The 3.1 trillion Norwegian kroner ($506 billion) Government Pension Fund — Global, Oslo, should create an investment advisory board to enable it to make “proactively contrarian” opportunistic investments, according to a recent report from the fund's Strategy Council.
The new board would fill what the report called a “decision-making vacuum” in the oversight of the giant fund, whose strategic investment direction and custom benchmark composition is set by the Ministry of Finance while management of assets is delegated to Norges Bank Investment Management, part of Norway's central bank.
A proactive contrarian approach would involve pulling back from markets after sustained bull runs have left securities overpriced in historical terms, and plowing cash into distressed markets where valuations are low.
“Without being a market-timer, you can say, ‘We just don't want to be loading up on (a certain asset class) at this time,' ” Elroy Dimson, chairman of the Strategy Council and emeritus professor of finance at London Business School, said in an interview.
A similar strategy is being considered at the National Employment Savings Trust, a U.K. defined contribution plan aimed at low- to middle-income workers set to go live next spring (Pensions & Investments, Nov. 29).
The report, delivered to the Finance Ministry on Nov. 26, will feed into the ministry's internal debates on a number of topics related to the fund and could eventually form part of its annual recommendation for the fund's strategic direction made to the Storting, the Norwegian parliament, in the spring, said Pal Haugerud, deputy director general for asset management at the Finance Ministry. “This is not the time to take positions on individual proposals,” he added.
Colin Robertson, principal and global head of asset allocation at Aon Hewitt, London, said interest among pension fund officials is growing in medium-term asset allocation.
“There's been a lot of focus on the very short-term asset allocation and on the strategic long-term asset allocation, but very little in between,” Mr. Robertson said. Aon Hewitt has been able to add 50 basis points of excess return annually on average over the past five years. The consultant began providing the strategy to U.K. clients five years ago; an “upgraded, more hands-on service” attracted its first U.S. clients this year, Mr. Robertson said. He declined to name the clients.
“People are paying a lot more attention to (medium-term asset allocation) because of bubbles and because of the success we've had with it,” he said.
The Norway report concedes that the fund's rebalancing regime provides a limited amount of contrarian investing, however more could be done.
The theoretical underpinnings of the Strategy Council's contrarian proposal lie in the time-varying nature of asset class returns: “Outperformance seems period-specific,” according to the report. Some evidence suggests that certain risk factors or premiums have historically delivered outperformance (for example, the “credit premium” indicates U.S. corporate bonds have given investors a historical annual average of 40 basis points over U.S. Treasuries), however “what is open to debate is whether each return factor will provide a forward-looking premium,” the report states. That is, using forward-looking valuations, can investors reliably identify buying opportunities?
The Strategy Council suggests investors can do that because variance in returns over time “may be attributed to rationally time varying risk premia and/or to irrational investor behavior.” For example, the spread between investment-grade and government bonds in the U.S. fell to 0.8 percentage points at the end of 2006, then widened to more than 5 percentage points in late 2008 before coming back to 1.6 percentage points by the end of 2009. Although the prospective returns in late 2008 were much higher than historical averages, “it is understandable that investors require higher risk premia in such environments, and that relatively few investors jump at opportunities previously deemed enormously attractive.”
“In times of trouble many ordinary investors become more risk averse and raise their required returns (pushing risky-asset prices further down), whereas a long-horizon investor such as (the Norway fund) arguably has more stable risk preferences and thus can more naturally benefit from resulting market opportunities,” Antti Ilmanen, Strategy Council member and senior portfolio manager at hedge fund Brevan Howard Asset Management LLP, London, wrote in an e-mail.
The council's other members are: Eva Liljeblom, professor of finance and rector at Hanken School of Economics in Helsinki; and Oystein Stephansen, senior analyst at investment bank DnB NOR Markets, Oslo.
Part of the reasoning behind a third-party investment advisory committee to determine midterm and midsize deviations from the fund's custom benchmark is that Norway, as a country, might be too transparent, said Mr. Dimson, the council chairman.
According to the report, “Transparency is an undoubted strength for the (fund) but is not an unalloyed good. Transparency exacerbates headline risk aversion which could lead the (fund) to avoid certain investment strategies (insurance selling, contrarian investing) that would be naturally fitting — and likely profitable — for a large long-horizon investor, but that could occasionally result in adverse media and political reactions.”
In the interview, Mr. Dimson said that there are times when NBIM and the ministry can't communicate or share information because to do so would mean making it public and tipping the fund's hand to markets. “That's the downside to transparency,” Mr. Dimson said. “The Ministry of Finance must understand that.”
In the creation of an investment advisory committee, tighter disclosure rules could be made, and the actions of the body could be kept private for a year, giving the committee and fund enough time to decide and implement medium-term investment positions, he said.
The report gives practical recommendations to the ministry for implementing improvements to the fund's benchmark, and touches on some of the proposals made in a December 2009 report by three finance professors: Andrew Ang of Columbia University, William Goetzmann of Yale School of Management and Stephen Schaefer of London Business School. That report focused on active management, and suggested the fund move to a factor risk-based model for its benchmark (P&I, Jan. 25).
While the professors' report had “a remarkable impact around the world” and changed the way fellow institutional investors saw the Norway fund, the recommendation to move to a factor-based asset allocation model was “too cutting-edge to implement,” Mr. Dimson said. “That's a step too far.”
However, Mr. Dimson and his fellow council members did recommend Norway identify factor risk premiums and incorporate them into the existing benchmark, which is constructed using an asset class-based approach. The fund's overall benchmark is 60% equities and 40% bonds; a new 5% allocation to real estate gradually will reduce the bond allocation to 35% over time.
Mr. Dimson argues that the fund can take additional risk, and the most logical way to do so is by incorporating value and liquidity risk factors into the equity portfolio, and adding insurance-selling and illiquid asset classes such as a 2%-3% allocation to infrastructure.
“We favor inclusion of (factor) tilts, though ideally the magnitude of the tilt would for some factors vary over time” as part of a contrarian approach, Mr. Dimson wrote in a follow-up e-mail.
The Strategy Council is charged by the Norwegian Ministry of Finance to critically review the fund's investment strategy in order to fine-tune the investment strategy, increase transparency and encourage debate on important investment strategy decisions. This is the council's first report.
How frequently the council will report and whether the council's membership will change regularly have yet to be determined, Mr. Haugerud said.