Optimal asset allocation and consumption rules for commodity-based sovereign wealth funds

Abstract

This paper studies the optimal asset allocation for a sovereign wealth fund (SWF) subject to a stochastic stream of commodity-based income, where, without loss of generality, we focus on oil-based SWFs. Using CRRA utility, we assume the fund’s objective is to maximize the discounted utility of intertemporal consumption in the presence of time-varying investment opportunities, and given non-zero correlations between shocks to oil income and asset return innovations. We use the log-linear approximation method of Campbell (1993) to solve for the model’s optimal asset allocation and consumption rules. Using historical data, we estimate the model parameters using the maximization-by-parts algorithm of Song et al. (2005). We then calibrate the model to study the optimal allocation and consumption for varying levels of risk aversion, time preference and oil income volatility. Our results are of interest to SWFs seeking optimal portfolio choice in the face of changing investment opportunities which correlate with their stochastic stream of income.