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Feb. 2010 – Is There Alpha in Norway?

Norwegians have a well-deserved reputation for sound stewardship of their substantial oil wealth, and based on a recent study, they may become further noted for making a significant contribution to the active vs. passive investment debate.

Funded by severance taxes and income from a 67% ownership stake in energy giant Statoil, a government-run petroleum fund (now known as the Government Pension Fund — Global) was fi rst capitalized in 1996 and has become one of the world’s largest sovereign wealth funds, with over NOK 2.5 trillion in assets ($430 billion) as of September 30, 2009. The value of the fund exceeds NOK 1 million per Norwegian household, and the government has given a great deal of thought to the best way to manage this store of wealth for future generations.

The Norwegian Ministry of Finance determines the general investment strategy as well as ethical guidelines for “promoting good governance and safeguarding environmental and social concerns.” Norges Bank Investment Management, an affiliate of the Norwegian central bank, carries out the investment mandate using a combination of internal staff and external active money managers. Equity investments were first authorized in 1998, and the current asset allocation target is 60% equity (diversified across 46 countries) and 40% fixed income.

The fund is an unusually sophisticated market participant. With no current distribution requirements and a time horizon measured in generations, the fund is the quintessential patient investor, and with its ample resources, it can afford to hire the best and brightest managers the world has to offer. The fund devotes considerable effort to the process of hiring external money managers, seeking out not just successful organizations but specific individuals within those organizations with desirable characteristics. Combined with the traditional Scandinavian virtues of thrift and thoughtful analysis, the fund appears well-positioned to achieve its ambition, as described by the Ministry of Finance, “to be the best managed fund in the world.”

Following a disappointing performance in both absolute and relative terms in 2008 (the fund fell 23.3% for the year, trailing its benchmark by 337 basis points) the Ministry of Finance engaged an international team of experts to “evaluate the experiences in active management in Norges Bank.” The resulting 220-page report by Andrew Ang (Columbia Business School), William N. Goetzmann (Yale School of Management), and Stephen M. Schaefer (London Business School) provides an unusually detailed examination of an institution’s investment experience for more than eleven years, and the Ministry of Finance deserves credit for encouraging such a detailed independent investigation.

The conclusion? The authors’ “key finding” is that despite having an internal staff of 249 and hiring hundreds of external money managers, “to a first approximation, the Fund is actually not an actively managed portfolio” (Ang, Goetzmann, and Schafer 2009). Echoing an earlier performance study by Brinson, Hood, and Beebower (1986), they find that the Fund’s results are almost entirely explained by exposure to systematic risk factors rather than active management bets. “By far the most important infl uence on the performance of the Fund”, the authors say, “is the choice of benchmark. This accounts for over 99% of the total variance of the Fund’s returns so the contribution of active returns to the overall Fund performance has been small.

However, a significant fraction of even the small component of total Fund returns represented by active returns is explained by exposure to a limited number of common factors. The overall behavior of the Fund is therefore very similar to an index fund with a small overlay of exposures to systematic factors such as credit, value-growth, liquidity, volatility, etc.”

Based on their finding that the average active return from January 1998 to September 2009 was statistically indistinguishable from zero, the authors suggest that the fund could benefit by targeting various risk factors more explicitly and taking advantage of the fund’s unusually long time horizon to earn appropriate returns as compensation for risks that other investors might be unable or unwilling to bear.

Norges Bank Investment Management has responded with a defense of their approach, and it remains to be seen if the report precipitates any significant changes in the overall strategy. Regardless of what the Ministry of Finance decides to do, the exercise provides a compelling illustration of the challenge facing investors in seeking to outperform markets, and, if nothing else, we now have a new standard by which such efforts should be evaluated and impressive documentation that “structure explains performance.”

Also in This Issue:

The Stock-Bond Decision
Skill, Chance, and Active Management
Good Versus Bad Risk
The High-Yield Dow Investment Strategy
A Tale of Two Car Companies
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles