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APPLIED FINANCE CENTREFaculty of Business and Economics

The Rise of Sovereign Wealth Funds: New Investment Strategies

ROLAND WINN

Angel Place Campus, 22 June 2018

APPLIED FINANCE CENTREFaculty of Business and Economics

1. Beyond Strategic Asset AllocationLONG HORIZON INVESTING

Long Horizon InvestingADVANTAGES OF A SOVEREIGN WEALTH FUND

Average Institutional Investor

• Shorter or truncated horizon

• Limited, possibly declining, liquidity

• Time varying risk profile – staff/leadership, customers, governance, liquidity

Sovereign Fund

• Long Horizon

• Ample Liquidity

• Stable Risk Aversion

• Other potential factors – governance, tax, cost, intellectual property

3

Portfolio Construction Comparison

4

SAA VS. REFERENCE PORTFOLIO

Traditional Strategic Asset Allocation

Reference Portfolio

Source: Illustrative Purposes Only for Typical Growth Mandate

What? A low cost, passive, easily tracked, listed investment portfolio.

Why?Fewer assumptions,

greater certainty.

Cash

FixedIncomeEquities

Alternatives

Real Estate

Reference Portfolio Concept

“The CPP Reference Portfolio … portfolio of publicly traded securities that could be readily implemented using a low cost passive investment program.“

“will earn capital market returns over the long term”

“equilibrium concept”

“reflects the amount of risk that Government is prepared for the GIC to take in its long-term investment strategies”

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Example Reference Portfolios

Source: CPPIB, GIC, NZSF, UTAM.

55%

80% 85%

65%75%

50%

10%

5%

10%

5%

20% 15%

35%20%

30%40%

CPPI B '15 CPPI B '18 CPPI B '19 GI C NZSF UT AM

Equities - Int. Equities - Dom.Fixed Income - Int. Fixed Income - Dom.

Portfolio Construction Comparison

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Traditional Strategic Asset Allocation

Reference Portfolio Actual, Target or Policy Portfolio

Source: Illustrative Purposes Only for Typical Growth Mandate

α

Cash

FixedIncomeEquities

Alternatives

Real Estate

Making it work in practice

• Importance of long term asset class returns.

• Need strong belief in mean reversion.

• Well defined liquidity parameters― Belief that the underlying risks of the portfolio not correlated; or― Sufficient liquidity that correlated drawdowns are survivable.

• Strong governance mechanism.

• Ideally an independent business unit that allows for critical thinkers away from traditional asset classes and the market model.

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APPLIED FINANCE CENTREFaculty of Business and Economics

2. Case Example in Risk ArbitrageUNBUNDLING A HEDGE FUND STRATEGYAND TARGET ALPHA

APPLIED FINANCE CENTREFaculty of Business and Economics

Evolution of Hedge Funds

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THE OLD VS. THE NEW

High idiosyncratic risk that’s different

Unconstrained, high absolute return seeking

High leverage, high fees – 2/20

Correlations? We’ll make so much who cares!

Becoming more systematic

Target cash+ return

Can still be high leverage, fees falling

Purportedly uncorrelated return stream

What is Merger Arbitrage?

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EXAMPLE: OFFER OF $28 BY VARIAN MEDICAL FOR SIRTEX

$10$12$14$16$18$20$22$24$26$28$30

1. Merger Arbitrage buys

post-announcement

deals

3. A premium is derived from a discount to the

offer price

Source: Bloomberg

2. Investors may short the

acquirer or the market or not at

all

What could possibly go wrong?

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WHAT’S ON THE LABEL …

Source: S&P IQ

Cancelled vs. Completed Deals Russell 3000 (2001-17)

Source: Bloomberg, Big Mountain Capital

ρ = 42% β < 0.2

-150-100

-500

50100150200250

R3000 HFRX

MO

NTH

S

Up month Down month

Win/LossNo. Months Positive/Negative Jan-98 to Mar-18

Skewness and Downmarket Beta

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WHAT YOU’RE REALLY PAID FOR …

Normal Market Distribution(Actual vs. Assumed Returns)

0

10

20

30

40

50

60

-3.1

%-2

.7%

-2.3

%-1

.9%

-1.5

%-1

.1%

-0.8

%-0

.4%

0.0%

0.4%

0.8%

1.2%

1.6%

2.0%

2.4%

2.8%

3.2%

Source: Big Mountain Capital, Bloomberg

Negative Skew & Left Tail RiskHFRX Merger Arbitrage (Jan-98 to Mar-18)

Merger Arbitrage Return Behaviour

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KNOW WHAT YOU’RE BUYING

Source: Big Mountain CapitalNotes: Fees set at alpha for illustrative purposes only

Building Blocks of Expected Returns

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%Single Factor (CAPM) Model:

Two Factor Model:

Multi-Factor Model:

R2

18%

24%

>40%

IR*

1.0

0.8

0.4

*IR (Information Ratio Gross of Fees)

Alternative Implementation

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INVESTMENT STRATEGY UNBUNDLING THE ALPHA

Building Blocks of Expected Returns(Illustrative Only, Not to Scale)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

Available to most

investors

Target the “alpha”

Implementation Strategy

• Hire a manager - anybody willing to pay fees can do this

• Replicate with combination of credit and option selling –requires liquidity and some skill

• Target the alpha – systematic program to capture excess for volatility and liquidity premium and alpha signals – takes liquidity / long horizon / skill / dataSource: Big Mountain Capital

Notes: Fees set at alpha for illustrative purposes only

Applications

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INVESTMENT STRATEGIES

Re-Constituted Premia

Hedge Funds

Alternatives e.g.

Royalties

Alt/Smart Beta

Active index huggers

Dynamic asset

allocation

Asset allocation (e.g. Risk

Parity)

Summary

• Horizon is not an aspiration, it is your state of being.

• Long horizon provides greater degrees of freedom and some advantages but ultimately same talent pool.

• Increasing availability of data, ETFs and swaps creates target alpha opportunities.

• Disaggregation of returns is a useful discipline for everyone but hard to implement in practice. At least it helps you to know what you’re paying for.

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APPLIED FINANCE CENTREFaculty of Business and Economics

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Thank you for attending today’s talk

Background Materials

The rise of sovereign wealth funds (SWFs) has created an investor class with some particular attributes not available to the average investor. Chief amongst these is a truly long term horizon and strong liquidity profile in addition to tax and cost advantages. This has seen the development of alternative forms of portfolio construction and investment strategy designed to best use these endowments. This workshop will discuss:- The move away from Strategic Asset Allocation at some of these SWFs;- An alternative approach to developing investment strategy; and - Discuss a case example of how a traditional hedge fund strategy might be unbundled.

Video Link Used: https://www.youtube.com/watch?v=brTVoslt-hA

Pros and Cons in Practice

• Anchoring & relative value thinking – hugging the benchmark.

• Pervasiveness of market model.

• Does it allow for true risk neutral investors ~ NPV concept to your portfolio?

• Implementation mismatch and manager selection.

• Need personnel or unit that allows for independent critical thinkers away from traditional asset classes and the market model.

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