## _wp1119

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---

### Overview
- Sovereign Wealth Funds (SWFs) were severely hit by the global financial crisis, prompting reviews of investment practices.
- This paper examines:
  - how different types of SWFs approach investment objectives;
  - impact of the crisis on SWF performance;
  - extent of portfolio reallocations;
  - lessons on changes in SWF investment behavior; and
  - forward-looking issues including macro-stabilization, asset-liability management, and adjustments to the global regulatory environment.

### Classification of SWFs and implications
- Typical SWF categories:
  - Stabilization funds
  - Savings funds
  - Pension reserve funds
  - Reserve investment corporations
- Most established SWFs are savings funds for future generations or fiscal stabilization funds.
- Examples of pension reserve funds: Australia’s Future Fund; Chile’s Pension Reserve Fund (Chile-PRF); Ireland’s National Pensions Reserve Fund; New Zealand’s Superannuation Fund; Russia Federation’s National Wealth Fund (Russia-NWF).
- Examples of reserve investment corporations: China Investment Corporation (CIC); Korea Investment Corporation (KIC); Government Investment Corporation of Singapore (GIC).
- Some SWFs have multiple objectives (State Oil Fund of Azerbaijan, Kuwait Investment Authority, Norway’s Government Pension Fund-Global).
- Countries may operate more than one SWF with different objectives (Chile, the Russian Federation, Singapore).

### Key implications of classification for SAA
- Type influences investment objectives, liquidity needs, and investment horizon:
  - Reserve investment corporations may need liquid assets to manage balance of payments risks.
  - Savings SWFs generally have longer investment horizons than stabilization SWFs.
  - Pension reserve funds derive horizons from future liabilities, potentially decades ahead.
- Funding source and the broader government balance sheet can influence investment objectives and strategic asset allocation (SAA).

### Theoretical considerations behind SWFs’ Strategic Asset Allocations (SAA)
- SAA depends on:
  - Type of SWF
  - Investment horizon
  - Funding source
  - Other balance sheet characteristics
- Investment horizon and SAA:
  - Longer horizons traditionally associated with greater risk-taking.
  - Risk defined as probability of loss or underperformance relative to a reference asset over a given horizon.
  - Traditional literature suggests equities are less volatile over longer horizons because of reinvestment risks with short-term instruments and historical equity return premium over longer horizons.
  - Ability to invest in illiquid "alternative assets" (infrastructure, real estate, private equity) linked to truly long horizons.
  - Short or uncertain horizons (stabilization SWFs) should hold more cash and liquid bonds; SAAs of stabilization funds should resemble central bank reserve managers.
- Funding source and SAA:
  - Commodity-funded funds can diversify dependence on real assets by investing in negatively or weakly correlated financial assets.
  - Oil-funded SWFs should consider oil price risk, cycles, and assets in the ground when determining SAAs; some countries may hedge commodity price risk.
  - Stabilization SWFs sourced from fiscal surpluses are influenced by government budget dynamics.
  - SWFs sourced from international reserves may be influenced by private capital flows and private external debt depending on institutional arrangements and withdrawal rules.
  - For pension reserve funds, investment horizon and liability nature dominate over original funding source.
  - SAAs should account for vulnerability of other assets and liabilities on the wider sovereign balance sheet; multiple SWFs’ SAAs may need coordination.

### Comparison of observed asset allocations
- Analysis focuses on allocations across four asset classes: cash, fixed income, equities, and alternative assets.
- Data limitations: sectoral distribution within asset class not consistently available.
- Notable patterns (Figure 1, SWF Asset Allocation, 2007):
  - Savings funds show varying equity proportions.
  - Stabilization funds emphasize debt (fixed income) and cash and usually avoid alternative assets.
  - Pension reserve funds and reserve investment corporations typically have some equity exposure.
- Variation among similar-type SWFs arises from:
  - Investment horizon differences
  - Funding source
  - Other sovereign balance sheet considerations
  - Idiosyncratic institutional factors, maturity, and sophistication of the fund
  - Practical constraints in implementing SAAs for recently established or legally changing funds
- Additional considerations:
  - Views on relative performance of asset classes across horizons matter; equity risk premium can be negative even over 20- and 50-year horizons in some countries.
  - Ability to tolerate large unrealized losses depends on institutional factors and public/owner financial literacy.
  - Size of assets under management relative to potential withdrawals affects liquidity needs.
  - Extent of unexploited natural resources may influence preference for conserving financial resources.

### Unraveling of the crisis: performance and immediate effects
- The global financial crisis caused sharp downturns in asset prices, particularly equities and alternative investments, producing large losses for many SWFs—especially those with longer investment horizons.
- In some cases, losses reached 30 percent of portfolio values for 2008, impairing long-term returns.
- Domestic debates emerged criticizing SWF timing, investments in financial institutions early in the crisis, and investing abroad when domestic support was argued to be needed.
- Reference period for performance figures: 2007−2009 (Figure 2, SWF Returns, 2007−2009).

### Crisis-driven roles and uses of SWFs
- Stabilization funds were drawn upon to finance rising fiscal deficits and to support stimulus packages.
- Rising sovereign or quasi-sovereign liabilities can be expected to weigh on demand for SWF resources for some time.
- Some SWFs undertook roles beyond original mandates:
  - Providing liquidity to the banking system by depositing assets in domestic banks.
  - Helping with bank recapitalization.
  - Earmarking assets to support deposit insurance schemes.
  - Purchasing domestic stocks to boost markets and investor confidence.

### Investment performance, asset-management responses, and AUM dynamics
- Heavy demands on SWF resources and economic uncertainty induced more cautious investing; SWFs became wary about supporting further bail-outs of distressed companies due to heavy unrealized or realized losses after investing in financial institutions in developed countries.
- As financial market conditions started to improve in early 2009, some SWFs achieved record profits (Figure 2).
- Dynamics of assets under management during the crisis:
  - Value of stabilization fund assets remained on a steady growth path until the end of 2008, then declined by about 50 percent between the end-2008 and end-2009 after withdrawals.
  - Pension reserve funds and savings funds suffered equity valuation losses during September 2008 through March 2009, but have since recovered.
  - SWFs with both stabilization and savings objectives—mostly invested in fixed-income assets—weathered the crisis relatively unscathed.
- Note: Norway classified as savings fund. The 2009 return of Singapore-Temasek is the annual return from April 2009 to March 2010.

### Crisis implications for SAAs and reallocations
- Fund-specific allocation changes (Figure 4):
  - Several stabilization-focused SWFs reduced cash holdings (example: Chile-ESSF) or moved to fixed income (example: Trinidad and Tobago).
  - Alaska Permanent Fund and Ireland National Pension Reserve Fund increased the share of cash holdings.
  - Some SWFs with prior investments in alternative assets increased such investments; KIC introduced alternative assets investment and increased equity shares.
  - Some SWFs continued implementing previously approved SAAs (example: Norway increased equity shares; the Australian Future Fund introduced fixed-income and increased equity and alternative assets).
  - Continuous implementation of SAA helped Norway benefit from the rebound of risk assets since early 2009.
- Geographic reallocation trends:
  - Confidence in emerging markets’ recovery and concerns about advanced economies prompted tilts toward emerging markets.
  - Temasek plans to focus on emerging markets in Asia, Brazil, and the Russian Federation and reduce emphasis on OECD countries (from one-third to one-fifth of assets).
  - Norway’s SWF increased operations in Asia and plans to open an office in Singapore after opening one in Shanghai.
- Behavioral and mandate effects:
  - Some long-mandate SWFs faced unexpected liquidity needs, effectively shortening investment horizons.
  - Increased scrutiny and pressure to minimize future losses contributed to shifts toward more conservative positions for some funds; others saw medium-term upside opportunities.
  - Reviews of investment strategies and risk management frameworks are underway to clarify objectives, potential liquidity needs, investment horizons, and risks.

### Evolving approaches to asset allocation and governance
- Some SWFs are re-examining asset class-based SAA and considering risk factor-based approaches.
  - Example: The Board of the Alaska Permanent Fund grouped investments by risk and return profiles and by the market condition or liability each group addresses to build an “all-weather portfolio.”
- In many cases, profound changes to an SWF’s SAA may not be justified; improved communication strategies and stakeholder education about operations and risks are needed.
  - For savings-type SWFs, stakeholders must understand the likelihood of short-term losses and the fund’s ability to tolerate them, aided by stable political/economic environments and sound crisis management planning.
- SWFs’ approaches to corporate governance vary:
  - Some pursue active shareholder involvement.
  - Others take a less active ownership approach and rely on recipient country governments to promote and monitor corporate governance.

### Policy challenges ahead
- Sovereign financing:
  - Importance of regular macro-level risk assessments and careful weighing of sovereign financing options in normal times and during financial stress.
  - Thorough reserve adequacy assessments and stress testing of foreign exchange liquidity needs when setting SWF objectives can prevent costly asset sales under stress, especially for funds with long investment horizons.
  - Automatically using SWF assets to cover liquidity needs may not be optimal; issuing debt may be a cheaper option depending on feasibility and cost in times of stress.
  - If a country has strong debt management capacity, a commensurate credit rating, and deep liquid local markets, establishing a large-scale stabilization fund may not be necessary—though an SWF that effectively sterilizes cyclical receipts can still be a useful macro management tool.
  - Governments can lower the cost of macro stabilization by issuing more debt when times are good to finance or build stabilization funds, enabling drawdowns during downturns and potentially developing local debt markets.
- Regulatory environment and governance:
  - International financial markets are likely to face increased regulation and demands for greater transparency and accountability, which may affect SWFs’ cross-border operations and the attractiveness of some asset classes.
  - SWFs have actively participated in discussions on the evolving global regulatory environment.
  - SWFs seek well-targeted, high-quality financial regulation to avoid unintended consequences.

### Conclusions and outlook
- SAAs reflect fund characteristics, including type and funding source, but differences arise among similar-type SWFs due to investment horizon views, size, loss tolerance, untapped funding sources, and SWF maturity/sophistication.
- The crisis affected SAAs variably: some increased liquidity, others adopted more conservative or less conservative portfolios, and some assumed roles beyond original mandates.
- Not all shifts are ideal or justified; many SWFs are reviewing strategies and risk frameworks and need better communication to align SAAs with fundamental objectives.
- The crisis highlights the need for macro-stability risk assessment and careful sovereign financing considerations, including reserve adequacy, liquidity assessments, and cost-risk evaluations of asset and liability operations.
- Looking ahead:
  - The scope for SWFs’ stabilizing role in international capital markets remains substantial despite crisis losses and greater domestic focus.
  - SWFs’ relative size and longer-term investment strategies will continue to play an important stabilizing role in the global economy.
  - Regulatory considerations will grow in importance; active SWF involvement in regulatory developments will be required.

*Source: IMF Working Paper — Introduction section of _wp1119.*

### Introduction ...........................................................................................................

### Introduction

### Overview
- Sovereign Wealth Funds (SWFs) were severely hit by the global financial crisis, prompting reviews of investment practices.
- This paper examines: how different types of SWFs approach investment objectives; impact of the crisis on SWF performance; extent of portfolio reallocations; lessons on changes in SWF investment behavior; and forward-looking issues including macro-stabilization, asset-liability management, and adjustments to the global regulatory environment.

### Classification of SWFs and implications
- SWFs are typically categorized as:
  - Stabilization funds
  - Savings funds
  - Pension reserve funds
  - Reserve investment corporations
- Most established SWFs are savings funds for future generations or fiscal stabilization funds.
- Examples of pension reserve funds: Australia’s Future Fund; Chile’s Pension Reserve Fund (Chile-PRF); Ireland’s National Pensions Reserve Fund; New Zealand’s Superannuation Fund; Russia Federation’s National Wealth Fund (Russia-NWF).
- Examples of reserve investment corporations: China Investment Corporation (CIC); Korea Investment Corporation (KIC); Government Investment Corporation of Singapore (GIC).
- Some SWFs have multiple objectives (e.g., State Oil Fund of Azerbaijan, Kuwait Investment Authority, Norway’s Government Pension Fund-Global).
- Countries may operate more than one SWF with different objectives (Chile, the Russian Federation, Singapore).

### Key implications of classification
- Type influences investment objectives, liquidity needs, and investment horizon:
  - Reserve investment corporations may need liquid assets to manage balance of payments risks.
  - Savings SWFs generally have longer investment horizons than stabilization SWFs.
  - Pension reserve funds derive horizons from future liabilities, potentially decades ahead.
- Funding source and broader government balance sheet can influence investment objectives and SAA.

### Theoretical considerations behind SWFs’ Strategic Asset Allocations (SAA)
- SAA is influenced by:
  - Type of SWF
  - Investment horizon
  - Funding source
  - Other balance sheet characteristics
- Stylized underpinnings are used to assess observed asset allocations.

A. Investment Horizon and SAA
- Longer horizons are traditionally associated with the ability to take more risk.
- Risk is defined as probability of loss or underperformance relative to a reference asset over a given horizon.
- Traditional SAA literature suggests equities are less volatile over longer horizons because of reinvestment risks associated with short-term instruments and historical equity return premium over longer horizons.
- Ability to invest in illiquid assets (infrastructure, real estate, private equity) is linked to truly long horizons; such assets are classified here as “alternative assets.”
- Short or uncertain horizons (e.g., stabilization SWFs) should hold more cash and liquid bonds to meet potential outflows; SAAs of stabilization funds should resemble central bank reserve managers.
- Some reserve managers also invest in equities where objectives are multiple (e.g., Hong Kong SAR, the Netherlands, Switzerland).

B. Funding Source and SAA
- For commodity-funded stabilization and savings SWFs, portfolio choice can diversify dependence on real assets by investing in negatively or weakly correlated financial assets.
- SWFs funded from oil resources should consider oil price risk, cycles, and assets in the ground when determining SAAs; some countries may hedge commodity price risk.
- Stabilization SWFs sourced from fiscal surpluses are influenced by government budget dynamics.
- SWFs sourced from international reserves may be influenced by private capital flows and private external debt depending on institutional arrangements and withdrawal rules.
- For pension reserve funds, the original funding source is less likely to influence SAA; investment horizon and liability nature dominate.
- SAAs should account for vulnerability of other assets and liabilities on the wider sovereign balance sheet; multiple SWFs’ SAAs may need coordination.

### Comparison of observed asset allocations
- Analysis focuses on observed allocations across four asset classes: cash, fixed income, equities, and alternative assets.
- Data limitations: sectoral distribution within asset class not consistently available, limiting analysis of funding source effects.
- Notable patterns (Figure 1, SWF Asset Allocation, 2007):
  - Savings funds show varying equity proportions.
  - Stabilization funds emphasize debt (fixed income) and cash and usually avoid alternative assets.
  - Pension reserve funds and reserve investment corporations typically have some equity exposure.
- Observed allocations vary even among funds with similar objectives due to:
  - Investment horizon differences
  - Funding source
  - Other sovereign balance sheet considerations
  - Idiosyncratic institutional factors, maturity, and sophistication of the fund
  - Practical constraints in implementing targeted SAAs for recently established or legally changing funds
- Additional considerations:
  - Views on relative performance of asset classes across horizons matter; equity risk premium can be negative even over 20- and 50-year horizons in some countries.
  - Ability to tolerate large unrealized losses depends on institutional factors and public/owner financial literacy.
  - Size of assets under management relative to potential withdrawals affects liquidity needs.
  - Extent of unexploited natural resources may influence preference for conserving financial resources.

### Unraveling of the crisis
- The global financial crisis caused sharp downturns in asset prices, particularly equities and alternative investments, producing large losses for many SWFs—especially those with longer investment horizons.
- In some cases, losses reached 30 percent of portfolio values for 2008, impairing long-term returns.
- Domestic debates emerged over SWF strategies:
  - Criticisms for entering equity markets at the wrong time
  - Criticisms for investing in financial institutions early in the crisis and suffering heavy losses
  - Criticisms for investing abroad when domestic market support was needed
- These criticisms increased scrutiny of SWF investment outlooks and placed pressure on managers to avoid further losses.
- Reference period for performance figures: 2007−2009 (Figure 2, SWF Returns, 2007−2009).

### Crisis implications for SAAs and forward-looking considerations
- The crisis raised questions about whether market developments should alter underlying SAAs and under what circumstances fundamental portfolio realignments are warranted.
- Future investment strategies may need greater emphasis on:
  - Macro-stabilization objectives
  - Asset-liability management considerations
  - Preparing for forthcoming adjustments in the global regulatory environment

### Policy challenges ahead (previewed by the paper)
- Sovereign financing implications
- Changes in the regulatory environment
- These topics are addressed in later sections of the paper.

*Source: IMF Working Paper — Introduction section of _wp1119.*

### 21.      Moreover, the crisis has led some SWFs to take prominent roles in financing

### _wp1119 - 21.      Moreover, the crisis has led some SWFs to take prominent roles in financing

### Crisis-driven roles and uses of SWFs
- Stabilization funds have been drawn upon to finance rising fiscal deficits, and some have supported stimulus packages to prop up economic activity.
- Rising sovereign or quasi-sovereign liabilities can be expected to weigh on demand for SWF resources for some time to come.
- Some SWFs have taken on new roles beyond original mandates:
  - Providing liquidity to the banking system by depositing assets in domestic banks.
  - Helping with bank recapitalization.
  - Earmarking assets to support deposit insurance schemes.
  - Purchasing domestic stocks to boost markets and investor confidence.

### Investment performance and asset-management responses
- Heavy demands on SWF resources and economic uncertainty have induced more cautious investing; SWFs are wary about supporting further bail-outs of distressed companies due to heavy unrealized or realized losses experienced after investing in financial institutions in developed countries.12
- As financial market conditions started to improve in early 2009, some SWFs achieved record profits (Figure 2).
- Dynamics of SWFs’ assets under management during the crisis:
  - The value of stabilization fund assets remained on a steady growth path until the end of 2008, then declined by about 50 percent between the end-2008 and end-2009 after withdrawals.
  - Pension reserve funds and savings funds suffered equity valuation losses during September 2008 through March 2009, but have since recovered.
  - SWFs with both stabilization and savings objectives—mostly invested in fixed-income assets—have weathered the crisis relatively unscathed.
- Note: Norway classified as savings fund. The 2009 return of Singapore-Temasek is the annual return from April 2009 to March 2010.

### Crisis implications for Strategic Asset Allocation (SAA)
- Fund-specific effects on asset allocations (Figure 4):
  - Several stabilization-focused SWFs reduced cash holdings (e.g., Chile-ESSF) or moved to fixed income (e.g., Trinidad and Tobago).
  - Alaska Permanent Fund and Ireland National Pension Reserve Fund increased the share of cash holdings.13
  - SWFs with prior investments in alternative assets increased such investments; KIC introduced alternative assets investment and increased equity shares.
  - Some SWFs continued implementing previously approved SAAs (e.g., Norway increased equity shares; the Australian Future Fund introduced fixed-income and increased equity and alternative assets).
  - Continuous implementation of SAA helped Norway benefit from the rebound of risk assets since early 2009.
- Geographic reallocation trends:
  - Confidence in emerging markets’ recovery and concerns about advanced economies prompted tilts toward emerging markets.
  - Temasek plans to focus on emerging markets in Asia, Brazil, and the Russian Federation and reduce emphasis on OECD countries (from one-third to one-fifth of assets).14
  - Norway’s SWF increased operations in Asia and plans to open an office in Singapore after opening one in Shanghai.15
- Behavioral and mandate effects:
  - Some SWFs with longer-term mandates faced unexpected liquidity needs, shortening investment horizons.
  - Increased scrutiny and pressure to minimize future losses contributed to shifts toward more conservative positions for some funds; others saw medium-term upside opportunities.
  - Changes in domestic economic and financial environments led some SWFs to temporarily deviate from original mandates; reviews of investment strategies and risk management frameworks are underway to clarify objectives, potential liquidity needs, investment horizons, and risks.

### Evolving approaches to asset allocation
- Some SWFs are re-examining asset class-based SAA and considering risk factor-based approaches.
  - Example: The Board of the Alaska Permanent Fund chose an approach to group investments by risk and return profiles and by the market condition or liability each group addresses to build an “all-weather portfolio.”16
- In many cases, profound changes to an SWF’s SAA may not be justified; instead SWFs may need improved communication strategies and stakeholder education about operations and risks.
  - For savings-type SWFs, stakeholders must understand the likelihood of encountering short-term losses and the ability to tolerate them, aided by stable political/economic environments and sound crisis management planning.

### Policy challenges ahead — Sovereign financing
- The crisis underscores the importance of regular macro-level risk assessments and careful weighing of sovereign financing options in normal times and during financial stress.
- Key considerations:
  - Thorough reserve adequacy assessments and stress testing of foreign exchange liquidity needs when setting SWF objectives can prevent costly asset sales under stress, especially for funds with long investment horizons.17
  - Automatically using SWF assets to cover liquidity needs may not be optimal; issuing debt may be a cheaper option depending on feasibility and cost in times of stress.
  - If a country has strong debt management capacity, a commensurate credit rating, and deep liquid local markets, establishing a large-scale stabilization fund may not be necessary—though an SWF that effectively sterilizes cyclical receipts can still be a useful macro management tool.
  - Governments can lower the cost of macro stabilization by issuing more debt when times are good to finance or build stabilization funds, enabling drawdowns during downturns and potentially developing local debt markets.

### Policy challenges ahead — Regulatory environment and governance
- International financial markets are likely to face increased regulation and demands for greater transparency and accountability, which may affect SWFs’ cross-border operations and the attractiveness of some asset classes.
- SWFs have actively participated in discussions on the evolving global regulatory environment.18
- SWFs are interested in well-targeted, high-quality financial regulation to avoid unintended consequences.
- SWFs have shown interest in promoting good corporate governance principles:
  - Some pursue active shareholder involvement.
  - Others take a less active ownership approach and rely on recipient country governments to promote and monitor corporate governance.

### Conclusions and outlook
- SAAs of SWFs reflect fund characteristics, including type and funding source, but differences arise among similar-type SWFs due to investment horizon views, size, loss tolerance, untapped funding sources, and SWF maturity/sophistication.
- The crisis affected SWFs’ SAAs variably: some increased liquidity, others adopted more conservative or less conservative portfolios, and some took on roles beyond original mandates.
- Not all shifts are ideal or justified; some SWFs are reviewing strategies and risk frameworks and need better communication to align SAAs with fundamental objectives.
- The crisis highlights the need for macro-stability risk assessment and careful sovereign financing considerations, including reserve adequacy, liquidity assessments, and cost-risk evaluations of asset and liability operations.
- Looking ahead:
  - The scope for SWFs’ stabilizing role in international capital markets remains substantial despite crisis losses and greater domestic focus.
  - SWFs’ relative size and longer-term investment strategies will continue to play an important stabilizing role in the global economy.
  - Regulatory considerations will grow in importance; active SWF involvement in regulatory developments will be required.

*Source: SWF websites and authors' calculations.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp1119.pdf_