No. 1/2016:Investing it, spending it: Interactions between Spending and Investment Decisions with a Sovereign Wealth Fund

Abstract

The emergence of sizeable Sovereign Wealth Funds (SWF) in recent years has raised important questions of how such funds should be managed and how the proceeds should be spent. This paper takes a fresh look at these issues in view of modern finance literature. The most important finding is that investment management and spending decisions should not be separated because the preferred way of spending carries implications for the investment strategy. This result becomes particularly apparent if the SWF, like Norway's GPFG, is intended to finance a smooth stream of government spending, which we model as saving and investment with internal habit formation. The desire for backward as well as forward smoothing has implications for both portfolio rebalancing and overall risk taking, both of which should be limited. We furthermore find that short-run smoothing raises the long-term variability of spending because short-run smoothing affects the fund's principal value. The paper also studies the effects of time-varying risk-free rates and finds that optimal spending should respond to such variations, though only partially. Lastly, we point out that a spending rule based on the fund's annuity value should adjust the normal rate of return for risk. For the case of the Norwegian GPFG, the risk adjustment could reduce the optimal annual draw on the fund by an amount corresponding to as much as 3% of mainland GDP. However, a rule based on preferences among generations may be equally rational as a rule based on the annuity value.