Wednesday, June 24, 2015

The state pension fund as a sovereign wealth fund


Sovereign wealth funds have been very holistic in their approach to strategic asset allocation. These  funds think about the true risks for their clients (citizens) which is associated with the consumption and revenue pattern of their country. They truly have to think about portfolios that can weather 'bad times" or market downturns because they are investing their country's wealth. They have to account for demographics and the depletion of resources. There are a few states that have the same mandate as a sovereign wealth fund given revenues from natural resource extraction like Alaska, New Mexico, Texas, North Dakota, and Louisiana. These funds have to think about resource prices, cash flows, and how to make the money last over the long-term long even after the resources have been used. 

State pension funds should also be aware of the revenue and consumption patterns in their states and tie their expected returns to growth and demographics within the state. Their resource is human capital and investment patterns should reflect the type of growth and human capital within their boundaries. Consequently, the state pension has to think about diversification of "bad times" within their state no different than the  individual who has to think about diversification against their own bad times and risks. Their portfolio should reflect not just the overall business cycle but the unique or local cycle issues within the state.

Hiring and raises will be tied to state growth which will then feedback to pension obligations. States working through long-term slowdowns or regional cycles have to change their investment pattern to reflect these changes. If slower growth is systematic and not just cyclical, the portfolio should reflect the issues. The expected return of the portfolio has to reflect the unique cash flow patterns of the state. The agricultural-based state does not need commodity exposure especially from the long-side and the state that is focused on financial services does not need more bank exposure. Hitting the expected return target may be too simplistic in its approach to forming the right portfolio. This is a reflection of consumption based asset pricing models that are tailored to a state.

Why this is especially important now is that many states are thinking more deeply about their exposure to hedge funds as diversifiers. Perhaps an even deeper analysis is necessary to determine what exactly has to be hedged.


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