The $1.3tn contrarian wealth fund

Norway’s $1.3tn sovereign wealth fund has unveiled a new strategy. Given its size — it famously owns an average 1.5 per cent of every listed company in the world — it’s worth a closer look.

Some of the headline changes were trailed by chief executive Nicolai Tangen at an FT conference on Wednesday, a day before the formal strategy plan was released:

The world’s largest sovereign wealth fund will become a more vocal shareholder and plans to vote against companies that fail to set a net zero emissions target, overpay their top leaders, or do not have sufficiently diverse boards.

Some background: Norges Bank Investment Management is formally housed inside the central bank, its money comes from Norway’s oil and gas revenues, its investment mandate is formulated by the finance ministry and approved by parliament.

Also some disclosure: the author of this post is Norwegian [but you never mention it — Ed], lives in Oslo, and has given speeches to the fund literally talking his book (one free, and one where the fee was directly donated to UNICEF by NBIM).

The governance stuff is naturally what will generate the most heat. ESG is suffering a bit of a backlash at the moment (FTAV is a bit sceptical as well), but given Norwegian politics the sovereign wealth fund cannot help but be seen to be at the vanguard of the issue. NBIM was excluding companies on ethical grounds long before ESG was even a glimmer in the eyes of asset-management marketing directors.

But most interesting (to us) titbit hinted at by Tangen on Wednesday was that NBIM could take better advantage of its long-term investment perspective and limited liquidity needs to “be more contrarian”. (These days it’s getting harder to find anyone who won’t describe themselves as a contrarian.)

But how? After all, its mandate doesn’t leave much room for flexibility.

About 70 per cent of NBIM’s money is in equities, and roughly 30 per cent in fixed income. It is gradually building up a real estate portfolio that will in time account for 3–7 per cent of the fund’s assets (in 2020 NBIM was also allowed to invest up to 2 per cent in renewable infrastructure projects). The vast majority of the sovereign wealth fund’s money is pretty much passive.

But Tangen is a former hedge fund manager, and it makes sense that he wants to be more than just the world’s biggest beta monkey. And NBIM apparently now thinks that it can be smarter and more tactical within the straitjacket of its investment mandate.

Here’s the top level bit of the strategy report fleshing out a little what Tangen was hinting at:

Central to the management mandate is the benchmark index consisting of 70 percent equities and 30 percent fixed income. We manage the fund close to this index. However, we believe some investment opportunities diversify the fund beyond the reference index, particularly unlisted assets. All our investment processes have active elements. This improves our ability to achieve the highest possible return and to be a responsible owner.

We take advantage of the fund’s long horizon and limited short-term liquidity needs when we invest. We can withstand large fluctuations in the fund’s value and make investments whose underlying value may take a long time to realise. Our long horizon enables us to act differently from other investors in difficult and illiquid markets. We believe that the most profitable investment opportunities arise in volatile markets…

…In this strategy period we will strengthen our long-term mindset, be patient, and vary active risk as market conditions change. This allows us to take advantage of the best opportunities when they arise. Variations in asset prices can be related to behavioural factors or leverage causing procyclicality. Long-term investors are well-positioned to take advantage of such variations. We will seek to buy when others want to sell and sell when others want to buy.

Some of this kinda makes sense. The Norwegian government is supposed to only spend roughly the 3 per cent long-term real return of the fund annually (originally 4 per cent), so NBIM can take a very different perspective from even other supposedly long-term investors like pension plans.

Efforts to minimise the costs and maximising the advantages of scale are therefore natural. For example, in equities NBIM says it wants to invest more in automation, boost collaboration between traders and portfolio managers to improve execution, and be more opportunistic and aggressive in share lending and situations like IPOs and rights issues.

Our size makes us an attractive partner in capital market events. Investors who are passive in such events may risk less allocation than desired. To reduce the likelihood of this, we work actively with facilitators and companies considering such transactions. A large, stable capital base and the best credit standing also make us an attractive partner for securities lending. The fund’s characteristics enable us to achieve higher earnings on securities lending than the average investor.

Fine fine fine. This is an obvious area where NBIM can probably sweat a few more basis points of performance out of its portfolio. And even a few basis points adds up in absolute nominal dollar terms when you manage a whopping $1.3tn.

But we get a bit more nervous when we see the more concrete ways that Tangen wants the sovereign wealth fund to be more “contrarian”:

• “We will take sector risk when risk-reward is particularly attractive and use our specialist knowledge to identify trends that make us expect higher long-term returns in some sectors than others.”

• “We will expand our forensic accounting and behavioural analysis to reduce exposure to companies we expect to underperform.”

• “We will identify quality companies and take slightly larger stakes when we have reason to believe they will outperform.”

• “We will use external managers in segments and markets where we believe they will enhance returns. In some markets, we also believe external managers will reduce the risk of our investments by avoiding certain companies with problematic business models and weak corporate governance.”

• “We will pursue the opportunity to invest in companies before they list (pre-IPO). This would give us access to companies earlier in the company life cycle and potentially enhance returns.”

In similar vein, in fixed income NBIM plans to “invest in selected segments outside the benchmark to diversify the portfolio and harvest risk premia”, while the property division plans to us its ability to invest in both listed and private assets to “exploit periods of disruptions in real estate markets”. (CC: BREIT).

To encourage this shift NBIM plans to “promote psychological safety so that our portfolio managers dare to be contrarian and avoid herd behaviour”, and more actively tweak broader and sectoral allocation positions and risk-taking “as market conditions change”. Mkay.

We’re not going to go so far as to say that this is a former hedge fund manager hedge fundifying NBIM, even though it is tempting.

The fund is just too big and the mandate too restrictive. These are just tweaks around the edges. And frankly a lot of them make intuitive sense. Size and a practically unlimited investment horizon are huge advantages if harnessed well.

For example, one of the issues with exploiting many investment factors/risk premia is (if one believes in their existence in the first place) is that it is VERY hard to hang on when there are periodically long and/or deep stretches of underperformance.

This isn’t just a foible of ordinary yokel investors. In practice, pension plans often also struggle to keep faith. Even true believers can eventually throw in the towel — often just before things turn around. And as Tangen told my colleague Richard Milne, NBIM has already made some canny moves:

Last year, we overweighted integrated energy companies. When a lot of investors jumped up and down and told everybody how proud they were they had no energy exposure, that’s when we scooped a lot of these positions. They don’t come about all the time but sometimes various sectors or companies are oversold or overbought.

We had the same in the bond portfolio, where a big part were trading with negative rates. The risk-return was really skewed: you knew there were limits for how negative the rates could go but there was no limit for how much it could go up. You sometimes have these really skewed situations. Historically we haven’t been good enough at taking advantage of them.

However, the harsh reality is that attempts to time markets — whether it is in cute tactical asset allocation shifts or sectoral tilts — is a fraught business. Just because it makes intuitive sense it doesn’t mean it makes sense in theory or in practice.

The academic evidence suggests that market timing is hard. Even most practitioners agree that it should be avoided. If you avoid the worst of a sell-off you can still lose out overall by missing the rebound, for example. As Elroy Dimson, a finance professor at the London Business School who led a previous strategic review for NBIM a decade ago, has bluntly put it:

…oftentimes, when people make a prediction, they get it wrong. And the cost, for example, of trying to avoid the worst times or capture the best is that you might get it completely wrong. That simply increases the risk, over the long haul, of your investment portfolio.

Maybe NBIM’s in-house “specialist knowledge” will allow it to pick sectors and “quality” companies better than the broader market? Perhaps its four-person team of forensic accountants will be able to spot frauds quicker than any auditor, short seller, financial watchdog or journalist? Conceivably it could pick pre-IPO investments better than all the other big fund complexes that flooded this zone in recent years (and are now ruing it)?

It seems a stretch though. Oftentimes, contrarian investing seems to be a fancy way of saying: “Will blame long periods of underperformance on central banks and claim personal credit every time they enjoy six good months of returns”.

Tangen seems aware that with these changes he is making a rod for his own back though. As he told Richard:

Living in a world where you invest in a contrarian way, that’s a life without any friends. It’s kind of where I live. I’ve lived there my whole life.