Central banks, sovereign wealth funds and other government-owned investment groups are gearing up to implement important changes to their asset allocation and external fund management structure, according to a new report from State Street Global Advisors.
In the six-month period following the collapse of Lehman Brothers in September 2008, some SWFs suffered losses “of a magnitude to wipe out a decade or more of investment returns,” according to the report titled “Current Issue in Official Sector Asset Management” published Tuesday. The crisis served as “an extreme stress test” for the funds, said John Nugee, senior managing director of SSgA's Official Institutions Group and author of the report.
“Many have reassessed their risk appetites and loss tolerances,” Mr. Nugee said at a news conference Tuesday about the report. For example, many SWFs increased exposure to more volatile sectors in the early 2000s under the assumption that they have long-term investment horizons due to their indeterminate, possibly infinite, lifespan. But during the financial crisis, the more volatile assets suffered heavier losses and fund officials are now “rethinking this assumption,” Mr. Nugee said.
“They're asking whether it is possible that a long-term fund can have a short-term investment horizon?” he said. A broader review of their investment approach, Mr. Nugee added, “will result in sovereign funds becoming more active this year and next year” as they make important changes to their portfolios.
“Asset reallocations to reflect the outcome of their analysis will need to be made,” according to the report. “In addition, new cash has to be put to work.”
Similar to other institutional investors, SWFs have made more efficient use of passive strategies a top priority. According to one unnamed SWF official in the Middle East who was quoted in the report: “In the past, we used to assume that assets should be managed actively unless a certain asset class or market clearly did not offer opportunities for active managers. … Now we tend to see this investment decision the other way around. We conclude that assets should by default be managed passively unless evidence is clear that a given asset class has sufficient imperfections that active management is likely to be consistently rewarded.”
More effective portfolio diversification is another key. “There is growing interest in the concept that true diversification comes not from holding different asset classes but from access to different economic value streams,” according to the report. Fund officials may increase exposure in asset classes including natural resources, land and infrastructure. Even art is being considered.
“Refining these ideas into a quantifiable theory and utilizing it to build diverse portfolios remains work to be done,” according to the report.
Fund officials are “searching for inventive ways to solve the challenges they're given,” Mr. Nugee said. In re-examining portfolio risks, executives have also come to “a sharper realization of reputational risks,” he added.
“It is not only the size of a loss that matters, but also how it is incurred,” according to the report. “A $1 million loss on a bond portfolio because yields go up is ‘unfortunate.' … A $1 million loss because an opaque structured product fails to live up to its promise is a disaster.”