How Norway's SWF beat the street – without external managers
by Harry Brooks on Mar 11, 2013 at 10:24
Back in 2012 the operator of the Norwegian government's pension fund axed many of its external mandates, opting to rely instead on in-house expertise. One year on, it's delivered its second best return ever. Here's how it did it.
Going it alone
The operator of the Norwegian Government Pension Fund Global - the world’s second largest sovereign wealth fund - last year axed its externally managed mandates, cutting assets run by third parties within the $667 billion fund to the lowest level since the fund's launch in 1998.
At the time of the decision, NBIM's spokesperson said the fund had simply outgrown the need for external expertise. ‘When the fund started investing in equities in 1998 we didn’t have any expertise, everything was managed externally but over the years we have managed to build up competence in more and more areas,’ the spokesperson said. The spokesperson added NBIM had also taken all ETFs in house, having built up its expertise in passive products.
One year on, and the decision looks to have been a good one. The Government Pension Fund Global returned 13% over 2012, or 447 billion kroner, its second best performance of all time. The current market value of the fund stands at 3,816 billion kroner ($667 billion).
Thinking outside the (European) box
The first big strategy change at the Government Pension Fund Global was the decision to reduce investments in Europe to about 40% of the fund from more than 50% previously.
'The scope of equity investments was... broadened to include more emerging markets such as Qatar, Kenya and Romania,' NBIM's annual report noted. 'The fund will gradually move away from an equity allocation of 50% in Europe, 35% in the Americas, Africa and Middle East and 15% in Asia and Oceania toward a more market-weighted approach.
'The shift will allow the equity investments to largely reflect the size of the world’s various stock markets. The greatest exposure will be to Europe and North America, followed by developed markets in Asia and Oceania and emerging markets. The change seeks to improve the diversification of risk.'
This decision contributed to an impressive 18% return from equity investments over 2012.
EM government debt comes to the fore
The fund's approach to government bond investments also saw a fundamental change following the decision to move the investment methodology in-house.
'Government bond investments were weighted according to the size of a country’s economy rather than the size of its debt, reducing holdings of bonds from some of the most indebted countries,' the report noted. In addition, nine emerging market currencies were approved for fixed-income investments.
'Investments in government debt issued in emerging-market currencies were raised to 10% of the fixed-income holdings at the end of the year from 0.4% a year earlier. The fund for the first time invested in government bonds from countries such as Taiwan, Russia and Turkey.'
Bricks and mortar
Another area that benefited from a strategic rethink was real estate investments. This asset class delivered returns of 5.8% over the year following a decision to broaden the regions considered for investment.
'The fund purchased its first property in Switzerland and agreed to buy its first buildings in Germany,' the annual update noted.
'It also made its inaugural investment in a shopping centre and entered the market for logistics properties. The mandate was broadened in December to permit investments in real estate outside Europe starting in January 2013.'
The long-term nature of the Government Pension Fund Global means the relative illiquidity of the asset class isn't a big problem. The report notes that real estate investments offer a hedge against inflation, as rental income from these investments is often linked to inflation.
A balancing act
October 2012 saw the introduction of a new rule determining the extent to which the fund’s equity holdings may deviate from the strategic 60% allocation, a practice known as rebalancing.
'Much of the variation in stock prices over time seems to be explained by the risk premium in the equity market varying with the business cycle,' the annual report noted. 'The equity premium is high in periods of great economic uncertainty, and low in periods of limited uncertainty. A strategy that mechanically buys shares after prices have fallen, and sells following an upsurge in prices, aims to exploit these variations in the equity premium.'
The new rule specifies a limit for how far the equity allocation in the benchmark index may deviate from the strategic allocation before rebalancing must be performed, and has been set at four percentage points.
This means if the equity allocation in the benchmark index is less than 56% or more than 64% at the end of a calendar month, it will be returned to 60% at the end of the following month.