The Big Picture

September 22, 2013 4:16 am

Norway’s SWF considers oil-free, less liquid future

The Scarabeo 8 deepwater oil drilling rig, operated by ENI Norge AS, stands illuminated at night after being re-fitted at the Westcon AS yard in Olensvag, Norway©Bloomberg

Future inflows of Norway's SWF are entirely dependent on oil and gas revenues that have been higly profitable so far, but commentators think the fund should diversify its risk

Norway may be a country of just 5m people, but its sovereign wealth fund packs a punch every bit as powerful as the region’s infamous fermented herring.

The $760bn Government Pension Fund Global, popularly known as the oil fund, owns 2.5 per cent of Europe’s stock markets and 1 per cent of global market capitalisation, as well as 9 per cent of BlackRock, the world’s biggest fund manager.

As the world’s largest and most transparent sovereign wealth fund it serves as a model for others. Amid forecasts that it will exceed $1.1tn by 2020 and $1.5tn by 2025 as revenues from oil and gas continue to flow unabated, its influence is likely to grow stronger.

So when there is a serious debate about the fund’s future direction, as there is now, it matters.

The centre-right Conservatives, the dominant party after this month’s election, are in favour of letting the fund invest in private equity and infrastructure, alongside its existing voluminous holdings of equities, bonds and a recently added smattering of property. The Conservatives are also debating the idea of splitting the fund in two.

The Progress party, tipped to form part of the governing coalition, wants to go further, creating three smaller funds – two focused on renewable energy and foreign aid and a third to be managed by Norwegian fund houses.

Progress also objects to a law barring the government from withdrawing more than 4 per cent of the fund’s assets per year (accounting for 15 per cent of government expenditure, and the fund’s target return), arguing additional proceeds should be invested in Norway’s own infrastructure.

Amid this maelstrom, Re-Define, a think-tank, has released its own prognosis for the fund, commissioned by Norwegian Church Aid.

Re-Define produced three main recommendations: the fund should invest more in emerging markets and illiquid asset classes, rather than liquid securities in the developed world; it should sell its stakes in oil, gas and coal companies; and it should beef up its “laid-back approach” to corporate governance.

“It is structured as an endowment but 99 per cent of it is in liquid investments when they could be locking money away for 100 years,” says Sony Kapoor, director of Re-Define and author of the report,Investing for the Future” .

As of March, 62.4 per cent of the fund’s assets were invested in listed equities, 36.7 per cent in fixed income and 0.9 per cent in property, a figure in the process of being raised to 5 per cent.

About 94 per cent of holdings were in developed markets (54 per cent in Europe alone), with just 6 per cent in emerging markets, due to rise to 10 per cent under a Ministry of Finance plan unveiled last year.

“It’s a conservative strategy on the surface, but when you boil it down, it is looking more like a concentrated bet on the future of OECD countries being bright. One thing everyone agrees on is that the relative wealth and gross domestic product share of non-OECD countries is going to be growing,” says Mr Kapoor.

The solution to this perceived imbalance is not as simple as it might seem. Analysis by Elroy Dimson, emeritus professor of finance at London Business School, and his colleagues has consistently shown a lack of correlation between the level of economic growth in a country and stock market returns. If anything, there appears to be a small negative correlation, says Prof Dimson, who points out that emerging market equities have underperformed those of the developed world since the creation of the first indices in 1975.

Mr Kapoor accepts this, but says the answer is to move beyond listed equities. “The profitability in fast-growing emerging markets does not come from investing in public markets. By that stage the gains have gone. It comes from private markets,” says Mr Kapoor, who argues the fund should be targeting the “illiquidity premium” supposedly produced by non-listed assets such as private equity and infrastructure.

“The decision to limit investments to liquid securities wasn’t handed down by God himself.”

However, Prof Dimson, who is chairman of the strategy council of the oil fund, an advisory body, says the “legitimacy” of the fund in Norway has always rested on its transparency, meaning it has favoured assets with visible market prices, rather than those that rely on directors’ valuations.

He says the recent foray into property has moved the fund “a little bit of the way towards opaque valuations”, and that it may now be a “small step” to simpler areas of infrastructure such as roads and airports.

A 2010 report by the strategy council recommended the fund should consider some exposure to infrastructure, but Prof Dimson argues that the asset class is “hot” now, raising the risk of buyers overpaying.

“Given the long time horizon of the fund, the main thing they should be doing is buying when everyone wants to sell,” he adds.

The report recommended insurance selling strategies, but a subsequent wave of institutional money would seem to have pushed likely returns lower here as well.

Prof Dimson is circumspect about private equity. “If you don’t buy knowledgeably, you probably get the deals others don’t want,” he says. “Private equity on average, does no better than the S&P, but if you buy the top quartile [of funds] you do very well. If you don’t know what you are doing you end up in the bottom quartile.”

Mr Kapoor’s suggestion is that the fund should “piggyback” on the work of development finance institutions such as the World Bank’s IFC arm and the UK government’s CDC operation, co-investing $20bn-$30bn a year with them until the fund develops enough in-house expertise to strike out on its own.

Given that the fund’s future inflows are entirely dependent on oil and gas revenues, Mr Kapoor thinks it should diversify its risk by selling its stakes in fossil fuel companies, which account for 6 per cent of the fund and three of its 10 largest equity holdings.

Prof Dimson says this issue is a perennial dilemma, but points out that its investment in the oil majors have, thus far, been highly profitable.

“What you would really like to do is to sell forward the oil that is in the ground. They have looked at it, but the capacity in the market just isn’t there,” he says.

Prof Dimson is most exercised by the concept of splitting the fund, arguing this is certain to raise costs by duplicating activity, and is unlikely to lead to the creation of more agile sub-funds.

“The idea of nimbleness in Norway is ludicrous. They are the biggest fund in the world. If they split into three they might still be the biggest in the world in a few years time,” he says.

Mr Kapoor is adamant that change is necessary. “I would bet any money that unless the fund changes its strategy, it will never make its 4 per cent return target over a period of time,” he warns.

Given the current political vacuum, the Ministry of Finance declined to comment, as did Norges Bank Investment Management, which runs the fund.

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