Endowments foundations and SWFs - Sovereign wealth fund type...

Learning Outcomes

After studying this article, you will be able to identify and differentiate the main types of sovereign wealth funds (SWFs), describe the typical mandates and objectives for each type, and explain key implications for investment policy, asset allocation, and external constraints. You will also recognize core similarities and differences for SWFs, endowments, and private foundations—essential for the CFA Level 3 exam.

CFA Level 3 Syllabus

For CFA Level 3, you are required to understand the characteristics, mandates, and investment implications of different types of sovereign wealth funds, as well as how such mandates shape investment policy, asset allocation decisions, and regulatory constraints. Specifically, this topic addresses:

• Describing the main types of sovereign wealth funds and their primary investment objectives
• Explaining how the type and mandate of a SWF influence its risk profile, investment horizon, and liquidity needs
• Evaluating how legal, regulatory, and tax constraints affect SWFs, endowments, and private foundations
• Comparing typical asset allocations across SWF types and understanding the rationale for those differences

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which type of sovereign wealth fund is primarily designed to insulate a national budget from commodity price swings?
2. How do the investment objectives and liquidity needs differ between a savings fund SWF and a reserve fund SWF?
3. What are the common external (legal, tax, regulatory) constraints faced by SWFs?

Introduction

Understanding the variety of sovereign wealth fund (SWF) types and their mandates is essential for CFA exam success. SWFs, along with endowments and private foundations, manage sizable pools of capital with unique objectives and investment challenges shaped by their purpose, stakeholder demands, and regulatory context. This article defines the five core SWF types, explains the relationship between mandate and investment implications, and highlights key constraints and typical asset allocations for SWFs as compared to endowments and private foundations.

Key Term: sovereign wealth fund (SWF)
A state-owned investment fund that invests in financial and/or real assets, often for long-term national goals such as stabilization, savings, or economic development.

TYPES OF SOVEREIGN WEALTH FUNDS

Sovereign wealth funds vary widely in purpose and investment mandate. The International Monetary Fund identifies five primary types:

1. Budget Stabilization Funds
   These are established to smooth national budgets against external shocks—typically commodity price fluctuations. They hold highly liquid assets and focus on capital preservation, since withdrawals may be needed at short notice to offset fiscal shortfalls.

Key Term: budget stabilization fund
An SWF set up to stabilize fiscal budgets, especially in commodity-dependent economies, by mitigating the impact of revenue volatility.

Key Term: savings fund
An SWF designed to convert finite resource revenues into diversified financial assets, with the objective of intergenerational wealth transfer.

Key Term: reserve fund
An SWF created to manage excess foreign currency reserves more efficiently by investing for higher expected return than traditional short-term government securities.

Key Term: pension reserve fund
An SWF established to pre-fund public sector pension liabilities and meet demographic-driven spending needs.

Key Term: development fund
An SWF dedicated to supporting economic or strategic development through investment in national infrastructure, innovation, or priority sectors.

1. Savings Funds
   These convert natural resource or surplus revenues into diversified investments, aiming to preserve and grow national wealth for future generations. Their investment horizons are very long, emphasizing growth and risk assets.

2. Reserve Funds
   Established from excess central bank reserves, these target higher returns on sovereign assets than would be achieved through traditional reserves, typically investing in a mix of global equities and bonds.

3. Pension Reserve Funds
   These are dedicated to meeting future pension, health care, or contingent state liabilities. They accumulate assets for upcoming demographic expenditures and usually follow prudent, diversified investment policies with long time horizons.

4. Development Funds
   These SWFs invest to advance national economic development, frequently by supporting infrastructure projects, innovation, or major industries. They may have less clearly defined or longer-dated liabilities.

Worked Example 1.1

A country with volatile oil revenues wants to protect its budget from drops in oil prices. Which type of SWF is most appropriate, and what is its main investment goal?

Answer:
The country should create a budget stabilization fund. Its main goal is risk management—specifically, to maintain liquidity and capital stability so that it can cover unexpected budget deficits caused by commodity price drops.

Typical Mandates and Investment Implications

SWF mandates drive key investment policy features:

• Budget stabilization funds require capital preservation and high liquidity; returns are often benchmarked to short-term government securities or inflation.
• Savings and reserve funds accept higher investment risk, emphasizing long-term growth and asset diversification.
• Pension reserve funds balance growth objectives with meeting future social obligations, allocating to a mix of global equities, bonds, and alternatives.
• Development funds invest in projects with national strategic value, potentially making concentrated or illiquid investments.
• Endowments and private foundations (for context) have objectives similar to SWF savings funds, often focused on long-term spending power and intergenerational equity.

INVESTMENT HORIZON, LIQUIDITY, AND CONSTRAINTS

The type and mandate of a SWF determine its time horizon, allowable risk, and liquidity profile. The greater the expected stability of liabilities (e.g., savings funds with low, distant, or no defined liabilities), the higher the potential to invest for growth and illiquidity premia.

Key Term: investment horizon
The expected period over which assets are invested to meet future spending or obligations. Long horizons allow greater risk-taking and less demand for liquidity.

• Budget stabilization funds have uncertain, near-term liabilities and require high liquidity.
• Savings and pension reserve funds have very long-term obligations and low immediate liquidity needs.
• Reserve funds need moderate liquidity due to central bank/sovereign demands.
• Development funds may invest in assets with variable liquidity, depending on the nature and timing of national development goals.

ASSET ALLOCATION: ILLUSTRATIVE PROFILES

Asset allocation patterns for each SWF type reflect fundamental objectives and constraints:

Worked Example 1.2

A reserve SWF is mandated to reduce the negative carry from excess foreign currency reserves. What kind of asset mix might it choose?

Answer:
Reserve funds will hold a substantial proportion of global equities and investment-grade credit, while maintaining enough liquid fixed income for central bank flexibility.

EXTERNAL CONSTRAINTS: LEGAL, REGULATORY, AND TAX

All institutional investors, including SWFs, endowments, and foundations, face constraints that affect asset allocation and operations. These include:

• Legal and regulatory: Many SWFs and foundations must comply with laws limiting certain investments, borrowing, and risk—generally to ensure prudent management, transparency, and governance.
• Tax: SWFs often benefit from tax-exempt status internationally, but some investments (especially direct investments or stakes in private assets abroad) can still be exposed to withholding, local, or cross-border tax.
• Spending or payout rules: For example, US private foundations must distribute 5% of assets annually; many endowments and savings SWFs have fiscal rules limiting withdrawals.
• Accounting and reporting: Requirements for fair value accounting, periodic reporting, or restrictions on asset valuation may apply.

Key Term: legal/regulatory constraint
A rule, ordinance, or law that restricts investment options, asset allocation, or operations—for example, prohibiting borrowing or certain securities.

Exam Warning

Many candidates underestimate the effect of legal and regulatory constraints on SWF asset allocation, especially for development or stabilization funds. For the exam, always consider both the statutory objectives and the real-world liquidity and risk restrictions imposed by the fund's legal framework.

COMPARISONS: SWFs, ENDOWMENTS, AND PRIVATE FOUNDATIONS

All three institutional investor types aim for long-term purchasing power, but practical differences arise:

• SWFs: Usually government-owned, politically sensitive, can be very large relative to national wealth, and must balance national fiscal policy with generational equity and political sustainability.
• Endowments: Generally perpetual, non-governmental; annual spending is determined by a rate or board policy; asset allocation is often more aggressive than stabilization SWFs.
• Private foundations: Often face minimum payout rules, higher transparency demands, possible excise taxes, and at times less tolerance for risk and illiquid alternatives.

Summary

Sovereign wealth funds are state-owned investment pools with mandates reflecting budget stabilization, savings, reserve/sterilization, pension prefunding, or national development. Fund type and mandate dictate investment objectives, risk profile, and asset allocation. Budget stabilization funds require low risk and high liquidity; savings and pension reserve funds can pursue long-term growth, allocating to equities and alternatives. Development funds may focus on national priorities. All institutional funds operate under legal, regulatory, and often tax constraints, which must be reflected in the investment policy statement and asset mix.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify and differentiate the five main types of sovereign wealth funds
• Recognize how the mandate influences investment horizon, risk, and liquidity needs
• Relate SWF type to typical asset allocation patterns
• Understand legal, regulatory, and tax constraints on SWFs, endowments, and foundations
• Know investment policy priorities and practical constraints for different fund types

Key Terms and Concepts

• sovereign wealth fund (SWF)
• budget stabilization fund
• savings fund
• reserve fund
• pension reserve fund
• development fund
• investment horizon
• legal/regulatory constraint