Euromoney, September 2015
Norway’s sovereign wealth fund is probably the largest in the world, and certainly the most transparent – a double act that creates challenges for the 450 people who run it. How does one run such a behemoth, a fund twice the size of the national economy it supports, one so big that markets move at the mere thought of what it might do next? And why has it just lost nearly $9 billion in a quarter? Two of its CIOs explain to Chris Wright.
There are big sovereign wealth funds, and there are transparent sovereign wealth funds, but only Norway’s is unarguably both. The Government Pension Fund Global, run by Norges Bank Investment Management, has, at the time of writing, NOK7,076,982,100,419 (US$860.48 billion) under management. Update: ten minutes later, the figure is NOK7,072,104,116,491. You see our point.
The flickering, constantly changing market value figure that appears on the fund’s home page, disclosing the AUM figure not annually or quarterly or daily but so often that the last six digits can barely even be read before they change again, is emblematic of a commitment to transparency that comes from an almost unique set of circumstances.
Norway’s is one of the only truly vast sovereign wealth funds that happens to be in a democracy, and its funds and management are wholly accountable to the country’s parliament and citizens (with particular vigour when, as happened in the second quarter, the fund lost NOK73 billion in its first decline for three years). You can argue the same is true in Kuwait and Singapore, but neither is quite a democracy in the western style, with anything like the same level of accountability; Korea, Australia, Alberta and Alaska are true democracies, but their sovereign funds are considerably smaller. Norway probably pulls off the double act of being the world’s largest fund (since we don’t know what the Abu Dhabi Investment Authority holds, it’s hard to be certain) and the one that is the most open.
So what happens when one combines scale with enforced openness? How does one run such a beast? And what responsibilities come with this scale? In rare interviews, two of NBIM’s CIOs explain to Euromoney.
You could open an interview with NBIM with almost any subject – mandate, allocation, external managers, football, Game of Thrones – and the response would begin with something like: “let me take a step back and explain our governance structure.”
This is understandable. Everyone at NBIM is at pains to make clear that they simply steward money for the nation, that they act within mandates passed down from parliament, and that any decision is taken within the parameters of that sense of strictly defined responsibility.
Basically, it works like this. An act of Norway’s parliament gives the Ministry of Finance formal responsibility for the management of the fund. Then the ministry delegates the operational management of the fund to the Norwegian central bank through an investment mandate. Finally, the central bank’s executive board delegates management to Norges Bank Investment Management.
“All major allocation decisions, and any decisions that affect the total risk of the fund, have to be anchored in parliament,” explains Ole Christian Bech-Moen, CIO for Allocation Strategies. An example would be the rebalancing rule, which specifies a limit for how far the equity allocation in the benchmark index may deviate from its strategic allocation of 60% before rebalancing must be performed (the limit is four percentage points). “That goes all the way to parliament, because it’s a major decision affecting the fund.”
Norway’s fastidious scrutiny of the fund is hardly surprising. “We are now roughly 200% of GDP,” says Bech-Moen. “It’s a big fund, and it’s important for us to have the necessary trust from the ultimate asset owner in our management of the fund.” And that’s why the place is so transparent. “Transparency is one way of getting that trust.”
Transparency does have some knock-on effects, some positive, others challenging. “Transparency will make us a lot better,” says Bech-Moen. “Being transparent, formulating our strategies in public, will give us a lot of feedback on those strategies, to make them better.” But, as he says, “we are operating in financial markets, so there is a limit to how transparent we can be – in particular in the forward looking part, since it may affect prices if we are open about what we are intending to do.”
Petter Johnsen, CIO of equity strategies at NBIM, adds: “It’s always a balancing act. We clearly believe, given the importance of the fund in the Norwegian context, it is crucial for the legitimacy of the fund that we are transparent about what we do. It instils discipline. But we do not tend to have forward-looking statements in terms of where we view the opportunity sets.”
Indeed, just the whisper that NBIM might be considering entering or exiting a company, or a country, or even a sector, can have a considerable impact on valuations, such is the super-tanker nature of the fund.
There are, too, great positives that can come with influence, and NBIM is one of the most active of sovereign wealth funds in certain areas of investor relations, as well as holding a clear position on socially responsible investment.
Within the parameters of the mandate handed down from the ministry to achieve the highest possible return, “it is recognised – and we agree with the owner on this – that a good return is contingent on sustainable development in economic, environmental and social terms,” says Johnsen. “It is in our interest: we stand to benefit from the healthy and sustainable development of the companies and markets we invest in.”
Historically, NBIM has flexed its muscles most clearly in practical matters around governance and shareholder power. “First, it’s improving industry standards, dialogue with regulators, and exercising ownership responsibly,” says Johnsen. “That involves ongoing portfolio monitoring of the companies we invest in. Voting is a crucial part of how we see responsible investing, and we try as often as is practically possible to vote in all AGMs.” He says NBIM’s equity teams will hold over 3,000 meetings a year with executives, usually the CEO or CFO. A particular drive now is around proxy access, or the right for shareholders to nominate directors.
More recently, the fund has been in the headlines for its views on coal. In early June, Norway’s parliament formally endorsed a move to sell off coal investments, which is thought to affect 122 companies across the world, and reportedly involving $9-10 billion of divestments. (NBIM distances itself from these numbers and says it’s not yet clear how many will be affected, nor their value. At the end of 2013, the fund had NOK2.6 billion of holdings in companies that mainly extract coal, NOK36.6 billion in general mining including coal, and NOK77.3 billion in utilities that use coal.) Agreeing exactly how the divestment would work required agreement between opposing parties in Norway, but they eventually concluded the fund should withdraw investments from all companies whose business relies more than 30% on coal, whether in revenue or – and this is why the utilities are relevant – by the percentage of power they generate from it.
NBIM had already been pulling out of coal stocks for some time, on a straightforward rationale of risk and price outlook; its Responsible Investment Report for 2014 said it divested from 22 companies in coal mining, oil sands, cement production and coal-fired power production during that financial year. It pulled out from a further 27 due to other environmental considerations that year and another 66 in the previous two years, often over deforestation concerns.
Like anything at NBIM, the coal announcement marked the conclusion of several years of contemplation. “It is important to stress,” the fund noted in a letter to the Ministry of Finance in February (which, needless to say, it then immediately published on its web site), “that a decision not to invest in a company is an active decision and falls within the scope of active management.” Steps like this are taken very seriously.
Two interesting questions arise from all this. One is: why? And the other is: what are the impacts?
Generally, NBIM managers try to paint their views on sustainable investment as being a pragmatic return-based decision rather than a moral one. There is a Council on Ethics, appointed by the Ministry of Finance to monitor the portfolio and to evaluate whether or not the fund’s investments in specified companies are consistent with its guidelines for observation and exclusion, but that’s not necessarily the reason for an exit from an investment. “That’s a separate path, compared to the divestments that we might take,” explains Johnsen. “We do some divestments that are basically risk-based decisions, taking into account an overall financial assessment of a company where environmental and social factors will play a part; there, we might divest based on a forward looking view that we don’t think this business is viable in the long term.” Coal perhaps fits both the ethical and the pragmatic side. The crucial parliamentary decision on June 5 that led to the latest set of divestments was a new climate criterion aimed at mining companies and power producers that have a significant portion of their income and business related to coal. But, as NBIM says: “The ethical exclusion criteria must not be confused with the fund’s own risk based divestments. We have divested from a number of companies in recent years following broad financial assessments that include environmental and social factors.” If we understand the point correctly, coal would probably have been out as a bad investment anyway, irrespective of one’s position on climate change.
Then there are the knock-on effects. Being sold down by the world’s biggest sovereign wealth fund is neither good for the share price nor particularly good PR, and in this respect, like it or not, NBIM can make a difference. For example, it wrote to a number of diversified mining and resources companies asking them for an exploration of where coal fits into the portfolio; it would be no surprise if a company with, say, 32% of its assets coming from coal might sell down some of those holdings in order to drop below the 30% ceiling at which NBIM can no longer own it. Meanwhile, anyone who appears to be on the hit list is likely to see their share price hit: the Guardian reported in June that the UK utility SSE, in which the fund holds $956 million of shares, would face the single biggest sell-off, and the stock lost 6.5% in the two weeks following the political agreement on the divestment policy on May 27.
Be that as it may, it’s a hellish challenge trying to get anyone at NBIM to admit they perform any social good beyond their mandate, even if they clearly do. Asked about the fund’s role as a good citizen, Johnsen will only concede that it’s useful as a signal across the portfolio when developments at one company might have a follow-on impact on other companies the fund holds. NBIM is all about the service, the portfolio, the mandate: if it in any sense changes the world along the way, that appears to be an unintended side-effect, or at least not a stated objective.
Nevertheless, the market does have a habit of trying to think ahead of NBIM. Some, for example, have inferred that the fund’s divestment of coal stocks infers a broader view that it does not like resource stocks in general, a further death knell for that maligned sector. Is that right? “What I would say is that the divestments we have done, focusing on coal, are not just related to resource stocks per se,” says Johnsen. “It relates to other parts of the value chain, such as electricity production from coal. I’m not going to give forward-looking statements on our views, but it’s a question of our financial assessment of the long-term viability of models. It’s public record that we have written to some big integrated miners asking specific questions on their business model, but this is not just related to a view on resource stocks.”
One of the things that distinguishes NBIM from many peers is the exceptional level of research, often embracing or sponsoring academia in the process. An example is factor-based investing, the method of using specific tilts like momentum, value and low-volatility to increase returns from a portfolio without increasing risk.
This idea has been around since the 1970s, but its strength as an investment discipline arguably stems from a decision by NBIM, reeling from the financial crisis in 2008, to commission a detailed study on it from Professors Ang, Goetzman and Schaefer of Columbia University, Yale University and the London Business School respectively. Joop Huij, in Robeco’s Quantitative Research department in Rotterdam, says the report was so influential that the whole style of investing is sometimes now known as the Norway model. It was quite a report. “It’s one of the few reports I know with a summary of the summary,” he says. But it was also symptomatic of a fastidious approach to learning by the fund. “The government wanted to understand: why is this? Is the way that we manage our wealth the most efficient way to do it?”
As it happens, NBIM didn’t adopt everything in the report, though Bech-Moen says the fund does have both a value and a small cap tilt embedded within the fund’s internal reference portfolio. Characteristically, the fund publishes all of its research of this kind in its discussion notes section of the website. “We do a lot of this research internally but are also trying to strengthen our ties with academia to gain experience from them as well,” he says. It has something called the Norwegian Finance Initiative to strengthen the academic foundation of the fund’s management.
Yet for a fund with a truly scientific approach to risk, return and analysis, it looks surprisingly boring. It invests in only three asset classes – fixed income, equities and real estate – and only has 2.3% of the fund in the last of those, though it’s in the process of building up to 5% (the strategic allocation to equities is 60% of the fund, leaving 35% for fixed income. In theory asset allocation bands are wide and flexible – from 50 to 70% for equities, for example – but in practice, tracking error limitations and the rebalancing rule make it unlikely that the fund would drift that far).
The story of NBIM’s move into real estate explains a lot about how the fund works, and just how hard and labour intensive it is to effect change in an institution of this size.
“We have a very long term horizon. We don’t have to rush into new asset classes,” says Bech-Moen. “We are building up expertise gradually. We did that with emerging markets, we did that with equities, and that’s our approach in real estate as well.” The fund is starting out investing in a limited number of US and European cities, and will at some point expand to established Asian cities too.
Getting to this point took years. “It has,” says Bech-Moen, “been a very long process.” It began with the Ministry of Finance setting up an expert panel to look at whether the fund should invest in the new asset class, and asked Norges Bank itself for advice. Analysis was done by the expert group and by NBIM; both then advised the Ministry of Finance; the ministry added its own analysis; a white paper was written, and presented to parliament; parliament discussed it, and eventually gave approval. “This takes a bit of time,” says Bech-Moen. “But we are fine with that. We want the strategies to be well-anchored politically and well founded in academic theory. We want to be sure this is a good idea.”
Given the fact that the real estate team accounts for around 100 out of the fund’s total 450 staff, despite accounting for 2.3% of assets, one can understand why it doesn’t rush into new things. This helps to explain why, in contrast to peers like ADIA and the Government of Singapore Investment Corporation, or newer institutions like Australia’s Future Fund, we don’t see NBIM in alternatives. We may, though: in December, the ministry appointed an expert group to assess an increase in the allocation to real estate, and the case for unlisted infrastructure investments. Norges Bank has, in parallel, been asked to assess the same two questions. “That is something we are working on now,” says Bech-Moen, “doing the necessary background analysis to formulate our advice to the ministry of finance.” So watch this space… but you might be watching for a while, certainly years.
Anyway, if NBIM’s allocation does appear a little dull, until recently it hadn’t obviously harmed results. The fund returned an annualised 6% a year from January 1 1998 to the first quarter of 2015. In Singapore GIC’s 20-year return, when last disclosed in 2014, was 6.5%, suggesting that GIC’s myriad cutting-edge investments into private equity, hedge funds and the rest haven’t given it a huge edge over Norges Bank’s belt-and-braces approach (ADIA’s 20-year return in its 2014 annual result, the last available, was 7.4%). NBIM returned 7.6%, or NOK544 billion, in 2014.
After our interviews, though, NBIM reported a NOK73 billion ($8.8 billion) loss in Q2, its first decline in three years, thanks to falling stock markets and a weakening currency. Coming alongside a weakening oil price, and therefore less expectation of new money coming in from oil revenues, it has prompted discussion in Norway about the fund’s future and direction, and whether it should invest closer to home. Comments from CEO Yngve Slyngstad to Bloomberg TV in August, though, suggested nothing much is going to change. “We take 100% of the government’s [oil] revenue into the fund, and that means that we still have a net positive inflow,” he said. “Although it’s very small these days, it’s still net positive, so it doesn’t really change anything with regards to investment strategy. But yes, we do not have the same amount of cash flow to reinvest in new markets. The fund is quite stable, quite large and therefore we don’t move around that much.”
Besides, looking at NBIM in big lumped allocations misses the subtlety of what’s going on within the portfolio. It’s by no means just a selection of developed-world blue chips. At the end of 2014 investments in emerging and frontier markets accounted for 10.6% of the fund. Equity holdings by then were in 9,134 different companies, with investments related to 75 countries and 47 currencies, recent additions being Ghana, Mauritius and Nigeria. It was in 18 countries normally classed as frontier, and a further six not even within FTSE frontier indices, such as Panama and Kazakhstan. It holds, for example, 20 companies in Vietnam and 11 in Kenya.
These less well-trodden parts of the world tend to be where NBIM uses its external managers these days, who at the end of 2014 accounted for NOK276 billion in 80 mandates, corresponding to less than 5% of total assets (compare this to 65% at ADIA, though much of that is passive). While the externals in fixed interest are big names like Ashmore and Templeton, many of the almost 70 fund managers known to hold equity mandates are far less well known: Abax Investments, Avaron Asset Management, Keel Capital, Karma Capital Advisors.
“We use external managers mainly to enter markets, often countries, that are costly and unrealistic for us to build up in-house expertise to manage,” Bech-Moen explains. “Typically we choose managers with local expertise and presence in those markets.” The use of external managers has sometimes been controversial in Norway, but Bech-Moen is unequivocal: “It has been a success. Firstly, if you go back in history, it enabled us to start investing in equities fairly soon after the decision was taken: in the beginning we only used external managers while we built up internal expertise. And also it has been a success performance-wise. NOK15 billion is the relative excess return generated by external managers.”
These new investments, single stocks in frontier places, must seem a drop in the bucket for a fund of this extraordinary size. “Liquidity is of course different for us than for other managers because we’re so large,” says Bech-Moen. Johnsen adds: “Small cap, given our size, is a more limited opportunity naturally. But we always think, should we increase our small cap names? It’s more systemic harvesting to gain larger exposure to a universe of companies.”
At this rate it won’t be long, a couple of years perhaps, until Norway boasts a trillion dollar fund. When it does, that will represent about $200,000 apiece for every one of Norway’s five million people. They’ve all been theoretical krone millionaires since 2013 anyway.
It makes sense for a fund like this to move slowly and systematically, eschewing the maverick dealmaking of a Qatar Investment Authority for the studious contemplation of risk. It might not be the most exciting fund in the world; its asset allocation graphs are downright boring. But it is working, and along the way, the supertanker is making some considerable waves. Just ask the coal industry.