Annual Report 2013 - Portfolio Strategy

April 11, 2014

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Sovereign wealth funds with long-dated liabilities are well placed to take on certain types of risk, such as those associated with asset illiquidity and market volatility. In 2013 sovereign funds looked to capitalize on these characteristics to boost returns.

At a high level many sovereign funds are rethinking their portfolios’ risk exposure. Since the financial crisis they and other institutional investors increasingly have favored risk budgeting: categorizing assets by risk type and setting allocations, or budgets, for each one.
This approach allows a sovereign fund to deliver above-market returns by taking on risk in the areas that best suit its investment horizon and liability profile.

The New Zealand Superannuation Fund (NZSF) has broken new ground when it comes to applying risk budgeting principles to sovereign wealth fund portfolios. In 2009, NZSF established a reference portfolio that reflects the level of risk the New Zealand government is willing to take and strives to outperform the market by applying a dynamic asset allocation to that framework.

The influence of the decade-old NZSF’s innovative portfolio approach on its more-established peers became evident when Singapore’s GIC unveiled a new investment framework in May 2013. GIC now has a reference portfolio split 65-35 between global equities and fixed income respectively.

To beat the long-term returns of the reference portfolio, GIC invests in six core asset classes: developed-markets equities, emerging-markets equities, fixed income and cash, inflation-linked bonds, real estate and private equity. This strategically weighted policy portfolio reflects the assets in which the fund is permitted to invest. To further boost returns, GIC layers on its active portfolio — strategies deployed by staff with help from external hedge fund managers.

The high-level investment trends that continued from 2012 into 2013 showed the influence of the risk budgeting approach. For example, sovereign wealth funds have been increasing their overall allocation to private assets, such as private debt and other types of nontraded credit, brick-and-mortar real estate and infrastructure, all of which have associated illiquidity risk.

Many sovereign wealth funds also have been chasing emerging-markets exposure to increase returns; this means taking on volatility risk, which they’re well placed to absorb as long-term investors. However, they have sought to mitigate other risks associated with investments in developing-markets companies, such as those associated with lower governance and transparency requirements, by investing in businesses headquartered in developed markets that derive much of their revenue from selling goods and services in emerging markets. Funds are refining this strategy in the wake of China’s economic slowdown to best take advantage of those emerging economies that are less dependent on Chinese demand.

Equity Strategy

To minimize risk, generate returns from strong U.S. and U.K. stock exchanges and ride out volatility in emerging economies’ equity markets, some sovereign wealth funds appeared to allocate to simple instruments, such as index-replicating equity strategies and exchange-traded funds, in 2013. As sovereign funds have brought more investment capacity in-house over the past half decade, they’ve tended to invest such strategies internally, making these investments harder to track. In 2013, however, NZSF and others chose to award some passive equity mandates to external managers.

Traditionally risk-averse sovereign wealth funds like Chile’s Economic and Social Stabilization Fund, the National Fund of the Republic of Kazakhstan, the Petroleum Fund of Timor-Leste and the State Oil Fund of the Republic of Azerbaijan are starting to add more equities to their portfolios, which traditionally have been primarily allocated to investment-grade debt. This shift lets the funds, which awarded mandates for index-replicating equity strategies benchmarked to the MSCI World Index, increase returns and take advantage of their long-term investment horizons.

More-experienced and already diversified sovereign investors focused on developing specialized equity exposures to emerging markets. Norges Bank Investment Management, which manages Norway’s giant Government Pension Fund Global, and the Abu Dhabi Investment Authority (ADIA) sought out country-specific equity managers, largely in emerging markets, to harness deep knowledge and expertise they couldn’t develop themselves.

Other sovereign funds, like Alaska Permanent Fund Corp., allocated to active strategies in global emerging markets rather than looking for specific country niches. We also saw some funds favor high-conviction strategies to earn alpha.

Fixed-Income Strategy

The debt markets proved particularly challenging for sovereign wealth funds in 2013. With the yield on traditionally liquid investment-grade bonds failing to keep up with inflation, sovereign funds had to become more resourceful at uncovering opportunities. Because they lack explicit liabilities and can take advantage of illiquidity premiums, the funds are well placed to explore unconventional debt securities like high-yield bonds and private debt.

As the perceived risk of emerging-markets sovereign debt rose in 2013, some sovereign funds — including traditionally risk-averse players like the Hong Kong Monetary Authority — allocated to high-yielding corporate bonds from developed markets, particularly the U.S., to boost the returns on their fixed-income portfolios.

Making money in corporate credit is challenging, especially when there’s a high risk of default or when investments require an understanding of complicated structures, such as the corporate debt elements of collateralized loan obligations that survived the 2008 crash.

In 2013 the complexity of those instruments prompted even sovereign investors with experience in unconventional asset classes to approach best-in-class credit managers. Apollo Global Management has been among the most successful at attracting sovereign fund money: Sovereign Wealth Center research reveals that the New York–based firm manages money for ADIA, the Abu Dhabi Investment Council, China Investment Corp., the NZSF and the Qatar Investment Authority (QIA), among others.

As optimism returned to the markets in the second half of 2013, the low-return environment affected even the supposedly high-yielding corporate debt markets. Yields on U.S. junk bonds dropped substantially: The Barclays Capital U.S. Corporate High Yield Bond Index dipped below 5 percent in early-May 2013, and returns hovered around 5.9 percent for the rest of the year.

As a result, some sovereign wealth funds began dabbling in direct loans. But providing credit presents difficulties for those sovereign funds that struggle to categorize direct credit because it falls somewhere between fixed-income securities and private equity investments in the funds’ risk-return profiles. However, these challenges haven’t stopped some of the more adventurous sovereign funds from making high-profile bets. For example, QIA participated in the $1 billion debt issue of struggling Canadian smartphone maker BlackBerry.

Some sovereign funds explored opportunities in direct emerging-markets corporate debt. China’s State Administration of Foreign Exchange (SAFE) committed $3 billion over six years to the Managed Co-Lending Portfolio Program overseen by International Finance Corp. (IFC), a subsidiary of the World Bank Group. The program will provide the senior portion of a new portfolio of IFC-originated loans to businesses in emerging markets.

More-conventional deals in emerging-markets corporate debt included GIC, Singapore’s largest sovereign wealth vehicle, subscribing to all of a $35 million convertible bond issue by Hong Kong–based Green Dragon Gas, which produces and sells coal-bed methane in China.

Sovereign wealth funds have been investing in hybrid debt securities such as mezzanine loans and slightly more arcane fixed-income instruments like catastrophe bonds, again taking advantage of the fact that they can carry considerable illiquidity in their portfolios. In June 2013, for example, QIA provided New York–based Blackstone Group with £200 million ($350 million) worth of mezzanine debt, which the asset management giant used to refinance its 2011 purchase of Chiswick Park, a 33-acre office complex in West London.
Loans secured against commercial property became part of the sovereign wealth fund mainstream in 2013, with some funds entering this space for the first time. GIC is an old hand, having provided direct senior secured performing commercial-property-backed loans for several years. In 2013 the fund expanded its exposure by supporting London-based Laxfield Capital’s program to invest as much as £1 billion in U.K. commercial mortgages by the end of 2014.

Some sovereign wealth funds have extended their lending interests beyond glitzy office blocks and plush hotels. For example, ADIA provided a €55 million ($71 million) junior loan alongside a debt fund managed by AXA Real Estate, the property management arm of Paris-based insurer AXA, to Apollo-Rida Poland, a joint venture between two U.S. companies, AREA Property Partners and Rida Development Corp., to refinance its portfolio of 28 retail properties.

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