Portfolio Choice for Oil-Based Sovereign Wealth Funds

Abstract

Given recent interest in the activities of sovereign wealth funds (SWF), this article reviews the financial economics of portfolio choice for oil based investors. The author views the optimal asset allocation problem of a sovereign wealth fund as the decision making problem of an investor with non-tradable endowed wealth (oil reserves). Optimal portfolios combine speculative demand (optimal growth) as well as hedging demand (hedging resource fluctuation risk) and their level of risk taking should depend both on the fraction of financial wealth to resource wealth as well as the oil shock hedging properties of its investments. As an additional factor, the author introduces background risk for a SWF in the form of oil reserve uncertainty. SWF with large uncertainty about the size of their reserves should invest less aggressively and vice versa. The article also identifies the optimal speed of the extraction policy (oil to equity transformation) as a driving force for portfolio adjustments across time and presents a dynamic programming approach to approximate portfolio adjustments.

TOPICS: Retirement investing, global, portfolio construction, risk management