I’ve talked ad nauseam about the inherent qualities of SWFs that (in theory) give them a competitive advantage over private sector fund managers (such as time horizon and scale). But I’d like to raise the issue once again, as I finally got around to reading the entire Dimson Report on investment strategy for Norway’s Government Pension Fund-Global.
As was the case with the earlier Ang, Goetzmann and Schaefer paper for the Norwegian Ministry of Finance, the Dimson, Ilmanen, Liljeblom and Stephansen paper (which is the first deliverable of the fund’s new Strategy Council) is darn good. Here’s a blurb that sets up the paper’s premise:
“The Norwegian Government aims for the Government Pension Fund Global (hereafter the GPFG or the Fund) to be the world’s best managed fund. The objective of the Strategy Council is to offer independent and critical views on the strategy of the Fund and give advice on how to develop the investment strategy further.”
In other words, the paper offers a theoretical take on how a long-term giant like the GPFG should structure its investment strategy to meet its objectives. Moreover, it serves as a primer on risk factors and factor based allocation strategies, which are all the rage among finance wonks at the moment. For me, though, the following excerpt about the unique return opportunities available to SWFs was the most compelling:
“First, the underlying investors – the Norwegian Government on behalf of its citizens – have a long investment horizon. This implies little need for liquidity within the Fund. This gives the GPFG a natural relative advantage for harvesting liquidity premia.
Second, this long horizon makes the Fund more tolerant of return volatility and short-term capital losses than most other investors. Consequently, it should lean towards earning higher risk premia, notably through equity investments.
Third, GPFG has to be cognisant of its large size…In GPFG’s case, its large capital size makes it less practical to use leverage or to exploit illiquid niche markets in a way that has a meaningful impact on the bottom line.
Fourth, as another consequence of its large size, indices that are not based on market capitalisations may be less appropriate for the Fund than for a smaller entity that does not have capacity issues. The large size pushes GPFG toward market-capitalisation weights, for bonds and equities and even, as we note below, currency exposure. The regional weights in the benchmark indices should therefore be reviewed.
Fifth, the Fund can be an opportunistic seller of liquidity. The Fund can be favoured by illiquidity when many investors wish to take the other side of GPFG’s trades. As a large long-horizon investor, the Fund may most effectively earn liquidity and other premia by serving as an opportunistic liquidity provider through contrarian transactions in liquid markets, and through buying unpopular asset classes.
Sixth, as long as oil remains a significant underground resource, the GPFG arguably has less need for inflation hedging than most investors. A deflation scenario is a more damaging tail risk for Norway than an inflation scenario. Nominal government bonds are the best deflation hedges and conversely the assets most subject to inflation risk. It may be reasonable to maintain some amount of government bonds at this stage, despite their low expected returns. Eventually, however, as oil wealth depletes and inflation risks become as important as deflation risks, these bonds could be replaced by assets that provide superior protection against inflation.
Finally, among strategy styles, a value tilt seems more natural for a long-horizon investor than for one with an average time horizon. Value stocks are ones that have typically experienced price declines and waning investor interest. Given the patient, liquidity-supplying and inherently market-stabilizing nature of value strategies, they potentially fit with the long-term objectives of the Fund. Many stocks change their value attributes relatively slowly and (in contrast to, say, momentum trading) the portfolio turnover implicit in a value strategy need not be unacceptably large.”
And what does this imply for the fund in terms of concrete recommendations?
“There are a number of modifications to the investment strategy that could be contemplated given the above distinctive features of GPFG and expected risk premia:
- Accept higher risk (from various sources)
- Expand exposure to illiquid assets
- Extend rebalancing to become more pro-actively contrarian
- Develop various forms of insurance selling”
That’s very sensible. In fact, I’ve made similar arguments in this blog (see here and here). However, as we learned after the 2008 crash, Norway’s politicians (and the general public) have little patience for downside volatility along this long-term path. Gordon and I flagged this up in our recent papers on the GPF-G (see here and here). So, while the fund may have an “infinite” time horizon, it doesn’t really behave that way in practice. Interestingly, Dimson et al. pick up on this point:
“The overriding concern in terms of governance is to ensure the legitimacy of GPFG in terms of public support. If the public were to lose confidence in the operation of the Fund that would entail the risk of major changes to the set-up and undermine the current structure. We note that this attitude can lead to underutilization of the Fund’s distinctive characteristics and excess conservatism which would make it harder for the GPFG to reach its long-run real return targets. Hopefully, public attitudes will evolve over time, aided by good performance and better communication – by the manager, by the Ministry, by this Council, and by the media.”
So, Dimson et al. are correct on all counts. These long-term giants do have a competitive advantage in financial markets. And this presents SWFs with a real opportunity to generate returns. Domestic legitimacy may be a constraint, but, as the chart below suggests, some of the “giants” have managed to take advantage. We may need a case study of the CPPIB’s communication strategy…