The Two Dimensions of Liquidity Risk for Sovereign Wealth Funds

Posted on 05/17/2023

For some sovereign wealth funds, liquidity risk is very important. Some of these funds transfer vast sums of money to the finance ministry.

Liquidity risk for SWFs have two dimensions.

Asset Illiquidity
The first is asset illiquidity. This is the inability to liquidate assets in a timely manner at reasonable values. Fixed income and listed stocks have greater liquidity versus private equity and real estate. A question looms, what portfolio percent can a sovereign wealth fund liquify its fund within a week?

Cashflow Illiquidity
The other dimension is cashflow illiquidity. This is the inability to support cashflow requirements at reasonable costs. The key drivers of cashflow liquidity are sources of cash and the uses of cash. Sources of cash for some sovereign wealth funds include oil/mineral royalties or payments, proceeds from bonds raised or assets sold, and investment income. Uses of cash include expenses, money transfers to the government, and investment opportunities.

Linking both dimensions, moderate-to-catastrophic stresses could magnify deviations in asset allocation. Cash requirements can lead to undesired and sub-optimal asset allocation deviations with potential longer-lasting adverse impacts on fund performance.

For some sovereign wealth funds, a downturn in listed stocks could impact a fund’s cashflow liquidity profile. The S&P 500 index is up 7.5% in both the first quarter of 2023 and the fourth quarter of 2022. The loss via S&P 500 index through the through first three quarters of 2022 was 23.8%. The rebound in last two quarters reduced the loss to -9.7%. Norway Government Pension Fund Global has around a 70% allocation to listed equities versus other sovereign wealth funds that have large allocations to private equity, infrastructure, hedge funds, private credit, and real estate.

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