Wednesday, August 22, 2012

What We Can Learn From Norway's Approach to Asset Allocation

I will be traveling the rest of the week. Random Glenings will next be published on Monday, August 27.

The Financial Times had an excellent piece on Monday concerning the investment approach of Norway's Government Pension Fund Global (GPFG).

Titled "Norway's National Nest Egg", the article describes how the Norwegians have built a formidable track record of success through a transparent, straightforward investment strategy:

The {GPFG} has grown faster and been more successful than anyone envisioned.  Originally expected to last 30 years or so, the fund - now in its 22nd year - is expected by politicians to last for a century or more.

Norway is one of the wealthiest countries in the world.  While traditionally export activities have been a major driver of economic activity, Norway's huge natural resources have become perhaps the most important source of national wealth in recent years.

In particular, Norway is the world's sixth largest oil exporter, and second largest gas exporter.  Revenues from the sale of energy products have resulted in massive amounts of wealth flowing into the country.

The GPFG was established in 1990 to manage Norway's resource wealth in a long-term and sustainable fashion.  The country's leaders were eager to avoid the so-called "Dutch disease" where a sudden increase in a country's wealth lead to a large jump in inflation.

In addition, the Norwegians recognized that energy was obviously a finite resource, and that investing the proceeds from the sale of oil and gas was the most prudent path to take.

GPFG has proven to be one of the most recognized and successful funds in th world.  Although the government can withdraw up to 4% of the fund's assets each year to supplement fiscal budgets, the fund is now expected well beyond the expected life of some of its natural resources.

Interestingly, however, its current asset allocation is a very traditional mix of 60% stocks and 40% bonds - the same "boring" allocation that many money managers advocate for their clients. In recent years the fund has considered adding 5% in real estate, but it has moved in this direction slowly.

Norway's approach is in stark contrast to the widely-followed model espoused by David Swensen at Yale University.  Swensen argues that the market typically overpays for liquidity, and that significantly better returns can be found in less liquid asset classes such as private equity and hedge funds. 

The FT's article references a research piece published last year in the Journal of Portfolio Management.  Titled "The Norway Model", the authors (Chambers; Dimson; and Ilmanaen) discuss in more detail how the management of GPFG works, and why it has proven to be so successful:

...Norway is among the world's most visible investors, and consequently the Fund's rollercoaster experience has been experience has been scrutinized closely. Short-term underperformance during the recent financial crisis provoked widespread soul-searching and criticism within Norway.  Yet the GPFG fared better through the 2007-08 turbulence than most institutional investors, and by 2010 it had fully recovered the absolute and relative losses it experience over that period...

The Norway model is the virtually the opposite of the Swensen model. Norway has relied almost exclusively on publicly traded securities, it is constrained to a low tracking error, and it has a rigorous asset allocation that allows little deviation from the policy portfolio. More generally, it relies on beta returns, not alpha returns.  This contrasts with the Swenson model, which aims for investment managers to bridge their deficit in systematic risk exposure by exploiting market mispricing.