## Setting up a Sovereign Wealth Fund: Some Policy and Operational Considerations (WP/09/179)

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---

### Introduction
- Purpose: offer a policy and operational “roadmap” to policymakers considering setting up an SWF and to those reviewing existing SWFs.
- Basis: relies largely on experience of existing SWFs, consistency with macroeconomic frameworks, investment objectives, and the authors’ international reserves management experience.
- Key organizational logic:
  - Start with policymakers’ broad objectives (e.g., enhancing returns on international reserves, meeting pension liabilities, stabilizing fiscal revenues, investing for development).
  - First decision: whether to set up an SWF — hinges on whether international reserves are “adequate” or “optimal.”
  - Second decision: operational design consistent with policy objectives — funding, withdrawal, and spending rules.
  - Third decision: institutional arrangements and clear governance delineating which institution sets policy objectives, operational objectives, and investment guidelines.
  - Fourth decision: strategic asset allocation (SAA) and investment policy consistent with objectives and operational constraints, including whether to invest domestically (weighing Dutch Disease risks).
- Behavioral note: governments often adopt a “mental accounting” approach when dividing sovereign assets, leading to ad hoc SWF creation after critical mass of reserves is reached.

### What is a Sovereign Wealth Fund?
- Definition: a special purpose investment fund or arrangement, owned by the general government, created for macroeconomic purposes, holding/managing/administering financial assets to achieve financial objectives and employing investment strategies including foreign financial assets.
- Typical funding origins: balance of payments surpluses, official foreign currency operations, proceeds of privatizations, fiscal surpluses, and/or commodity export receipts.
- Distinguishing features:
  - Capacity for long-term investment horizon and relatively less risk aversion compared to agencies managing traditional foreign exchange reserves.
  - Exclusions: foreign currency reserve assets held solely for BoP or monetary policy purposes, traditional SOE operations, government-employee pension funds, or assets managed for the benefit of individuals.
- Heterogeneity: SWF is an all-encompassing term covering diverse funds that share public ownership and macroeconomic purpose(s), often multiple (e.g., savings and fiscal stabilization).

### When to Set Up an SWF?
- No definitive theoretical model; practice driven by asset accumulation episodes (commodity price booms, export booms).
- Theoretical optimal approach: treat government balance sheet in entirety and optimize asset allocation including commodity-in-ground and future tax revenue.
- Practical approach: often ad hoc; SWFs typically established when a critical mass of BoP or fiscal surpluses is reached.
- Mental accounting (Thaler (1980)): policymakers earmark “excess” revenues or reserves for different purposes once perceived adequacy is reached.

#### A. When are a Country’s Reserves Adequate?
- Recommendation: establish and agree the “adequate” or “optimal” level of reserves between the central bank and the government before other institutional measures.
- Crisis-prevention benchmark for emerging markets: the ratio of international reserves to short-term external debt.
  - Simple benchmark: target coverage of short-term external debt of all residents and in all instruments and currencies measured by remaining maturity (implies sufficient reserves to cover obligations for a full year if cut off from external capital inflows).
- Factors increasing desired reserve levels:
  - Large external current account deficits
  - Overvalued exchange rates
  - High levels of short-term public domestic debt
  - Derivative positions of the public sector
  - Weak banking systems
- Factors reducing reserve needs:
  - Flexible exchange rate regime
  - Exchange rate management discouraging high private sector foreign exchange exposure
  - Public sector ability to borrow in domestic currency from non-residents
  - Sound private sector risk management
  - Sound banking supervision
  - Government’s ability to borrow quickly and in large amounts from non-residents
- Insurance/optimizing models referenced: Jeanne-Ranciere (2006) and Jeanne (2007) — tradeoff between crisis-reduction benefits of reserves and their low-return opportunity cost.

#### B. Options in Case of Ample Reserves
- Assess origin and longevity of ample reserves (capital inflows, fiscal surpluses, privatization receipts, commodity revenues) and alternative uses before establishing an SWF.
- Option 1 — Reduce or match external debt obligations:
  - Use ample reserves to repay external loans to reduce currency mismatches and carry costs.
- Option 2 — Manage reserves on central bank balance sheet with a long-term perspective:
  - Split reserves into tranches (example: Backing Portfolio and Investment Portfolio as in the Hong Kong Monetary Authority).
  - Backing Portfolio: highly liquid, short-term U.S. dollar-denominated fixed income securities.
  - Investment Portfolio: more dynamic investments, including equities.
  - Constraint: limited tolerance for reporting losses and marked-to-market accounting may limit risk and size of the investment tranche.
- Option 3 — Set up an SWF (on central bank balance sheet or as a separate institution):
  - Typically chosen when other options are exhausted or when there is a clear, sustained source of higher reserves (e.g., prolonged commodity price boom).
  - Rationale for commodity exporters: reduce volatility of government revenues and limit Dutch Disease effects that could crowd out the private sector.

#### C. BoP Crises and SWF Liquidity Support
- Contingent liquidity support could prevent the SWF from pursuing a long-term investment horizon and holding less liquid assets.
- If the SWF needs to provide BoP support, establish clear policy, rules, and procedures to promote transparency and accountability.
- Examples:
  - The Pula Fund in Botswana has agreed trigger points allowing the fund to be drawn from when macroeconomic policy adjustments proved insufficient to stabilize the reserve level in the Liquidity Portfolio.
  - Korea Investment Corporation (KIC): assets are qualified as reserve assets and could be used for BoP purposes.
- Commodity funds often disburse when commodity prices are weak and thus tend to support BoP even without an explicit BoP support function.

### SWF Objectives and Types
- IMF distinguishes five types of SWFs: (i) reserve investment corporations; (ii) pension-reserve funds; (iii) fiscal stabilization funds; (iv) fiscal savings funds; and (v) development funds.
- Pension-reserve funds:
  - Build assets to cover identified liabilities related to an aging population; examples: Australia, Ireland, New Zealand, and Chile.
- Fiscal stabilization and fiscal savings funds:
  - Stabilization funds smooth boom/bust cycles (example: Trinidad and Tobago).
  - Saving funds focus on intergenerational equity and convert finite extractive assets into perpetual financial cash flows.
  - Funds may evolve (example: Russia redesigned its funds as they grew).
- Objectives can be multiple or change over time; coordination with macroeconomic framework, fiscal and monetary authorities is critical.

### Formulating Operational Objectives
- Operational objectives derive investment policy and asset allocation.
- Stabilization funds: save when actual commodity price exceeds a reference price; withdraw when below (examples: Algeria and Russia).
- Savings funds: operational objective often to maximize the real annual payout per capita or payout as a share of GDP.
- Reserve investment corporations: maximize returns subject to given risk tolerance; operational objective can be return-based.
- Pension/liability-focused funds: follow ALM approaches; horizon and liabilities often well identified (examples: Australia, New Zealand).

### Funding, Withdrawal, and Spending Rules
- Policies for funding, withdrawal, and spending should be clear and consistent with fund purposes.
- Stabilization SWFs: usually have clearly laid out deposit and withdrawal rules.
- Savings SWFs:
  - Receive contributions from excess revenues; purpose to spend earnings or profits for future generations.
  - Fiscal processes may allow flexible withdrawals to avoid borrowing, but this can constrain investment processes.
  - Best practice: clear investment mandate without need to keep liquidity for unpredictable government calls, while allowing investments in government bonds if consistent with the macro framework.
- Integration in fiscal framework:
  - Example: Norway’s Government Pension Fund-Global is integrated into government finances; accumulation = net cash flow from petroleum revenues + return on assets; outflow = transfer to the budget to finance the non-oil budget deficit.
- Direct payments and discretionary access:
  - Example: Alaska’s Permanent Reserve Fund pays an annual dividend based on half of the average realized income for five years.
  - Example: Government of Singapore Investment Corporation (GIC) — Constitution allows the government to spend up to 50 percent of the “Net Investment Income” derived from past reserves.

### Institutional Structure, Governance, and Decision-Making
- Legal form options: separate legal entity, unit within central bank, or within Ministry of Finance.
- Operational management should be independent to minimize political influence.
- Separate legal entities: differentiate owner, governing body(ies), and operational management; independence can be embedded in appointment/removal rules.
- Units within central banks: require clear legal foundation and internal governance; units within ministries often have less operational independence and suit narrow mandates.
- Cost and capacity trade-offs:
  - Separate entities have sunk costs; units in existing institutions can be more cost-efficient for small funds.
  - Advanced investment mandates may require clear separation and appropriate pay culture.
  - Activities of a unit within a central bank should not impact the central bank’s income statement and balance sheet because the owner (government) takes the return and related volatility.
- Decision-making hierarchy (four types):
  - (i) determination of policy objectives and overall risk tolerance;
  - (ii) determination of operational objectives;
  - (iii) determination of strategic asset allocation (SAA), including allowable deviations from benchmarks and their reflection in investment guidelines;
  - (iv) operational execution of investment decisions in compliance with investment guidelines.
- Reporting lines:
  - Units in central banks: Ministry of Finance often reports to Parliament on fund activities based on audited financial statements.
  - Separate legal entities: typically report to the government represented by the Minister of Finance and have explicit reporting requirements.
  - Timely and accurate reporting ensures integration into macroeconomic policymaking.

### Determinants of Investment Policy and SAA Design
- SAA integrates operational objectives with expectations about risk/return characteristics, including correlations and liabilities.
- Expectations must be consistent with macroeconomic projections and constraints (example: profit growth bounded by GDP growth).
- Diversification: combine asset classes with low or negative correlation; choose allocations that offset the country’s economic risk profile.
- SAA outcome: portfolio weights for eligible asset classes expressed in strategic benchmarks for measurement and assessment.
- SAA reviews: periodic or when investor objectives change significantly.
- Early-stage SWFs: be cautious while building experience and positions.
- Key determinants: investment horizon, risk tolerance, asset classes and correlations, ALM, and other constraints.

### Investment Horizon, Risk, and ALM
- Time horizon depends on whether the fund is an endowment or intended to be depleted.
- Practical uncertainties: uncertain size of natural resource reserves; politically motivated claims on funds.
- Methods to reflect uncertainties: assign larger discount rates to future inflows or reduce the investment horizon.
- Capital preservation:
  - Sponsor’s desire to preserve capital often implies zero tolerance for negative returns in nominal or real terms.
  - Early investing to build buffers, establish experienced oversight, and educate stakeholders can lessen costs of strict capital-preservation constraints.
- Asset classes and correlation:
  - Short horizons → high allocation to fixed income.
  - ALM may justify inclusion of long-term asset classes with low or negative correlation to the country’s exposures.
  - Commodity-exposed owners should consider assets inversely related to commodity prices.
- ALM objective: maximize return over the investment horizon net of withdrawals and non-investment income, subject to risk tolerance and asset returns; recognize future revenues and liabilities in SAA.

### Currency Composition, Liquidity, Legal Constraints
- Currency composition depends on SWF objective and liability structure.
  - Stabilization funds: weight basket toward countries that import the commodity; avoid investing in the currency to which the domestic currency is pegged.
  - Pension/fiscal savings funds: consider correlation of liabilities with foreign currencies; long horizons favor diversification.
- Liquidity requirements:
  - If outflows are certain in timing and amount, match with liquid assets per ALM.
- Legal and regulatory constraints:
  - Legislation commonly specifies permissible asset classes; restrictions often include prohibitions on domestic investment, private equity, real estate, hedge funds, derivatives, and swaps.
  - Prefer legislation focusing on overall objectives rather than specifying asset classes, especially for nascent funds.

### Financing Domestic Projects and Use of External Managers
- Domestic investment considerations:
  - Developmental objectives may justify domestic investment but must be consistent with macroeconomic policy.
  - Risks: stimulate domestic demand, pressure prices, cause real effective exchange rate appreciation, crowd out private investment, and complicate fiscal transparency and budgetary control.
  - Projects with clear public-good characteristics arguably belong in the budget.
- Hiring external asset managers:
  - Benefits: expertise, access to markets, lower operational risk, skills for specialized instruments, and training.
  - Delegation allows SWF focus on SAA and manager selection; in-house expertise acquisition can be costly for advanced asset classes.
  - Ultimate responsibility for market, credit, and liquidity risks remains with the SWF/government.
  - Contracts must specify SAA, benchmarks, permissible deviations, risk parameters, permitted instruments, and reporting.
  - Use multiple external managers to diversify manager-specific risk, but avoid an excessively large number to limit administrative burden and total fees.

### Conclusion and Areas for Further Research
- The paper provides a roadmap covering whether to set up an SWF, alternatives, institutional arrangements, fiscal rules, and investment policy.
- Identified areas for further research:
  - Level of adequate reserves or revenues.
  - Optimal level of foreign debts that a country should hold and not use foreign assets to repay.
  - Theory on sovereign asset liability management.

*Prepared by Udaibir S. Das, Yinqiu Lu, Christian Mulder, and Amadou Sy. IMF Working Paper WP/09/179, August 2009*

### Section 1

### Setting up a Sovereign Wealth Fund: Some Policy and Operational Considerations (WP/09/179)

### Introduction
- Purpose: offer a policy and operational “roadmap” to policymakers considering setting up an SWF and to those reviewing existing SWFs.
- Basis: relies largely on experience of existing SWFs, consistency with macroeconomic frameworks, investment objectives, and the authors’ international reserves management experience.
- Key organizational logic:
  - Start with policymakers’ broad objectives (e.g., enhancing returns on international reserves, meeting pension liabilities, stabilizing fiscal revenues, investing for development).
  - First decision: whether to set up an SWF — hinges on whether international reserves are “adequate” or “optimal.”
  - Second decision: operational design consistent with policy objectives — funding, withdrawal, and spending rules.
  - Third decision: institutional arrangements and clear governance delineating which institution sets policy objectives, operational objectives, and investment guidelines.
  - Fourth decision: strategic asset allocation (SAA) and investment policy consistent with objectives and operational constraints, including whether to invest domestically (weighing Dutch Disease risks).
- Behavioral note: governments often adopt a “mental accounting” approach when dividing sovereign assets, leading to ad hoc SWF creation after critical mass of reserves is reached.

### What is a Sovereign Wealth Fund?
- Definition: a special purpose investment fund or arrangement, owned by the general government, created for macroeconomic purposes, holding/managing/administering financial assets to achieve financial objectives and employing investment strategies including foreign financial assets.
- Typical origins of SWF funding: balance of payments surpluses, official foreign currency operations, proceeds of privatizations, fiscal surpluses, and/or commodity export receipts.
- Distinguishing features:
  - Capacity for long-term investment horizon and relatively less risk aversion compared to agencies managing traditional foreign exchange reserves.
  - Exclusions: foreign currency reserve assets held solely for BoP or monetary policy purposes, traditional SOE operations, government-employee pension funds, or assets managed for the benefit of individuals.
- Heterogeneity: SWF is an all-encompassing term covering diverse funds that share public ownership and macroeconomic purpose(s), often multiple (e.g., savings and fiscal stabilization).

### When to Set Up an SWF?
- No definitive theoretical model exists for timing SWF creation; practice driven by asset accumulation episodes (commodity price booms, export booms).
- Optimal approach (theoretical): treat government balance sheet in entirety — identify all financial assets and liabilities (including commodity-in-ground and future tax revenue) and optimize asset allocation accordingly.
- Practical approach: often ad hoc; SWFs typically established when a critical mass of BoP or fiscal surpluses is reached.
- Mental accounting framework (Thaler (1980)): policymakers earmark “excess” revenues or reserves for different purposes once perceived adequacy is reached; only then is higher risk tolerance applied to an “excess” account.

#### A. When are a Country’s Reserves Adequate?
- Recommendation: establish and agree the “adequate” or “optimal” level of reserves between the central bank and the government before other institutional measures.
- Crisis-prevention benchmark for emerging markets: the ratio of international reserves to short-term external debt.
  - Simple benchmark: target coverage of short-term external debt of all residents and in all instruments and currencies measured by remaining maturity (implies sufficient reserves to cover obligations for a full year if cut off from external capital inflows).
- Factors increasing desired reserve levels:
  - Large external current account deficits
  - Overvalued exchange rates
  - High levels of short-term public domestic debt
  - Derivative positions of the public sector
  - Weak banking systems
- Factors reducing reserve needs:
  - Flexible exchange rate regime
  - Exchange rate management discouraging high private sector foreign exchange exposure
  - Public sector ability to borrow in domestic currency from non-residents
  - Sound private sector risk management
  - Sound banking supervision
  - Government’s ability to borrow quickly and in large amounts from non-residents
- Insurance/optimizing models: Jeanne-Ranciere (2006) and Jeanne (2007) — tradeoff between crisis-reduction benefits of reserves and their low-return opportunity cost.

#### B. What are the Options in Case of Ample Reserves?
- Assess the origin and longevity of ample reserves (capital inflows, fiscal surpluses, privatization receipts, commodity revenues) and alternative uses before establishing an SWF.
- Option 1 — Reduce or match external debt obligations:
  - Use ample reserves to repay external loans to reduce currency mismatches and carry costs (example: Banco de Mexico repaid IDB and World Bank loans after negative income results in 2004 and 2005).
- Option 2 — Manage reserves on central bank balance sheet with a long-term perspective:
  - Split reserves into tranches (e.g., Backing Portfolio and Investment Portfolio as in the Hong Kong Monetary Authority).
  - Backing Portfolio: highly liquid, short-term U.S. dollar-denominated fixed income securities.
  - Investment Portfolio: more dynamic investments, including equities.
  - Constraint: limited tolerance for reporting losses and marked-to-market accounting may limit risk and size of the investment tranche.
- Option 3 — Set up an SWF (on central bank balance sheet or as a separate institution):
  - Typically chosen when other options are exhausted or when there is a clear, sustained source of higher reserves (e.g., prolonged commodity price boom).
  - Rationale for commodity exporters: reduce volatility of government revenues and limit Dutch Disease effects that could crowd out the private sector.

#### C. What if BoP Crises Call for Liquidity Support from the SWF?
- Clarification: providing liquidity during a balance of payment (BoP) crisis is the objective of a country’s official foreign currency reserves, and not the typical objective of an SWF.

*Prepared by Udaibir S. Das, Yinqiu Lu, Christian Mulder, and Amadou Sy. IMF Working Paper WP/09/179, August 2009*

### Section 2

### _wp09179 - Section 2

### Contingent Liquidity Support and Interaction with BoP
- Contingent call for liquidity support could potentially prevent the SWF from pursuing long-term investment horizon and holding less liquid assets.
- If the SWF needs to provide BoP support, a clear policy and supporting rules and procedures should be established consistent with that purpose to promote transparency and accountability of the SWF.
- Examples:
  - The Pula Fund in Botswana has agreed trigger points that allow the fund to be drawn from in the event that macroeconomic policy adjustments have proved insufficient to stabilize the reserve level in the Liquidity Portfolio.9
  - In the case of Korea Investment Corporation (KIC), assets are qualified as reserve assets and could be used for BoP purposes.10
- Typically, commodity funds also result in disbursements when commodity prices are weak and thus tend to support balance of payments even when they have no explicit balance of payments support function.

*Source: _wp09179 - Section 2.*

### What Are an SWF’s Objectives?
- The IMF broadly distinguishes five types of SWFs: (i) reserve investment corporations that aim to enhance returns on reserves; (ii) pension-reserve funds; (iii) fiscal stabilization funds; (iv) fiscal savings funds; and (v) development funds that use returns to invest for development purposes.11

- Pension-reserve funds:
  - Seek to build assets to cover an identified liability often related to an aging population.
  - Aim to accumulate assets now to offset projected higher liability related to sustaining pensions and social welfare in the future.
  - Examples: Australia, Ireland, New Zealand, and Chile.12
  - Depending on the macroeconomic framework, these assets can often be invested abroad for future import financing when the domestic population comes of age.

- Fiscal stabilization and fiscal savings funds:
  - Address two issues with commodity wealth: price volatility and discontinuous quantities.
  - Saving funds focus on intergenerational equity and transfers, often via an endowment-type fund converting a finite extractive asset into an infinite stream of financial cash flows.
  - Stabilization funds smooth boom/bust cycles (example: Trinidad and Tobago13) and may mitigate Dutch Disease by saving assets abroad.
  - Stabilization funds may grow and be redesigned as stabilization and savings funds (example: Russia14).

- Objectives may be multiple or change over time, especially in natural resource exporting countries: initial stabilization objectives can broaden to include savings as assets grow.

- Coordination requirement:
  - The SWF’s policy objective and activities should be consistent with a country’s overall macroeconomic framework because SWF assets and returns impact public finances, monetary conditions, the balance of payments, and the overall balance-sheet.
  - Appropriate coordination between the SWF and fiscal and monetary authorities is critical.

*Source: _wp09179 - Section 2.*

### Formulating Operational Objectives to Achieve Policy Objectives
- Operational objectives are needed to derive investment policy and asset allocation strategy.

- For stabilization funds:
  - Typical operational rule: save commodity revenue if actual commodity price exceeds a certain reference price (based on a long-term trend), withdraw if actual price drops below the reference price (examples: Algeria and Russia).15

- For savings funds:
  - Operational objective often: maximize the real annual payout per capita or the payout as a share of gross domestic product (GDP).
  - Variations in population growth, real GDP growth, and assumptions about discovery of future wealth can have profound implications.

- For reserve investment corporations:
  - Tend to maximize returns subject to a given risk tolerance; operational objective can be a return objective based on historical trade-offs between enhanced return and risk.
  - Risk tolerance and investment horizon are often implicit.

- For pension and liability-focused funds:
  - Follow asset liability management (ALM) approaches used by pension funds.
  - Horizon over which liabilities materialize is often well identified, allowing explicit maximization of net value over the identified time horizon subject to risk tolerance.
  - Often summarized as a concrete return target (examples: Australia, and New Zealand).17

*Source: _wp09179 - Section 2.*

### Funding, Withdrawal, and Spending Rules
- Policies and rules for funding, withdrawal, and spending should be clear and consistent with the fund’s purposes.
- Stabilization SWFs usually have clearly laid out deposit and withdrawal rules.
- Savings SWFs:
  - Receive contributions from excess revenues; purpose is to spend earnings or profits to share wealth with future generations.
  - Fiscal processes may allow flexibility in withdrawals to avoid borrowing, but this can constrain investment processes.
  - It may be best to provide the SWF with a clear investment mandate without the need to keep liquidity for unpredictable government calls, while allowing investments in government bonds if consistent with the macro framework.18

- Integration in fiscal framework:
  - Savings SWFs are often integrated in the general budget framework, explicitly linking fiscal policy to accumulation and return on financial assets.
  - Example: Norway’s Government Pension Fund-Global is an integrated part of government finances; accumulation consists of net cash flow from petroleum revenues plus return on assets; outflow is a transfer to the budget to finance the non-oil budget deficit.20

- Direct payments and discretionary access:
  - Some SWFs pay dividends directly to citizens or government (example: Alaska’s Permanent Reserve Fund pays an annual dividend based on half of the average realized income for five years).21
  - Other funds allow government discretion (example: Government of Singapore Investment Corporation (GIC) — Constitution allows the government to spend up to 50 percent of the “Net Investment Income” derived from past reserves).22

*Source: _wp09179 - Section 2.*

### Institutional Structure Considerations
- Legal form options:
  - SWFs can be separate legal entities, units within a central bank, or within the Ministry of Finance.
  - Regardless of form, operational management should be conducted independently to minimize political influence.

- Governance and operational independence:
  - Separate legal entities usually differentiate owner, governing body(ies), and operational management; operational independence can be embedded in appointment/removal rules for governing body members.
  - Units within central banks should have clear legal foundation and internal governance; units within ministries of finance often have less operational independence and are suitable only for narrowly defined mandates.
  - Clear separation between execution units and oversight is necessary.

- Cost and capacity trade-offs:
  - Separate legal entities have sunk costs; units in central bank or ministry can use existing resources and be more cost-efficient for small funds.
  - For advanced investment mandates, clear separation may be preferable; pay culture and structure in existing institutions may hamper efficiency.
  - Activities of a unit within a central bank should not impact the central bank’s income statement and balance sheet because the owner (government) takes the return and related volatility.

*Source: _wp09179 - Section 2.*

### Decision-Making Hierarchy and Reporting Lines
- Organizational structure should establish separation of responsibilities and authority to limit risks and ensure integrity and control.
- Four types of decision making:
  - (i) determination of policy objectives and overall risk tolerance;
  - (ii) determination of operational objectives;
  - (iii) determination of strategic asset allocation (SAA), including allowable deviations from benchmarks and their reflection in investment guidelines;
  - (iv) operational execution of investment decisions in compliance with investment guidelines.
- Specific separation depends on SWF nature and objectives; in some cases level (ii) is merged with level (iii); generally SAA decision is responsibility of the organs of the SWF.
- Reporting lines:
  - If SWF is a unit in the central bank, the Ministry of Finance often reports to Parliament on fund activities based on audited financial statements.
  - Separate legal entities typically report to the government represented by the Minister of Finance and often have explicit reporting requirements.
  - Timely and accurate reporting of SWF activities to the owner or national agencies ensures integration into macroeconomic policy making.

*Source: _wp09179 - Section 2.*

### Determinants of Investment Policy and SAA Design
- SAA is both a dynamic process and an outcome; it integrates operational objectives with expectations about risk/return characteristics of asset classes, including correlations and liabilities.
- Expectations should be consistent with macroeconomic projections and constraints (example: profit growth bounded by GDP growth).
- Diversification by combining asset classes with low or negative correlation can provide benefits; from a sovereign perspective, asset allocations with offsetting characteristics to the country’s economic risk profile make sense.
- SAA result: portfolio weights for eligible asset classes reflecting objectives and risk tolerance; SAA expressed in strategic benchmarks for measurement, attribution and assessment of return.
- SAA should be reviewed periodically or when investor objectives change significantly.
- Early-stage SWFs should be cautious while experience is accumulated and positions are built.

- Key determinants of SAA:
  - Investment horizon: reflects expected use period and period over which return is to be maximized; intergenerational funds and pension funds typically have very long horizons, stabilization funds have relatively short horizons depending on the average commodity price cycle.
  - Risk tolerance, asset classes and correlations, ALM, and other constraints.

*Source: _wp09179 - Section 2.*

### Section 3

### _wp09179 - Section 3

### Investment horizon and time preference
- Time horizon depends on whether the focus is on keeping the funds forever (endowments), or on depleting the funds through interventions/withdrawals.
- Practical uncertainties that affect the investment horizon:
  - Uncertain size of natural resource reserves.
  - Unusual (politically motivated) claims on the funds.
  - These forces often work in opposite directions: resource depletion may be offset by discoveries, lengthening the horizon; political changes may shorten the horizon.
- Methods to reflect uncertainties:
  - Assign a larger discount rate to future inflows (effectively assigning a lower probability to them).
  - Take a more agnostic approach and reduce the investment horizon.
- Operational implication:
  - For return-focused funds, the time horizon is more fluid and may concentrate on specific holdings, their distribution across sectors and countries, and the choice between holding cash equivalents and being invested.

### Risk constraint: capital preservation
- Risk tolerance is a key constraint on maximizing expected return over the investment horizon; it should focus on the entire investment horizon and withdrawal points.
- Example: Less concern for daily volatility if the investment horizon is a year; daily +/-10 percent moves matter mainly for the value at withdrawal.
- Common practical constraint: sponsor’s desire to preserve capital.
  - Capital preservation objective is equivalent to zero tolerance for negative returns, in either nominal or real terms.
  - If formulated from the start of the Fund, the constraint has a time dimension: buffers build over time to allow more risk.
- Policy and operational recommendations:
  - Early investing to build a buffer, establishing an oversight body with experienced professionals, and educating lay stakeholders can limit costs imposed by capital-preservation constraints.
  - An easing into risk tolerance aligned with the real investment horizon is desirable.

### Asset classes and their correlation
- Return maximization is subject to risk tolerance and expected asset class returns.
- Practical investor behavior:
  - Limit investments to specific asset classes that broadly display the same properties.
- Short investment horizons:
  - Typically result in high allocation to fixed income assets with predictable returns.
  - Funds with stabilization objectives usually have shorter horizons and conservative SAA with low risk-return profiles.
- ALM considerations:
  - May justify inclusion of long-term asset classes with low or negative correlation to exposures (e.g., modest long-term bonds and equity inversely correlated with oil prices).
- Longer horizons:
  - Allow broader allocation across asset classes; however, complex asset classes should be excluded unless adequately understood.
  - Wealth fund remains exposed and responsible for investment risk even when management is delegated.
- Special case — commodity-exposed owners:
  - Need to account for future revenue stream associated with the commodity in the ground (equivalent to a large commodity-price-sensitive financial asset).
  - Balanced portfolios usually require assets inversely related to commodity prices (examples: specific stocks like car industry or airlines; long-term bonds that may increase in price if oil prices fall to the extent inflation is dampened).

### Asset liability management (ALM)
- Objective: maximize return over the investment horizon net of withdrawals and non-investment income, subject to risk tolerance and asset class returns.
- Recognize future revenues (e.g., commodity taxes) and future liabilities for better SAA determination.
- Analogous to pension funds: consider correlation between asset prices and liabilities in portfolio optimization.
- Recognize current liabilities, notably for reserves built through sterilized intervention if not yet covered by central bank reserves.

### Currency composition
- Choice of currency composition depends on the SWF objective and liability structure.
- Stabilization funds:
  - Sharp drops in commodity export prices may require withdrawals, implying short horizons and high liquidity constraints.
  - Currency composition should be negatively correlated with the commodity price; typically weight the basket toward countries that import the commodity.
  - General rule: countries should not invest assets in the currency to which their own currency is pegged to avoid passing risk to the central bank.
- Funds with liabilities (pension/fiscal savings):
  - Consider correlation of liabilities with foreign currencies; can be invested in currencies of countries supplying imports.
  - Over long horizons, shifting import patterns may make general diversification arguments more important.

### Other considerations
- Liquidity requirements:
  - If outflows are certain in timing and amount, set aside the required amount in liquid assets with matching cash flows or risk characteristics per ALM principles.
- Legal and regulatory constraints:
  - Legislation typically specifies permissible asset classes; common restrictions include prohibition on domestic investment, private equity, real estate, hedge funds, derivatives, and swaps.
  - Capital preservation objectives may be enshrined in legislation, further constraining risk taking.
  - Prefer legislation that is generic and focuses on overall objectives, allowing qualified bodies to derive the appropriate SAA rather than specifying asset classes, especially when funds are nascent with limited buffers and stakeholder experience.

### Considerations for an SWF to finance domestic projects
- Decision depends on SWF purpose; developmental objectives may justify domestic investment but must be consistent with macroeconomic policy.
- Risks of financing domestic inputs:
  - Stimulate domestic demand and put upward pressure on prices, potentially causing real effective exchange rate appreciation and adverse consequences for exports and growth.
  - Sterilization of domestic financing could raise interest rates and crowd out private investment.
- Governance and fiscal integration:
  - Even if projects clearly augment growth and have positive externalities, they arguably should be part of government fiscal policy and budget.
  - Allowing spending outside the budget raises issues of fiscal accounting and transparency, risks undermining budgetary control, creates unequal treatment of spending, and risks mismanagement and waste.

### Considerations when an SWF hires external asset managers
- Potential benefits of external managers:
  - Bring expertise, access to new markets, lower operational risk, skills for specialized instruments and markets, and training for SWF staff.
  - Delegation allows SWF focus on SAA and manager selection; external managers can provide benchmarking.
  - In advanced asset classes, in-house expertise acquisition can be costly and inefficient, especially in low-income countries.
- Ultimate responsibility:
  - SWF or government bears market, credit, and liquidity risks whether assets are managed internally or externally.
  - SWF must ensure risks taken by external managers are within the SWF’s overall tolerance.
- Contractual and reporting requirements:
  - Strategic asset allocation and clear benchmarks for currency composition and investment risk profile (duration, credit, etc.) remain owner’s responsibility.
  - Specify allowed degree of deviation by external managers from benchmarks.
  - Clearly specify risk parameters and permitted instruments for measurement and reporting.
  - Evaluate risks of externally managed portfolios in conjunction with internally managed portfolios for a global risk view.
- Number of external managers:
  - Employ several managers to diversify manager-specific risk when pursuing active management.
  - Avoid excessively large number of managers to limit administrative burden and total fees given generally digressive fee frameworks with portfolio size.

### Conclusion
- The paper provides policy and operational considerations and a “roadmap” for policymakers considering establishing an SWF or reviewing existing policies and operations.
- Topics covered include whether to set up an SWF, alternatives, institutional arrangements, fiscal rules, and investment policy.
- Identified areas for further research in macroeconomics and finance:
  - Level of adequate reserves or revenues.
  - Optimal level of foreign debts that a country should hold and not use foreign assets to repay.
  - Theory on sovereign asset liability management.

*Source: _wp09179 - Section 3*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09179.pdf_