysis made by SSGA.
There is no guarantee that the estimates will be achieved.
Returns do not represent those of a fund but were achieved by running a Monte Carlo
simulation using ISGs long term expected returns and volatility levels for Global
Equities, Private Equity, US Corporates and US Treasuries. The forward looking
simulation assumes no transaction and rebalancing costs, so actual results will differ.
Theresult would be an extension of the expected life cycle by
only about 1.5 years, so any changes wouldneed to happen
muchearlier. Figure 4 below shows theexpected distribution
insuch a scenario.
This is typically a central challenge faced by pension schemes:
how to navigate an efficient deficit recovery path within an
effective risk management framework? The aim is to minimise
the funding volatility and regret risk over time by navigating
through an efficient recovery path which adjusts the allocation
in light of market performance. By pragmatically managing the
path back to being fully funded, and establishing a dynamic
de-risking framework, a pension scheme can increase the
certainty of becoming fully funded, while reducing the
possibility that the funding ratio deteriorates significantly.
Conversely, if the fund exhibited a strong outperformance in the
early part of the cycle, then it would have the luxury of being
able to de-risk in a prudent manner. In Figure 5, we illustrate
the example of the funds performance being in the 75th
percentile during the first 20 years. At that stage, the fund could
de-risk and shift its entire equity portfolio into fixed income.
The expected outcome would be to comfortably meet its 40-year
target with minimal volatility and downside risk.
Figure 5: Expected Distribution of 40-year Portfolio
Returns after De-Risking after 20 years
USD (Billions)
100
80
60
40
20
0 0 10 20 30 40
10th Percentile 25th Percentile Median 75th Percentile 90th Percentile
10th Percentile (re-risk) 25th Percentile (re-risk) Median (re-risk)
75th Percentile (re-risk) 90th Percentile (re-risk)
Source: SSGA Research as of 31 August 2016.
The above estimates based on certain assumptions and analysis made by SSGA.
There is no guarantee that the estimates will be achieved.
Returns do not represent those of a fund but were achieved by running a Monte Carlo
simulation using ISGs long term expected returns and volatility levels for Global
Equities, Private Equity, US Corporates and US Treasuries. The forward looking
simulation assumes no transaction and rebalancing costs, so actual results will differ.
State Street Global Advisors 5
Nothing Lasts Forever: Imagining the Life Cycle of a Sovereign Wealth Fund

The high annual transfer payout ($1 billion inflation- Figure 6: Expected Distribution of 40-year Portfolio
adjusted,over 4% of the funds starting value) quickly Returns starting with Higher-Risk Profile and then
becomesdebilitating for any investment strategy so that De-Risking after 20 years
front-loaded decisions carry disproportional weight. If
USD (Billions)
liabilities were to become explicit, an outcome-oriented
120
investment strategy would need to be implemented early on
tobetter meet final objectives. In Figure 6, we simulate a 90
morerisk seeking approach at the starting point with 81%
inequities and the remainder in private equity. At midpoint, 60
i.e.after 20 years, this portfolio is de-risked and all equities
areconverted into fixed income instruments. The resultis 30
thateven the median performance extends the life
0
cycle3.5years beyond the currentasset allocation.
-30 0 10 20 30 40

10th Percentile 25th Percentile Median 75th Percentile 90th Percentile

10th Percentile (re-risk) 25th Percentile (re-risk) Median (re-risk)

75th Percentile (re-risk) 90th Percentile (re-risk)

Source: SSGA Research as of August 2016.

The above estimates based on certain assumptions and analysis made by SSGA.
There is no guarantee that the estimates will be achieved.
Returns do not represent those of a fund but were achieved by running a Monte Carlo
simulation using ISGs long term expected returns and volatility levels for Global
Equities, Private Equity, US Corporates and US Treasuries. The forward looking
simulation assumes no transaction and rebalancing costs, so actual results will differ.

6
Conclusion
Looking at these basic simulated returns, a defined life cycle
ofan SWF would suggest three points:
1. External reference points may not be relevant for a specific
fund. This applies to standardized benchmarks, possible
reference portfolios or peer performance comparisons.
What is important is an internal benchmark that supports
the realisation of thefundsmandate.
2. The simulation of imaginary future liabilities helps frame
investment strategy in forward-looking terms. All existing
benchmarks or reference points are historical and hence,
by definition, backward-looking.
3. Achieving any policy mandate is likely to be very
challenging with unrealistic dividends and time horizons.
Current investment approaches would likely fail, while
funds would need to ratchet up their risk profile to
approach such policy goals. Another alternative would be
to consistently outperform median return expectations
and identify long-term alpha.
In reality, many SWFs have begun to adopt these strategies
by harvesting an illiquidity premium and pursuing longer-
term investments, including illiquid instruments in private
equity, real estate and others. Depending on the specific
goals desired by the respective SWFs, the question arises
whether todays asset allocation is adequately matched with
long-term outcomes. A precise articulation of those
outcomes would help align investment strategy with the
underlying mission of any SWF.

State Street Global Advisors 7

1
IMF Working Paper WP 13/231, Sovereign Wealth Funds: Aspects of Governance Structures
and Investment Management. Authors: Abdullah al-Hassan, Michael Papaioannou, Martin
Skancke, Cheng Chih Sung. November 2013.
2
BP Statistical Review of World Energy 2015, p.6, available at https://.bp.com/content/dam/bp/
pdf/energy-economics/statistical-review-2015/bp-statistical-review-of-world-energy-2015-
full-report.pdf
3
For cash & fixed income, we assumed roughly one-fifth was in money market-like vehicles and
used the BoA Merrill Lynch US Treasury Index. For the remaining 80% of fixed income, we used
the BoA Merrill Lynch US Corporate Index. For equities, we used the MSCI AC World Daily
Total Return Net USD Index. For private markets, we used the S&P Listed Private Equity Index.
ssga.com
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Investing involves risk including the risk of loss of principal.
Asset Allocation is a method of diversification which positions assets among major
investment categories. Asset Allocation may be used in an effort to manage risk and
enhance returns. It does not, however, guarantee a profit or protect against loss.
Equity securities may fluctuate in value in response to the activities of individual
companies and general market and economic conditions.
Bonds generally present less short-term risk and volatility than stocks, but contain
interest rate risk (as interest rates raise, bond prices usually fall); issuer default
risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually
pronounced for longer-term securities. Any fixed income security sold or redeemed
prior to maturity may be subject to a substantial gain or loss.
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investors. Commodities investing entail significant risk as commodity prices can be
extremely volatile due to wide range of factors. A few such factors include overall
market movements, real or perceived inflationary trends, commodity index volatility,
international, economic and political changes, change in interest and currency
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