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What investors can learn from Norway

(MoneyWatch) While the Yale Endowment Fund is probably the best known institutional fund, many people might be surprised to learn what is the largest fund on the planet -- the Norwegian Government Pension Fund Global (GPFG). It's also highly rated for its professional, low-cost, transparent, and socially responsible approach to asset management.

In fact, institutional and individual investors would do well to consider Norway as a model for managing financial assets. The country was ranked No. 1 among 53 sovereign wealth funds in 37 nations. The "Norway Model" contrasts with the Yale model in that it relies almost exclusively on publicly traded securities. It's also constrained to a low tracking error, has a rigorous asset allocation that allows little deviation from the policy portfolio, and avoids private equity.

The Norwegian finance ministry decides on the fund's level of acceptable risks, constructs the benchmark (regional allocation, asset classes), sets the rules and criteria (such as maximum ownership levels), and defines the overall investment universe. The main factors driving their strategy are:

  • A belief that markets are largely efficient.
  • A focus on low costs. For the past decade, GPFG's costs have ranged from 0.08 percent to 0.14 percent.
  • The long horizon makes the fund more tolerant of volatility than many investors, enabling it to lean toward earning higher risk premia, notably through a stock focus.
  • As a long-horizon investor with relatively stable risk preferences over time, the fund can serve as an opportunistic liquidity provider through contrarian transactions in liquid markets and through buying unpopular asset classes.
  • The fund's strategic benchmark is 60 percent equity/35 percent fixed income/5 percent real estate. Each asset class consists of three regional indexes: Europe, America, and Asia, weighted broadly by global market capitalization.
  • Wherever possible, the GPFG uses portfolio rebalancing by allocating the monthly revenue inflows to the asset class/region with the largest negative deviation from the benchmark.
  • As long as oil remains a significant underground resource, the fund has less need for inflation-hedging than do most investors, and a deflation scenario is a more damaging tail risk than an inflation scenario. Since nominal government bonds are the best deflation hedges, it's reasonable to hold government bonds despite their low expected returns.

The GPFG has also decided to diversify its thinking about risk factors beyond the traditional view of focusing on the equity risk premium.

Diversifying the sources of risk premia

While investors have traditionally focused on the equity risk premium as the key source of excess returns, there's a growing consensus in the academic literature that multiple return sources appear to influence asset prices. The main guidance from theory is that required risk premia should be high for investments that tend to lose money in "bad times" -- recessions, financial crises, liquidity shortages, and so on. And while academics still debate whether excess returns are determined by rational or irrational behavior by investors, both sources of return probably matter.

In sum, the long-term objectives of the GPFG suggest a tilt towards patient, liquidity-supplying, and market-stabilizing value strategies, holding assets that have typically experienced price declines (instead of performance chasing) and waning investor interest.

The strategies listed above are basically all replicable not only by other institutional investors, but also by individuals. All investors should have well-defined investment plans, including rebalancing tables that set forth the amount of acceptable style drift, and they should always rebalance whenever funds are available to do so. Even the low costs of the GPFG can be approximated through the use of low-cost, passively managed funds such as index funds and ETFs.

All investors can now diversify globally and across multiple sources of risk. All investors can also avoid the moral hazards and principal-agent problems inherent in using hedge funds and private equity. There is much less opportunity for agency problems when portfolio holdings are marked-to-market, centrally custodied, transparent, and observable.

Photo courtesy of Flickr user Alexandre Dulaunoy