Asset allocation for sovereign funds: why the macro context matters

We recently published a research paper developing a simulation-based framework for analysing asset allocation decisions alongside key economic drivers for sovereign and public funds. This article summarises the key ideas and what they mean for how sovereign funds should think about allocation. We will be presenting this work at the World Bank Group Treasury and CFA Institute joint conference on Public Asset Management: Best Practices and Innovations for the Future, in March.

Public funds — sovereign wealth funds, reserve managers, and public pension institutions — are increasingly in the spotlight. Elevated government debt levels, new policy discussions around the creation of sovereign wealth funds, and volatile commodity cycles all mean that the stakes around sovereign fund allocation are rising. Yet the standard tools used for portfolio analysis often miss the most important interactions. Sovereign funds operate at the intersection of financial markets and macroeconomic policy, and their allocation decisions need to reflect this.

Why sovereign funds are different

The core issue is straightforward: sovereign funds cannot think only in terms of portfolio returns. Their long-horizon decisions need to account for the economic environments in which those returns are realised. Fiscal revenues and spending, exchange rates, commodity price cycles, and sovereign debt dynamics all interact with financial returns in ways that generate complex risks for public balance sheets.

More broadly, any institutional investor ultimately faces the challenge of aligning portfolio choices with real-world objectives and constraints — whether those are liabilities, spending rules, regulatory capital requirements, or balance sheet risks. In that sense, asset allocation should rarely be separated from investor objectives. Sovereign funds, however, sit at the extreme end of this spectrum. Their objectives are deeply intertwined with macroeconomic outcomes and public balance sheet dynamics, making the case for an integrated framework especially strong.

Real-world examples illustrate this clearly. Norway's Government Pension Fund Global supports the non-oil budget deficit through a spending rule tied to expected long-term returns, enabling counter-cyclical fiscal expenditure during downturns. The implication is that long-term outcomes for the fund are shaped by the interaction of portfolio returns and fiscal deficits — not by portfolio returns alone. Japan's Government Pension Investment Fund has become increasingly important for funding retirement liabilities in a context where public debt is elevated relative to GDP. The sustainability of debt levels shapes the demands placed on the fund's assets, as well as the investment risks it faces. In the Middle East, sovereign wealth funds are primarily funded by commodity revenues, where oil price cycles drive the timing of inflows and can cause sharp drawdowns when prices collapse. In other cases, such as Singapore's GIC and South Korea's KIC, sovereign funds grew out of reserve management, meaning there has always been an inherent macro perspective on how these pools of capital are deployed.

A common thread across these examples is that the drivers that matter for public fund outcomes — asset returns, fiscal balances, commodity prices, debt servicing costs — do not evolve independently. Their combined dynamics can amplify or offset each other in ways that are difficult to assess without an integrated approach. Partial approaches that examine portfolios, fiscal policy, or debt dynamics in isolation can miss the trade-offs that are most consequential for these institutions. As we have previously discussed, modelling the investor alongside the markets is a crucial step toward better allocation decisions.

Bringing macro context to portfolio simulations

In our research paper, we introduce a unified simulation engine that connects asset returns with the broader economic and fiscal environments relevant for public funds. The underlying architecture is modular and flexible: it can incorporate a broad set of asset classes and market segments, and it can be directly linked to a corresponding module that represents liabilities, fiscal objectives, spending rules, or balance sheet constraints. Rather than a one-off analytical exercise, this structure is designed to be scalable and adaptable across institutions with different mandates.

While this comprehensive approach is technically demanding, there are few other options if we are to make sense of a complex context for public funds. The practical benefit is that it creates a "laboratory" in which decision-makers can explore how different allocation choices interact with macro objectives and constraints. The simulation environment offers full flexibility to evaluate distributions of future outcomes at any horizon. With thousands of simulated paths, we can track how public fund values, fiscal balances, and debt levels co-evolve under different allocation strategies. If we are unsure whether underlying model assumptions are appropriate, the model structure can be easily amended to understand how sensitive asset allocation decisions are to these assumptions.

Gold reserves vs. a diversified portfolio

As an illustrative case study in the paper, we compare two starkly different strategic choices for how sovereign wealth can be deployed. Using the model, we analyse the implications of capital either being stored as official gold reserves, or converted into a diversified multi-asset 60/40 portfolio. We calibrate the framework to capture the current economic, fiscal, and debt trajectories in the United States. By doing this, we add a quantitative angle to recent discussions around the establishment of a US sovereign wealth fund. This debate is in its very early stages, but one of the more discussed routes to establishing capital for a fund is to make use of existing gold reserves.

A full exploration of this case study would involve a follow-up research paper. For now, however, we can still gain quick insights into how the two wealth allocations compare in terms of how they interact with macro outcomes. Long-run returns on the 60/40 portfolio are strongly linked to cumulative economic growth, because equity cash flows expand with stronger activity and higher growth lifts the level of government bond yields. Gold, by contrast, loads only weakly on growth, reflecting its lack of an earnings channel. Both portfolios carry some inflation sensitivity, though through different mechanisms. Under high inflation scenarios in the model, gold benefits from its traditional hedging properties, while the 60/40 portfolio combines higher nominal equity returns with the drag of inflation-induced yield rises on bonds.

These are the kinds of trade-offs that a sovereign fund needs to understand, and that are omitted in standard portfolio analytics. The question is not simply "which portfolio has the higher expected return?" but "how does each portfolio interact with the fiscal, growth, and debt outcomes that define success for this institution?"

Looking ahead

Each sovereign fund has unique mandates, macro dynamics, and constraints, and a comprehensive evaluation requires tailoring the framework to specific objectives and investment contexts. Our simulation approach is designed to be flexible and adaptable to a wide range of economies and fund structures.

For public funds, asset allocation analysis that ignores the macro-fiscal context is incomplete. By modelling the full system within a unified decision environment, institutions can evaluate trade-offs transparently, test their own assumptions, and build conviction around allocation choices in a context that reflects their real-world objectives. This type of framework puts investors in a stronger position to build portfolios that are resilient to the macro uncertainty ahead.

The full research paper is available here.