Norway’s Norges fund tilts to active

With an enormous portfolio that includes management of 1 per cent of the world’s equities, the NOK2.7 trillion (US$431 billion) Norges Bank Investment Management, recently did a study examining the role of active management. Amanda White spoke to chief strategic relations officer, Dag Dyrdal (pictured).

Any debate about active management includes deliberation over the efficiency of markets, risks and costs. But for larger, or more governance-focused funds, it is also an opportunity to understand underlying investments, and potentially influence their long-term value.

For Norway’s Government Pension Fund Global, a number of specific characteristics tilt the argument in favour of active management: the size of the fund, at NOK2.7 trillion (US$431 billion), the global scope of the investments, and the very long-term horizon. Subsequently Norges Bank Investment Management (NBIM), which manages the fund, has a natural predisposition to active management, having successfully actively managed the fund for 12 years.

Executive director of NBIM, Yngve Slyngstad, speaking at the Storting’s (Norwegian Parliament) annual hearing on the GPFG last month, said experience from 12 years of managing the GPFG suggests that active management could make an important contribution to the return on the GPFG in the long term.

“Active management has produced an annual excess return of 0.28 percentage point to date. Based on the current size of the GPFG, that is equivalent to $1.2 billion a year,” he said.

The fund’s overall asset allocation strategy, as approved by the Government, is an allocation of 60 per cent equities and 40 per cent fixed-income.

Chief strategic relations officer at NBIM, Dag Dyrdal, said over time the portfolio is becoming more diversified, with approval from March this year to invest in real estate, with the 5 per cent allocation to that asset class coming out of fixed-income.

There is also a mandate over time to consider responsible investing that includes private equity, which according to staff all weighs in favour of active management.

“The development and diversification of the mandate, adding real estate and possibly private equity and infrastructure, is an argument in favour of active management,” Dyrdal said.

“A perspective of active management is how much it is adding to market risk. Historically it has been less than 1 per cent. At the same time, active management has added 28 bps excess return annualised, so with limited risk-taking, we are adding a lot.”

In addition Dyrdal argues active management adds skills and information to the organisation, adding to the knowledge and understanding of the underlying investments.

However while the fund has been cheerfully actively managed, the Ministry of Finance on behalf of the owner of the fund thought it prudent to engage a complete evaluation of the style to assess its appropriateness on a long-term basis. The year-long project included reports by an international group of three economics professors and a benchmarking report by Mercer.

With an open and comprehensive dialogue between owner and manager, the strategy and management of the fund is well understood by the Ministry, and all aspects of the fund, such as asset allocation strategy, had been widely debated in Parliament, except for active management. The financial crisis, and the fund’s results in 2008, prompted the active management review.

NBIM, as the portfolio manager, was asked to present its own view, which was partly to review the academic research and link that to the management of the fund, and an argument why it was necessary to have an element of active management in the portfolio.

The exercise revealed some meaningful insights for the fund, not the least of which was the gap that exists in the academic research.

“It is hard to find proof or a verdict in the academic research, there is very little relevant research. Most was on US equities, and most was retail funds, which is very different from a large government fund so it was hard to draw conclusions from the research,” Dyrdal said.

“Our position and advice to Ministry was not a general view on active versus passive management. It might be better for some investors in some instances to use passive, but this fund has characteristics that make an element of active management worthwhile.”

Dyrdal said NBIM shares the view of other institutional investors that there is more opportunity to create excess return in emerging markets than developed markets, partly because fewer analysts cover those markets.

“We invest in many markets and regions and it is our belief that the efficiency of markets does differ,” he said.

To support that view, of the 13 per cent of the fund outsourced to external managers as single-market mandates, most are in emerging markets, and all of them are active.

NBIM has specialised external equity mandates in Poland, Russia, Turkey, China, India, Indonesia, Malaysia, Thailand, Brazil and South Africa, with the number of equity mandates based on broad regional strategies dropping in favour of this more specialised approach.

“The rationale for external management is for us to gain skills where we don’t have the expertise, and at least over the past couple of years the emphasis has been on emerging markets,” he said.

One of the consequences of active management is the required attention to manager selection, which NBIM focuses on, dedicating a team from within its 80-person portfolio management team to external managers. For its emerging markets managers one its pre-requisites is presence in local markets.

At the end of 2009 it had a total of 75 mandates managed by 45 different institutions, 70 of which were equity mandates. External mandates made up about 17 per cent of the fund’s equity investment, and about 3 per cent of the fund’s fixed income investments.

“External management makes up a larger part of our risk budget than our internal management,” Dyrdal said.

But while active management does increase some cost components, one of the arguments in favour of passive, NBIM adopts a fee schedule to external managers that depends on the excess return they deliver: so when this excess return is high, these fees will also be high.

Conversely Dyrdal believes there are some costs associated with passive strategies that are not always considered.

In fixed income, for example, he said there are large transaction costs to readjust to the benchmark.

“There are only investment-grade bonds in the benchmark so if we had a pure passive strategy we wouldn’t be allowed to sit in after bonds are downgraded below investment grade,” he said.

The fund has reduced its number of fixed-income mandates following a restructure and now has five external fixed-income managers, down from 14 at the end of 2008, and 38 in 2007. All five are specialist mandates and mainly for US mortgage bonds.

While NBIM makes a point of presenting all its assets as actively managed, there are different levels of active. About 75 per cent of the fund’s equity investments in 2009 were managed using enhanced indexing, and about 77 per cent of the bond investments were also enhanced-indexed.

There are also limits on active management and the Ministry of Finance has set a 1.5 per cent tracking error limit. At the end of 2009 the actual overlap with the equity portfolio benchmark was 85 per cent, which means about 15 per cent of the portfolio deviated from the benchmark as a result of active management.

The review of active management also demonstrated that active management has accounted for only a small part of the GPFG’s overall market risk, and supports the argument that properly implemented, active management will serve to decrease rather than increase total risk.

“Knowledge of the companies in which the GPFG invests and the countries to which it lends puts us in a position to evaluate the underlying risk associated with our investments.

“As one of the world’s largest shareholders, the GPFG has a duty to allocate capital to the most profitable companies and projects. Financial markets will not function if the largest shareholders do not take a position on the underlying value of companies through analysis and insight,” Slyngstad said.