Portfolio Allocation for Sovereign Wealth Funds in the Shadow of Commodity-Based National Wealth

Abstract

Purpose – Study the investment and risk management approach of sovereign wealth funds when national wealth including natural resources is accounted for rather than only financial asset. Methodology/Approach – Using a range of widely used asset classes, we simulate sovereign wealth fund returns when considering only financial assets but also under varying levels of national wealth holdings in oil. We optimize two-asset financial portfolios and three-asset portfolios when including oil to maximize the risk-adjusted returns. Findings – Sovereign wealth funds by failing to invest for the national wealth portfolio are overlooking a major source of volatility. To reduce the level of volatility associated with yearly national wealth returns, allocating a higher percentage of fixed assets to high-quality fixed income and low-risk equities will maximize the risk-adjusted returns of national wealth for sovereign wealth fund states. Social implications – By focusing solely on the financial assets managed by sovereign wealth funds, states are exposing themselves to significant national wealth risk. Originality/Value of the paper – This is the first work to estimate the impact on national wealth of oil-dependent states by failing to account for volatile commodity prices through the investment strategies of sovereign wealth funds.