Correspondence: Bernd Scherer, Morgan Stanley, Investment Management, 25 Cabot Square, Canary Wharf, Floor 07, London E14 4QA, UK. Tel: 44 20 7425 4016; E-mail: Bernd.Scherer@morganstanley.com

¹is an executive director at the investment banking arm of JPMorgan, advising European pension funds and insurance companies on strategic issues related to risk and capital management and asset management. Previously, he held various positions with Deutsche Bank's Asset Management and Investment Banking Divisions, as well as Group Treasury, and was Assistant Professor of Finance at Emory University's Business School. Andreas holds a MS and PhD in Finance and Accounting from the University of Rochester, NY.

²is MD and global head of Quantitative GTAA at Morgan Stanley. Prior to joining the firm, Bernd worked at Deutsche Bank Asset Management as head of the Quantitative Strategies Group's Research Center as well as Head of Portfolio Engineering in New York. He authored and edited six books on quantitative asset management and various articles in refereed journals. Bernd received Master's degrees in Economics from the University of Augsburg and the University of London and a PhD in Finance from the University of Giessen. He is a visiting professor at Birkbeck College (London) as well as WHU (Koblenz) and external adviser to the Swiss Finance Institute.

Received 29 April 2008; Revised 29 April 2008.

Abstract

This paper develops a framework for partially hedging the market risk of oil reserves through appropriately allocating financial assets for Sovereign Wealth Funds, in particular so-called 'oil revenue' or 'petroleum' funds. Empirically, the hedge potential is substantial even when using relatively coarse partitions of the investment universe, such as Morgan Stanley Capital International (MSCI) country or industry indices. For example, if the market values of oil reserves and financial funds are equal, risk reduction is by as much as 50 per cent (10 per cent if short sales are not allowed) from original levels, translating into a certainty equivalent return of 3.26 per cent pa (48 basis points if short sales are not allowed). Moreover, choosing a portfolio along the efficient frontier, which is typically viewed as the key task in asset allocation, is relatively unimportant compared to the hedge decision.