Wednesday, October 19, 2016

Norway's GPFG to Crank Up Equity Risk?

Richard Milne and Thomas Hale of the Financial Times report, Norway’s oil fund urged to invest billions more in equities (h/t, Denis Parisien):
Norway’s $880bn oil fund is being urged to invest billions of dollars more in equities and take on more risk in what would be a big shift in its asset allocation away from bonds.

The world’s largest sovereign wealth fund should invest 70 per cent of its assets in shares, up from today’s 60 per cent, at the expense of bonds, according to a government-commissioned report on Tuesday.

The move is highly significant for global markets as the oil fund owns on average 1.3 per cent of every single listed company in the world and 2.5 per cent in Europe.

The report is the latest salvo in a debate on how much risk the long-term investor should take and comes amid growing warnings of dwindling returns for government bonds in particular. The allocation to equities was increased from 40 per cent to 60 per cent in 2007.

“With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk,” Hilde Bjornland, an economics professor behind the recommendation, told the Financial Times.

The centre-right government will evaluate the recommendations before setting out its own position in the spring. Senior insiders said they expected the allocation change to go through as the report was co-authored by two former finance ministers.

Siv Jensen, the finance minister, told the Financial Times: “We are always thoroughly evaluating how we are running the fund … We know now that we have a very low interest rate regime globally. We have 40 per cent in bonds, and that will affect the return over time.”

Saker Nusseibeh, chief executive of Hermes Investment Management, a UK asset manager, said there was a broader trend of investors looking to increase their equity exposure. “This is about the realisation that you cannot make returns of the same amount that you used to make in the past,” he said.

He added: “If you are a sovereign wealth fund … you will question why you would have so much in fixed income at all.”

The latest survey of fund managers from Bank of America Merrill Lynch shows a rise in cash holdings, which in part reflects “scepticism or outright fear of bond markets”, according to Jared Woodard, an investment strategist at the bank.

In a sign of how the Norwegian debate might unfold, the chairman of the report, Knut Mork, voted against the other eight members and argued the allocation to equities should be cut to 50 per cent. This would give the government a more predictable income stream from the fund, he said.

The Norwegian government is permitted to take out up to 4 per cent of the value of the fund each year to use in the budget. But it is using only about 3 per cent this year.

The report estimated that the fund’s real rate of return was expected to be 2.3 per cent over the next 30 years. A majority of the commission suggested “one potential margin of safety” could be to restrict the government’s ability to take money out of the fund to the level of the expected real return.
Mikael Holter and Jonas Cho Walsgard of Bloomberg also report, Norway Sovereign Wealth Fund Urged to Add $87 Billion in Stocks:
Norway’s $874 billion wealth fund needs to add more stocks as record low interest rates and a weak global economy will otherwise lower returns to just above 2 percent a year over the next three decades, a government-appointed commission recommended.

The Finance Ministry should raise the fund’s stock mandate to 70 percent from 60 percent, the committee, comprised of academics, investors and two former finance ministers, urged on Tuesday. A decision on increasing its stock investments will be made by the ministry, which hasn’t always agreed with the conclusions of similar reviews on the fund’s holdings.

“A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value,” the group said. “The majority is of the view that the this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run.”

Norway is looking for ways to boost returns that have missed a real return goal of 4 percent as interest rates have plunged globally in the aftermath of the financial crisis. The government is this year withdrawing money from the fund for the first time to make up for lost oil income after crude prices collapsed over the past two years.


“The 60 percent equity share has over time been very good for us because it has given us considerable income from the fund,” Finance Minister Siv Jensen said in an interview after a press conference. “But we have also experienced that there can be swings from one year to another because the stock market moves over time.”

‘Considerably Less’

After getting its first capital infusion 20 years ago, the fund has steadily added risk, expanding into stocks in 1998, emerging markets in 2000 and real estate in 2011 to safeguard the wealth of western Europe’s largest oil exporter.

It’s currently mandated to hold 60 percent in stocks, 35 percent in bonds and 5 percent in real estate. After inflation and management costs, it has returned 3.43 percent over the past 10 years.

The committee said that the expected returns from the fund are now “considerably less” than 4 percent. With the current equity share, the commission predicts an annual real return of just 2.3 percent over the next 30 years.

Still, that didn’t stop the chairman of the commission, Knut Anton Mork, from disagreeing with the majority’s conclusion. The former chief economist at Svenska Handelsbanken in Oslo instead recommended cutting the stock holdings to 50 percent.

“The minority recognizes that the reduction in the oil and gas remaining in the ground over the last decade is an argument in favor of a higher equity share, but considers this less important than the predictability of budget contributions from the fund,” he said.
Lastly, Will Martin of the UK Business Insider reports, The world's biggest sovereign wealth fund is about to start taking more risks:
Norway's Global Government Pension Fund, the biggest sovereign wealth fund in the world by assets under management, could be about to start taking a lot more risks if it follows the advice of a government-commissioned report into the way it allocates its assets.

The new report, released on Tuesday, argues that the £716 billion ($880 billion) fund should increase its holdings of shares, and move around £71 billion ($87 billion) of its assets into riskier equity holdings.

This would mean that roughly 70% of the fund's assets are held in stocks, up from just less than 60% right now. As a result, the fund's government bond portfolio would shrink substantially

"A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value," the report noted.

"The majority is of the view that this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run."

Previously, the fund held around 40% in equities before increasing its allocation to 60% in 2007, just before the global financial crisis hit.

Norway's sovereign wealth fund is looking for new ways to make money given the rock-bottom yields most developed-market government debt has right now, and following the crash in oil that has seen prices for the world's most important commodity crash from more than $100 per barrel to just more than $50 now, having briefly dropped below $30 early in the year.

The crash has impacted Norway's economy so much that in 2016 — for the first time in nearly two decades — the fund is expected to  see net outflows, with the Bloomberg reporting February that the government will withdraw as much as 80 billion kroner (£7.99 billion; $9.8 billion) this year to support the economy.

Rock-bottom global bond yields are making things even more tricky, as interest rates close to zero all around the world continue to bite. The eurozone, Switzerland, Sweden, Denmark, and Japan all already have negative interest rates, and rates in most other developed markets are pretty close to zero. In the UK, the rate is 0.25%, while in the USA it is 0.5%.

Low interest rates mean low yields on bonds, meaning that the fixed-income market is not one where there is much money to be made right now, and that has helped drive the recommendation to move more money into stocks.

"With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk," Hilde Bjornland, an economist who was part of the team that compiled the report, told the Financial Times.

Should the fund take up the report's recommendations, it could have a substantial impact on European, and even global markets. The fund's stock holdings are already so large that if averaged out, it would hold 2.5% of every single listed company in Europe. In the UK for example, the fund has invested almost £50 billion in stocks, spread across 457 different companies.
There are two huge global whales that everyone looks at, Japan's Government Pension Investment Fund (GPIF) and Norway's Government Pension Fund Global (GPFG). The latter was created for the following reason:
The Government Pension Fund Global is saving for future generations in Norway. One day the oil will run out, but the return on the fund will continue to benefit the Norwegian population
As you can imagine, it's a big deal for Norwegians and global markets what decisions are taken in regards to the Fund's asset allocation and its investments which are managed by Norges Bank Investment Management.

I am very well aware of Norway's Government Pension Fund Global because when I wrote my report on the governance of the federal public service pension plan for the Government of Canada (Treasury Board) back in 2007, I used the governance of Norway's pension as an example on how to improve transparency and oversight.

What I like about Norway's pension fund is that it's clear about its investments, takes responsible investing very seriously and is extremely transparent, providing great insights in its reports, discussion notes, asset manager perspectives and of course, in its submissions to the Ministry of Finance.

For example, in its latest publicly available submission to the Ministry on October 14, there is an excellent discussion on how the Fund can properly benchmark unlisted real estate investments, going over three methods:
The first uses data from IPD for unlisted real estate investments, adjusted for autocorrelation. The return series from IPD can be broken down into the countries and sectors in which the fund is invested. The greatest challenge when using IPD data for calculating tracking error is that the time series are updated only quarterly or annually. The relative volatility of equities and bonds is currently calculated using weekly data, equally weighted, over a three-year period. Even an extension of the estimation period to ten years, for example, will yield relatively few observations if the calculations have to be performed on quarterly or annual data.

The second method uses data for shares in listed REITs, adjusted for leverage. The main benefit of using REITs over IPD data is the availability of observable daily prices. To be able to represent the fund’s unlisted real estate investments meaningfully, we need to select individual funds in the markets in which the fund is invested. Their leverage must also be adjusted to the same level as the “equivalent” investment in the fund. This selection process and adjustments to take account of differences in risk profile will to some extent need to be based on criteria that will be difficult for experts outside the bank to verify.

The third method is based on an external risk model developed by MSCI. The Bank has commissioned MSCI to compute a return series for an unlisted real estate portfolio that resembles the GPFG’s portfolio of unlisted real estate investments. An external risk model gives the Bank less insight into, and less control over, the parameters that influence the return series, but has the advantage of being calculated by an independent party.
I will let you read the entire submission to the Ministry of Finance as it is extremely interesting and well worth considering for large pensions that invest in global unlisted real estate and are not properly benchmarking these investments (and I include some of Canada's large venerable pensions with "stellar governance" in this group).

Now, the latest submission recommending to increase the allocation of global public equities to 70% from 60% and reducing the allocation of global fixed income to 25% from 35% is not yet available on its website in the news section.

It will be posted on the website but I am not very interested in reading their arguments as I don't agree with this recommendation at all and side with Knut Anton Mork who thinks the allocation should be cut to 50%.

But I also think the allocation to global fixed income should be cut by 10% so that the Fund can invest more in unlisted real estate and infrastructure all over the world (see below). 

My reasoning is that over the short, intermediate and even long run, the return on stocks and bonds will be very low and very volatile so now is definitely not the time to crank up the risk in global equities.

Look, Norway's pension fund can put out all the academic discussion notes it wants on the equity risk premium but when making big shifts in asset allocation, the folks at NBIM really need to think things through a lot more carefully because cranking up the allocation in stocks at this point exposes the Fund to a serious drawdown, one that might take years to recover from, especially if the world falls into a long deflationary cycle (my biggest fear).

Bill Gross rightly noted last month now is not the time to worry about return on capital but return of capital. In his latest comment, he notes that the doubling down strategy of central bankers significantly increases the risk in risk assets.

All this to say that I am surprised Norway's mammoth pension fund is seriously considering increasing risk by increasing its allocation to global equities at this time.

True, global bonds have entered the Twilight Zone and there are cracks in the bond market, which is why delivering alpha gurus are pounding the table that bonds are dead meat, as are other bond bubble clowns.

But unless someone convinces me that the fading risks of global deflation are credible and sustainable, I still see bonds as the ultimate diversifier in a deflationary world.

One thing is for sure, Fed Chair Janet Yellen isn't convinced that global deflation is dead which is why her speech last Friday on staying accommodative for longer, overshooting the Fed's 2% inflation target, was a real game changer for me.

More worrisome, Yellen's speech was a stark admission the Fed may be behind the deflation curve (or unable to mitigate the coming deflation tsunami) and investors may need to brace for a violent shift in markets, one which could spell doom for equities for a very long time.

And if that is the case, you have to wonder why in the world would Norway risk its savings from oil revenues and flush them down the global stock toilet?

I'm not being cynical doomsayer here, more of a realist. I've actually recommended selectively plunging into stocks right now, but that advice carries huge risks and it won't help a mega fund like Norway's GPFG.

Admittedly, it's a mathematical certainty that global bonds are not going deliver great returns over the next ten years, but it might be a lot worse in global stocks, especially when you adjust returns for risk.

So what advice do I have for Norway's GPFG? Take the time to read my conversation with HOOPP's Jim Keohane where he admitted HOOPP will never invest in negative yielding bonds, preferring real estate instead.

I personally recommend GPFG follows Canada's large pensions and ramp up its infrastructure investments which it just introduced into its asset allocation. Generally speaking, there is a growing appetite for infrastructure as large institutional investors are looking for scalable investments that can deliver steady cash flows over a long period.

[Note: Norway’s sovereign wealth fund has bemoaned the smaller scale of infrastructure projects in developing nations after a report to the government called for it be allowed to invest in the asset class, but in my opinion it should exclusively focus on developed nations initially.]

Still, I'm not going to lie to you, infrastructure investments are frothy and they carry their own set of unique risks (illiquidity, regulatory, political and currency risks like what happened to British infrastructure investments post Brexit).

But Norway's pension has to stop being so excessively reliant on global public markets and start considering the benefits of global private markets. There is a reason why the Canada Pension Plan Investment Board and other large Canadian pensions are scouring the globe for opportunities across public and private markets, delivering excellent long-term results, and I think Norway's GPFG and Japan's GPIF need to follow suit, provided they get the governance right (not worried about Norway's governance even if it's not perfect, it is excellent).

To be sure, Norway's GPFG is an excellent fund that is run very well but it's essentially at the mercy of public markets and far more vulnerable to abrupt shifts in global stocks than large Canadian pensions.

No matter how much risk management it has implemented, at the end of the day, Norway's GPFG is a giant beta fund and that means it will outperform Canada's large pensions during bull markets but grossly underperform them during bear markets.

On that note, let me remind all of you once again that it takes a lot of time and effort to research and write these comments. Please kindly show your appreciation by donating or subscribing on the right-hand side under my picture (you need to view web version on your cell to view the PayPal options on the right-hand side under my picture).

Below, a CNBC clip which discussed why Norway tapped its oil fund for the first time back in March. I hope this doesn't become a regular occurrence in the future which is why I'm openly questioning the recommendation to crank up the risk in global equities at this time.

There is a much better option, like following the asset allocation of Canada's large pensions which invest proportionally more in private markets and are delivering stellar long-term returns.

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