Risk Taking and Fiscal Smoothing with Sovereign Wealth Funds in Advanced Economies

Round 1

Reviewer 1 Report

This paper investigates the interaction between fiscal policy and portfolio management for SWFs, focusing on the Norwegian case. The authors find that increased portfolio risk spills over into public spending and can increase the long run spending risk.For short-term portfolio selection issues, zero-coupon bonds can be good substitutes for risk free investments, while for long term, risk-free investments are risky because interest rates fluctuate randomly.

Overall, this is a good paper, with a robust methodology and sound portfolio construction, that could contribute to the literature on SWFs portfolios and overall asset allocation.

I have just couple minor suggestions:

1) The topic is not well introduced: why right now assessing the portfolio optimization for SWFs is important? Are there new funds? What's different compared to 2008-2010 studies (like Balding, Paltrinieri and Pichler, Kunzel et al 2011 on portfolio and asset allocation)?

2) The literature review is not well developed. Which is the contribution? There are a lot of studies on Norway SWF, in the form of 'in depth studies'. The authors should cite them and what is different.. (i.e. the portfolio focus).

3) The methodology is sound, but I'd like to read couple more words on SWFs at the end of the paper and on Norway SWF in particular, given the research question.

Author Response

1)    The topic is not well introduced: why right now assessing the portfolio optimization for SWFs is important? Are there new funds? What's different compared to 2008-2010 studies (like Balding, Paltrinieri and Pichler, Kunzel et al 2011 on portfolio and asset allocation)?

We have rewritten the introduction and pointed out that the main differences from the references cited by the referee is the recent growth in the magnitude of some of the funds, including the Norwegian GPFG. As a consequence, they have become significantly more important for fiscal policy, for which financial risks add an important new stochastic element. This makes it so much more important to analyze SWF risk taking and SWF draws simultaneously. 

2)    The literature review is not well developed. Which is the contribution? There are a lot of studies on Norway SWF, in the form of 'in depth studies'. The authors should cite them and what is different. (i.e. the portfolio focus).

The new introduction contains an extended review of the literature. We now cite two of the “in-depth” studies that have received the most attention in Norway: “There has been several studies of Norway’s GPFG, but they all have a different focus than ours. Two of the most well-known studies (Ang, Goetzmann, and Schaefer, 2009 and Dahlquist and Ødegaard, 2018) empirically analyze the performance of the fund. Only a small fraction of the fund is actively managed, and the choice of benchmark index has therefore been most important for the fund’s (absolute) performance.” Similarly, we have added a reference to Chambers et al (2012) in connection with Table 1 in Section 4.

3)    The methodology is sound, but I'd like to read couple more words on SWFs at the end of the paper and on Norway SWF in particular, given the research question.

We have rewritten section 6 (Conclusions and future work) to accommodate the referee’s comment.

Reviewer 2 Report

I enjoyed reading this paper. There are numerous papers that look at the determinants of SWF success/failures but I believe this paper will constructively add to extant literature. From my reading, it looks at the optimal draw conditions under governments with developed SWFs may need to operate. While the paper is well executed and is well written, I do have a number of concerns with the paper, including (in no particular order of importance):

1.       The authors refer to various states with multiple SWFs, yet the authors have not sufficiently accounted for the possibility that states create such funds to build upon wealth or political currency, and also diversification purposes. The heterogeneity among SWFS needs to be adequately highlighted. As such, states that may/may not have multiple SWFs that achieve different aims for the state, may be more risk tolerant/averse. 

2.      It is my understanding that a SWF’s underlying objectives is to insulate the state's budget and economy against resource price and supply swings, to convert revenues from non-renewable resources, such as oil or minerals, into a more diversified portfolio of assets for use by future generations, to increase the earnings on foreign currency reserves, to provide budgetary support for potential unfunded contingent pension liabilities or other monetary requirements, and to increase political influence by making political foreign investments (As per Johan et al. (2013). This may need to be highlighted as it will affect risk tolerance by SWFs.

3.       The authors may need to discuss heterogeneity of portfolio composition among SWFs. Some may be more heavily invested in less liquid alternative investments such as hedge funds and private equity/venture capital. This not only affects portfolio risk but also restricts draw by states.

4. The abstract needs to be rewritten as it was very difficult to read.

Author Response

1.      The authors refer to various states with multiple SWFs, yet the authors have not sufficiently accounted for the possibility that states create such funds to build upon wealth or political currency, and also diversification purposes. The heterogeneity among SWFS needs to be adequately highlighted. As such, states that may/may not have multiple SWFs that achieve different aims for the state, may be more risk tolerant/averse.

We have rewritten the introduction. In it, we have given a much more detailed account of the existing SWFs, including the heterogeneity of their origin as well as their purposes. We have pointed out that the risk-taking ability may depend on the fund’s purpose, but then proceed to focus on the kind of SWFs we are interested in, namely advanced-country funds like the Norwegian GPFG. 

2.      It is my understanding that a SWF’s underlying objectives is to insulate the state's budget and economy against resource price and supply swings, to convert revenues from non-renewable resources, such as oil or minerals, into a more diversified portfolio of assets for use by future generations, to increase the earnings on foreign currency reserves, to provide budgetary support for potential unfunded contingent pension liabilities or other monetary requirements, and to increase political influence by making political foreign investments (As per Johan et al. (2013). This may need to be highlighted as it will affect risk tolerance by SWFs.

After laying out the heterogeneity of SWFs in terms of origin as well as purposes, the rewritten introduction focuses on SWFs founded on temporary revenues of non-renewable natural resources like oil and gas: “These oil funds, for short, were established as a way to convert the financially concentrated wealth of below-ground natural resources into a balanced portfolio of liquid financial assets in support of future fiscal obligations. The channeling of extraordinary revenues into SWFs furthermore serves as protection against the so-called Dutch disease, analyzed by van Wijnbergen (1984), Corden (1984), Krugman (1987), and many others. That is, they are supposed to shield the economy from a temporary expansion of domestic spending that risks depleting the stock of human capital in traditional export industries and thus leave the economy worse off when the non-renewable resources are depleted than before they were discovered. At the same time—and more or less by the same token—these funds are also intended as saving funds to allow the financial benefits of the finite resource stock to be shared by future generations.”

3.      The authors may need to discuss heterogeneity of portfolio composition among SWFs. Some may be more heavily invested in less liquid alternative investments such as hedge funds and private equity/venture capital. This not only affects portfolio risk but also restricts draw by states.

To take the above three points into account (and the comments from the other referee), we have rewritten the introduction. They are mostly emphasized in the paragraphs 3,  4, and 5.

4. The abstract needs to be rewritten as it was very difficult to read.

We have rewritten and simplified the abstract. The new abstract reads as follows:

Abstract: In an economy with a sovereign wealth fund (SWF), the government may draw on the fund to supplement other government revenues. If the fund is invested in risky assets, this introduces a new stochastic element into the government’s budget. We analyze the interaction between the draw from and risk taking in the SWF. Using non-expected utility preferences, we distinguish between intended changes and stochastic changes in the SWF draws over time. We show that the desire for smoothness in taxes and public services translates into smoothing of SWF draws and lower risk taking. It can even lead to procyclical rebalancing of the SWF portfolio. Future interest rates are associated with interest-rate risk. We show that this risk may lead to a higher optimal equity share in the SWF portfolio. Policy makers can use the draws from the SWF to smooth over time variation in risk-free rates.