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2021 | OriginalPaper | Buchkapitel

4. Investment in Practice

verfasst von : Ole Bjørn Røste

Erschienen in: Norway’s Sovereign Wealth Fund

Verlag: Springer International Publishing

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Abstract

This chapter discusses practical aspects of how off-shore investments are made regarding the locations of assets, organization of investment activities, allocation on asset classes, and selections within them. This clarifies key elements of an index-like management style. The investment horizon has implications for asset allocation. In aggressive approaches, one accepts risk to aim at high expected returns. One measure of the risk appetite is the allocation to equity. Further, locations of assets matter. Not all locations receive external investments. An investor must at a minimum be able to expect to receive the fruits of his investment if it is successful. Secure environments are thus preferred. There are scale economies in fund management, linked e.g. to overhead costs. This favors large funds. Large players may, however, move market prices through their transactions. This makes it more difficult to execute transactions for large than for small players, and hamper activities that require large transaction volumes.

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Vorheriges Kapitel The Economics and Politics of SWFs

Nächstes Kapitel The Ethics of Investment

Higher expected returns than borrowing costs would require more risk in the investment than the borrowing. Liquidity is not an issue, since it is assumed that the borrowed funds will be at hand if or when they are needed.

Sources: Wikipedia.org and Nobelprize.org, accessed on 28 and 29 February 2020.

A supernova is powerful and luminous stellar explosion. Sooner or later it will collapse. The original object, called the progenitor, either collapses to a neutron star or black hole or is completely destroyed (Source: Wikipedia.org, accessed 30 January 2020.

One example of perfect correlation is inflation, as it is possible to buy government bonds with inflation adjusted coupons and principal, for instance in the United States. This makes it possible to buy or sell inflation risk. However, the factor inflation has a much wider application, also to a range of other assets in relation to which also other factors may play a role.

This more aggressive investment approach has been met with some criticism, inter alia from Knut Anton Mork who dissented as chair in the report of a recent government commission that investigated the strategic asset class allocation issue. His recommended equity share was 50 per cent. Earlier, the first head of the management organization NBIM, Knut Kjær, expressed criticism explicitly linked to the impact of the investment environment on the quantitative easing in the monetary policy by the largest central banks after the financial crisis. When the strategic benchmark was revised in 2017, Norges Bank recommended a 75 per cent strategic equity allocation to equities.

Semiannual coupons apply to the United States. Most other countries pay annual coupons on debt.

This is an important risk that may overshadow other elements of risk in actual investment decisions. It relates to the perhaps most fundamental question in investments—will the promises be kept?, and in relation to this—who is one dealing with? It is introduced here as the second element, following the less important interest rate risk, only or pedagogical reasons.

This is a new, but important development in the key government bond markets. There are currently sizable negative returns also for long-dated bonds in low-inflation countries, like the Swiss 10-year benchmark bond.

A famous market adage that may have been wrongly attributed to Lord Keynes in the 1930’s, is that ‘the market can stay irrational longer than you can stay solvent’. It is thought to apply in particular to the timing of bearish bets. This phenomenon could bar the exploitation of even widely acknowledged market anomalies. The extent to which there are anomalies, however, is often disputed – which could render the above-cited adage more important.

Although every case may be different, it is probably a fair description that pawn shop owners to a larger extent than bankers and other secured creditors, may be open to keeping the collateral instead of having the loan repaid. For bankers and other institutional creditors, it may be more important to receive the cash one has agreed on. One reason for this, is that there is a high degree of uncertainty in large financial transactions. Whereas some players may specialize in absorbing various types of associated risk, many lenders want to avoid most of these risks.

See Norwegian Ministry of Finance (2008), St. meld. No. 16 (2007–2008).

For instance, in the United States the broad Case-Shiller home price index has underperformed compared to the Standard & Poor 500 stock index. In the 30 years since 1990, this much more volatile stock index has increased by a factor of about 8, whereas the more stable home price index has risen to about the double of the 1990 level.

The information ratio is a measure of how successful active management has been in a period, that is the active return, which is the difference between the return on the benchmark and the return on the investment divided by the tracking error – i.e. the standard deviation of the active return which is the additional risk. The higher the information ratio, the higher is the active return of the portfolio per unit of extra risk assumed. This measures performance.

This and the preceding paragraphs draw on Norwegian Ministry of Finance (2020a; 2020b; 2020c), and Norwegian Ministry of Finance (2015) Meld St. 32 (2019–2020), Chap. 3, which refers to a commissioned report by the Ministry from the index provision firm MSCI.

Weingast (1995) discusses the interaction between politics and economics in promoting growth historically in the developed countries. That author emphasizes limited government, able to promote growth but unable to abuse their powers to confiscate or expropriate wealth. The state level of federations is suggested as particularly well fit in this respect: Britain and the United States are examples from earlier times. China is a more recent one.

This reason to be cautious applies with force to real estate, where the location of the investment is pinned down to for instance a physical installation of long duration in economic terms, or to a particular piece of land.

The hacking of computer systems has, however, turned out to be a problem for instance in relation to bitcoins, a virtual currency which was presumed by many to be particularly safe as such. However, large amounts have been stolen from accounts with various bitcoin exchanges (exchange and payment facilities) by hackers of the exchanges computer systems. See for instance, CNBC news 7 August 2016 on the theft, the day before, by cyber robbers of the world’s largest bitcoin exchange, Hong Kong’s Bitfinex. Nearly 120.000 bitcoins were stolen, of a value of about U.S. dollars 72 million. This exchange was able to stay in business. Theft cannot be avoided through digitally stored wealth. Earlier, in 2014, a much larger theft was made at Mt. Gox, a Tokyo bitcoin exchange: Half a billion U.S. dollars-worth of digital assets vanished. That exchange was also the largest bitcoin exchange at the time, and then went bankrupt. There was suspicion that much of the theft was due to an inside job, and the expression ‘getting Goxed’ was reportedly coined.

For instance, in relation to a natural resource pool, this may be tapped into in covert fashions—either by drilling oil wells horizontally, or not only vertically, or by emptying a stack of resources by truck in the night.

This author has sensed large differences within Norway in this respect, particularly between the central part of the country in and near capital Oslo and the more peripheral parts in the inland and coastal areas further to the North.

This section draws on Meld St. 21 (2014–2015), pp. 20–22.

The Wall Street Journal 14 December 2011.

There are significant scale economies in investment. This is very important for small funds, for instance with regard to the hiring of competent staff. For large funds, in particular the largest ones, this is less pressing. This implies that large funds should be able to manage money more cheaply than small funds. Costs are important, as the expense ratio outperforms, e.g., Morningstar’s funds ratings as a predictor of future returns (Malkiel, 2013).

See, e.g., The New Palgrave Dictionary of Economics, 2nd ed. 2008, particularly the contributions by C. Wilson (2008), J. Ledyard (2008), and J. Hörne (2008). The 2001 Sveriges Riksbank’s Prize in memory of Alfred Nobel (‘Nobel Prize’) was awarded to George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz for their analyses of markets with asymmetric information. Another influential contributor, is Arrow (1963), who had received the Nobel Prize with John Hicks in 1972—for their contributions to general equilibrium theory.

The official source for this is Innst. S. nr. 95 (2004–2005).

According to Norwegian Ministry of Finance (2020a, b, c). There is no such cap for listed real estate.

The approximation is that the distribution is assumed to be normal, implying that about 96 per cent of the realized data points—the 96 per cent confidence interval—will be within the bounds of ± two standard deviations. Realized returns will wary more, as the equity premium measures excess return in relation to fixed-income returns with the highest credit quality, i.e. not an absolute return level for equities.

Malkiel (2016) likens this with the tossing of a coin, where some genius might toss 8 heads in a row. Thus, even if there were no true abilities, one might become mislead to think that there were. Although this mechanism is too simple to cover the ability differences between fund managers, it could shed some light on the likely explanations of differing track records. However, to the extent that excess returns would not tend to decrease over long time spans, they are likely to imply skill differences rather than luck. Another mechanism that may make investment management firms look better than they are, is the tendency to discontinue funds that perform badly and merge them with large, more successful units. There is thus a survival bias in the favor of successful investment managers.

According to a statement by Governor Olsen of Norges Bank to business daily Dagens Næringsliv 20 April 2016.

As mentioned above, IMF (2008) applies a slightly different typology, where the essence is the same as here.

According to Norwegian Ministry of Finance (2020a, b, c).

For 2020 the Dow Jones Industrial Average, the Standard & Poor 500 and the technology-heavy Nasdaq Composite indexes increased by 0.7, 16.3, and 24.3 per cent, respectively.

A simple back-of-the-envelope calculation, assuming returns from stocks, real estate, and bond of 4, 2 ½ and 1 per cent, respectively, would suggest an outcome at about 3.2 per cent. The value of this crude calculation is limited by our confidence in the input, as the true future returns are never known ahead of time. In the latest years the GPF-G returns have been in the 5–6 pct. range for 2017 and 2018, nearly 18 per cent for 2019 and about 11 per cent for 2020. In view of this, one could think that the best expectation of future returns may well be larger than 3 per cent p. a.

Even if the price of liquidity in investment markets is not pegged under normal times, the large movements in price of liquidity in relation to market turmoil, might overshadow the variations in price prior to this development. Speculative attacks on fixed exchange rates have been analyzed, e.g., by Krugman (1979, and later) and Obstfeld (1994, and later). A source that tracks diverse financial crisis across time and space, is Reinhart and Rogoff (2009).

Related to this, Acemoglu and Robinson (2013) pointed out that in policy advice that aim to reduce market failures and distortions, the political effects of contemplated reforms must also be taken into account. One should be particularly careful when already strong interests in a society would stand to gain from a proposed reform. If already strong groups gain further strength, the effects of an otherwise wanted reform could be negative.

While some funds undoubtedly have much larger costs measured in basis points, there are also examples of index funds available for small retail investors that charge less than 5 basis points for their service. Examples include the Fidelity and Vanguard mutual funds tracking the Standard & Poor 500 index, which cover about 80 per cent of the U. S. stock market by valuation. These funds’ expense ratio is only 1½ and 3 basis points, respectively.

Source: Norwegian Ministry of Finance (2020a, b, c).

The Handbook starts out as follows: “Sovereign Wealth Funds (SWFs) represent both an increasingly important – and potentially dominant – category of alternative investor, and a novel form for governments to protect their interests both at home and abroad. As such, they represent both economic actors and embody powers vested in the financial and economic interests they can leverage.” The authors expect that short-term interest may on occasions dominate due to popular pressures, demands from predatory elites, and/or unforeseen external shocks. However, this seems to apply to other SWFs than the GPF-G, which is seen by many as the most transparent SWF.

The ownership of listed shares varies by region, from 1 per cent for North America and 2 ½ per cent for Europe.

In listed real estate, large shares of firms may be owned. This should be understood in the context of the real estate strategy.

Acemoglu, D., and J. Robinson. 2013. “Economics versus Politics: Pitfalls of Policy Advice”. Journal of Economic Perspectives 27 (2): 173–192.

Ang, A. 2010. The Four Benchmarks of Sovereign Wealth Funds, unpublished manuscript, Columbia Business School, NYC, NY.

Ang, A., N. Goetzmann, and S. Schaefer. 2009. Evaluation of Active Management of the Norwegian Government Pension Fund—Global, report to the Norwegian Ministry of Finance.

Balding, C. 2012. Sovereign Wealth Funds. NYC, NY: Oxford University Press.CrossRef

Clark, G., and R. Urwin. 2008. “Best-Practice Investment Management”. Journal of Asset Management 9 (1): 2–21.CrossRef

Clark, G., A. Dixon, and A. Monk. 2013. Sovereign Wealth Funds. Legitimacy, Governance and Global Power. Princeton NJ and Oxford: Princeton University Press.CrossRef

Cumming, D., G. Wood, I. Filatotchev, and J. Reinecke, eds. 2017. The Oxford Handbook of Sovereign Wealth Funds. Oxford: Oxford University Press.

International Monetary Fund. 2008. Sovereign Wealth Funds—A Work Agenda. Policy Papers. Washington DC: IMF.CrossRef

Knack, S. (ed.) 2003. Democracy, Governance and Growth. Ann Arbor: University of Michigan Press.

Kotter, J., and L. Ugur. 2011. “Friend or Foe? Target Selection Decisions of Sovereign Wealth Funds and Their Consequences”. Journal of Financial Economics 101 (2): 360–381.CrossRef

Krugman, P. 1979. “A Model of Balance of Payment Crises”. Journal of Money, Credit and Banking 11: 311–325.

Ledyard, J. 2008. “Market Failure”. The New Palgrave Dictionary of Economics 2nd edn. Palgrave MacMillan.

Malkiel, B. 2011. “Physics Envy; Creating Financial Models Involving Human Behavior is Like Forcing ‘the Ugly Stepsister’s Foot Into Cinderella’s Pretty Glass Slipper’”, The Wall Street Journal 14 December.

Malkiel, B. 2013. “Asset Management Fees and the Growth of Finance”. Journal of Economic Perspectives 27 (2): 97–108.CrossRef

Malkiel, B. 2016. A Random Walk Down Wall Street. The Time-Tested Strategy for Successful Investing. NYC, NY.: WW Norton Co.

North, D. 1990. Institutions, Institutional Change and Economic Performance (Political Economy of Institutions and Decisions), Cambridge, MA: Cambridge University Press.

Norwegian Ministry of Finance. 2008. St. meld. Nr. 16 (2007–2008). Forvaltningen av Statens Pensjonsfond i 2008 (The Management of the SPF-G in 2008), Oslo.

Norwegian Ministry of Finance. 2015. Meld. St. 21 (2014–2015). Forvaltningen av Statens Pensjonsfond i 2014 (The Management of the SPF-G in 2014), Oslo.

Norwegian Ministry of Finance. 2015. The Management of the SPF-G in 2014 - Meld. St. 21 (2014–2015), Oslo.

Norwegian Ministry of Finance. 2019. Meld. St. (2018–2019). Forvaltningen av Statens Pensjonsfond i 2018 (The Management of The SPF-G in 2019), Oslo.

Norwegian Ministry of Finance. 2020a. Meld. St. 2 (2019–2020). Revised National Budget 2020, Oslo.

Norwegian Ministry of Finance. 2020b. Meld. St. 32 (2019–2020). Forvaltningen av Statens Pensjonsfond i 2019 (The Management of the SPF-G in 2019), Oslo.

Norwegian Ministry of Finance. 2020c. Meld. St. 1 (2020–2021). National Budget 2021, Oslo.

Obstfeld, M. 1994. “The Logic of Currency Crises”. Cahiers Economiques and Monetaires 43: 189–213. Banque de France.

Olson, M. 2003. “Big Bills Left on the Side-Walk”. In Democracy, Governance and Growth, ed. S. Knack, 29–55. Ann Arbor, MI: The University of Michigan Press.

Reinhart, C. and K. Rogoff. 2009. This Time is Different. Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press.

Rodrik, D. 2008. “Second-Best Institutions”. American Economic Review 98 (2): 100–104.CrossRef

The Gjedrem Commission (Sentralbanklovutvalget). 2017. “Ny Sentralbanklov. Organisering av Norges Bank og Statens Pensjonsfond Utland.” Norges Offentlige Utredninger – NOU 2017: 13. Oslo: Ministry of Finance.

Truman, E. 2008. “A Blueprint for Sovereign Wealth Fund Practices”. In Peterson’s Institute for International Economics Policy Brief no. 3, Washington DC.

Weingast, B. 1995. “The Economic Role of Political Institutions”. Journal of Law, Economics, and Organization 11 (1): 1–31.

Wilson, C. 2008. Adverse Selection, The New Palgrave Dictionary of Economics, 2nd ed. London: Palgrave MacMillan.

Titel: Investment in Practice
verfasst von: Ole Bjørn Røste
Verlag: Springer International Publishing
Buch: Norway’s Sovereign Wealth Fund
Print ISBN: 978-3-030-74106-8

Electronic ISBN: 978-3-030-74107-5

Copyright-Jahr: 2021
DOI: https://doi.org/10.1007/978-3-030-74107-5_4

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