Wednesday, October 30, 2013

Norway's Big Reversal Bet?

Mikael Holter of Bloomberg reports, Norway’s Sovereign Wealth Fund Shuns Stocks on Reversal Bet (h/t, Abnormal Returns):
Norway’s sovereign wealth fund, the world’s largest, warned that stock-market gains may reverse as Europe’s biggest equity investor said it won’t use new inflows to buy more shares.

“Our share in the stock market has been stable or falling even though markets are rising, and that means in practice that we’re not using inflows to buy stocks,” Yngve Slyngstad, chief executive officer of Norges Bank Investment Management, said at a press conference today in Oslo. The fund is preparing for a “correction” in stock prices, he said.

The warning follows a surge in stock values that added 7.6 percent to the fund’s equity portfolio last quarter. The $810 billion Government Pension Fund Global, the official name, returned 5 percent in the third quarter, representing a 228 billion kroner ($39 billion) gain, it said today. Bond investments climbed 0.3 percent and real estate holdings returned 4.1 percent, it said.

The fund has no immediate pension obligations and uses its long-term outlook to buy assets when others have to sell. After losing a record 633 billion kroner following the 2008 collapse of Lehman Brothers Holdings Inc. and ensuing global market slump, the fund raised its equity holdings by about 136 billion kroner in early 2009. In the second half of 2011, the fund bought more than 150 billion kroner in stocks as part of a strategy to invest in depressed assets.
Positive Signs

“In general, we see market corrections more as opportunities than as threats, so it’s not something that worries us,” Slyngstad said today in an interview. “If they come, that’s just a positive sign for us as an investor.”

Stocks rallied in the third quarter as the U.S. Federal Reserve unexpectedly refrained from ending its $85 billion-a-month quantitative easing program in September. Growth forecasts for China, the world’s second-biggest economy, also improved, propelling equities globally. The MSCI World Index of stocks gained 7.7 percent in the quarter, paring some gains late last month during the U.S. government shutdown.

The advance has pushed valuations for European shares to the most expensive level since the end of 2009. The Stoxx Europe 600 Index trades at 20.8 times reported operating profit, double the level from September 2011, according to data compiled by Bloomberg.
Holding Cash

Norway’s wealth fund, which gets its guidelines from the government, held 63.6 percent in stocks at the end of September, up from 63.4 percent in the second quarter. Bond holdings slid to 35.5 percent from 35.7 percent while real estate accounted for 0.9 percent. The fund is mandated to hold 60 percent in stocks, 35 percent in bonds and is building up to 5 percent in real estate, while allowing for fluctuations. It mostly follows global indexes and has some leeway to stray from those benchmarks.

“If we’re not buying equities these days, we’re buying bonds or just hold this as cash,” Slyngstad said. “We would of course like to invest more of it in the real estate market but that takes longer. As long as there are strong markets we don’t see any urge to increase our equity holdings.”

The investor, which posted its second-best year in 2012, is also undergoing a shift in strategy to capture more global growth. That’s involved moving investments away from Europe as emerging markets in Asia and South American make up a bigger share of the world economy. The fund has weighted its bond portfolio according to gross domestic product, after shifting away from a market weighting to avoid nations with growing debt burdens.
Largest Holdings

Its largest stock holding at the end of the quarter was Nestle SA (NESN), at a value of 38.5 billion kroner. The biggest bond holding was in U.S. Treasuries, at a value of 344 billion kroner, followed by Japanese and German government bonds.

“We consider U.S. Treasuries one of the safest investments you can do, and these last few weeks have not changed that view in any way,” Slyngstad said in the interview, referring to the first partial government shutdown in 17 years.

Mexico rose to fifth place in the fund’s bond holdings, while Brazil and South Korea joined the top 10, at the expense of France and Canada.

The fund will take “the time needed” to increase real estate investments to reach the target of 5 percent of total holdings, making bigger investments increasingly on its own rather than in partnerships, Slyngstad said. An initial ambition to reach the target in five years from its first real estate investment in 2010 may not be realized, he said.
Splitting Fund

Norway generates money for the fund from taxes on oil and gas, ownership of petroleum fields and dividends from its 67 percent stake in Statoil ASA, the country’s largest energy company. Norway is western Europe’s largest oil and gas producer. The fund, which had an average holding of 1.2 percent of the world’s listed companies at the end of 2012, invests abroad to avoid stoking domestic inflation.

Prime Minister Erna Solberg, whose government took power this month, said before the election she would consider splitting the fund into smaller units.

The government deposited 58 billion kroner of petroleum revenue into the fund in the quarter. The return beat the benchmark set by the Finance Ministry by 0.1 percentage point.

The investor got its first capital infusion in 1996 and has been taking on more risk as it expands globally. It first added stocks in 1998, emerging markets in 2000 and real estate in 2011 to boost returns and safeguard wealth.
I don't write enough about Norway's Government Pension Fund Global (GPFG). I should because Norway has done a superb job creating a sovereign wealth fund, intelligently investing their oil and gas proceeds for future generations. Unbelievably, Norway didn't even make Mercer's list of the world's best pension spots (I know it's a sovereign wealth fund, not a pension fund, but this country should have made top spot). Instead, the authors of that report praised Australia and its pension lessons from Down Under

And unlike other sovereign wealth funds, Norway's fund is extremely transparent. In fact, I used GPFG's governance framework as one of a few leading examples in a report I wrote back in 2007 for the Treasury Board of Canada on improving the governance of the federal public service pension plan. My report is still collecting dust somewhere in Ottawa but my contacts at the Office of the Auditor General of Canada tell me they are hard at work auditing the governance of that plan and I look forward to reading their latest report when it's publicly available.

Back to Norway's big reversal bet. GPFG is the world's biggest stock investor and soaring stock markets have helped bolster its performance in 2013:
The return on the GPFG during the first half of the year was 5.5 per cent, as measured in the currency basket of the Fund. When measured in Norwegian kroner, the return on the Fund was 15.9 per cent. The difference between the return in Norwegian kroner and in the currency basket of the Fund was caused by depreciation of the Norwegian krone relative to the currency basket of the Fund over this period. However, the return in international currency is the relevant measure with regard to developments in the international purchasing power of the Fund.
The return on the equity portfolio was 9.2 per cent, the return on the fixed-income portfolio was -0.4 per cent, and the return on the real estate portfolio was 3.6 per cent, as measured in the currency basket of the Fund (click on image below):

All in all, Norges Bank achieved a return in the first half of 2013 that exceeded the return on the benchmark index by 0.65 percentage point. Excess returns were generated in both equity management and fixed-income management (click on image below).

The average annual net real rate of return since yearend 1997, i.e. the return net of asset management costs and inflation, is calculated to be 3.2 per cent, as measured in the currency basket of the Fund. When measured from 1 January 1997 to the first half 2013, inclusive, the average annual net real return is calculated to be 3.4 per cent. The graph below shows the accumulated return on the equity and fixed income benchmark indices since 1998 (click on image).
As you can see, GPFG has performed well over the last ten years (gross return of 5.95%) and keeps its costs low (annual management cost is a mere 6 basis points). But the Fund is exposed to the whims of global stock markets and as shown in the chart above, it too got clobbered during the tech meltdown of 2001 and the global financial crisis of 2008.

The Fund's third quarter results are now available. You can read the quarterly report and see the highlights below:
  • Equity investments returned 7.6 per cent, while fixed-income investments returned 0.3 per cent. 
  • The return on equity and fixed-income investments was 0.1 percentage point higher than the return on the fund’s benchmark.  
  • Investments in real estate returned 4.1 per cent. 
  • The fund had a market value of 4,714 billion kroner at the end of the quarter and was invested 63.6 per cent in equities, 35.5 per cent in fixed income and 0.9 per cent in real estate.
And now that the Fund has recovered nicely from the crisis, it's looking to lower its risk in public equities and diversify its holdings. Like every other institutional investor in the world, GPFG sees multiple expansion getting out of whack as the Fed and other central banks pump enormous amount of liquidity into the global financial system, and it's exercising caution and looking to diversify its holdings as global stock markets soar.

One area of interest is real estate. Richard Milne of the Financial Times reports, Norway’s oil fund to ramp up property holdings:
The world’s largest sovereign wealth fund is aiming to ramp up hugely its property investments as it seeks to increase its holdings of real assets.

Norway’s $810bn oil fund is permitted to hold up to 5 per cent of its assets in property but its rapidly increasing size means that, despite amassing $7bn in real estate investments since 2010, this only amounts to 0.9 per cent of the fund.

Yngve Slyngstad, the fund’s chief executive, underlined how its property organisation had increased from 3 to 50 workers in the past three years.

He said it was “feasible but not likely” that the fund could reach its 5 per cent target by 2015, which would imply about $40bn of investments in the next two years.

“We have now built up a real estate team of a significant size that will be able to handle more transactions,” he told the Financial Times. “Whether we are going to do them or not that depends on the market and the opportunities.”

The oil fund has proceeded cautiously in property, investing with partners around the world.

But Mr Slyngstad opened the door to the fund investing on its own. “That may be a natural extension of the way we invest,” he added.

The fund has made its first property investments in the US in recent months, including paying $684m last month for a 45 per cent stake in the Times Square Tower in New York.

Mr Slyngstad’s comments on increasing its property investments came as the oil fund said it had made a return of 5 per cent in the third quarter, aided by the strong performance of equity markets.

Its equity investments returned 7.6 per cent while bonds earned only 0.3 per cent in the quarter.

At the end of September, it had a record 63.6 per cent of its holdings in equities and 35.5 per cent in bonds, the lowest to date.

Mr Slyngstad told a press conference that the fund was using most of its inflows from Norway’s petroleum reserves to buy bonds, adding that it was braced for a “correction” in stock prices.

The fund reduced its holdings in US and French debt during the third quarter.

But Mr Slyngstad said that the recent shutdown of the US government and flirtation with default had not changed the oil fund’s views of Treasuries being one of the safest investments in the world.

Norway’s new government, which came to power this month, has plans to change the oil fund’s mandate.

It announced in the coalition agreement vague plans for the fund to invest in emerging markets and possibly infrastructure.

Mr Slyngstad said the fund would wait to hear from the ministry of finance but also added: “We think it’s natural over a longer time that this fund invests in more asset classes and more in so-called real assets, of which infrastructure is one.

“Whether this is happening soon or in the long-distant future, we don’t know.”
I would caution Mr Slyngstad and his team at GPFF to take a measured approach when investing in illiquid investments, which is what they're doing. Admittedly, these are long-term investments which will help smooth the Fund's returns but record low interest rates are fueling a bubble in real estate, infrastructure and private equity.

Some pretty smart people are worried that pensions are taking on too much illiquidity risk at the wrong time and I agree. Think many pensions are ill-prepared for a rough landing, foolishly praying for an alternatives miracle. They better pray the Fed and other central banks avert a prolonged deflationary cycle because if they don't, the next financial crisis will decimate many pension plans.

As far as Norway is concerned, I like what they've done with their sovereign wealth fund and think they are on the right track. Mr Slyngstad is running a mammoth fund and they are doing a great job investing the proceeds of their oil-rich country. And while I realize that a correction in stocks is an opportunity for GPFG, I would love to talk to him about other investments to hedge downside risk, including tail risk strategies that are coming back to vogue as investors ponder volatility strategies (my email is

Below, Yngve Slyngstad, head of Norway's oil fund, explains why the world's largest sovereign wealth fund could dramatically increase its property investments. He also discusses their views on Treasuries and the possibility of investing in infrastructure.