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Review of the fund’s active management

Yngve Slyngstad presented during a seminar on the fund’s active management 22 September.

22 September 2014

The report “Review of the Active Management of the Norwegian Government Pension Fund Global" written by Andrew Ang, Michael W. Brandt and David F. Denison (2014), was presented during a seminar arranged by the Ministry of Finance. The report was published 20 January 2014.

The report was presented by Andrew Ang, Professor of Columbia Business School. Professor Campell Harvey of Fuqua School of Business/Duke University and Øyvind Norli of BI Norwegian Business School commented on the report. Yngve Slyngstad, CEO of Norges Bank Investment Management, held a speech on the management of the fund. The speech is published below.

Presentation (PDF)

Safeguarding and building wealth for future generations

remarks on the management of the Norwegian Government Pension Fund Global

Remarks by CEO Yngve Slyngstad, Norges Bank Investment Management, at the Ministry of Finance seminar, 22 September 2014.

Please note that the text below may differ from the actual speech.

Chart 1: Mission statement

Ladies and gentlemen,

Thank you for inviting me to address this seminar. I appreciate the opportunity to share some perspectives on the management of the Government Pension Fund Global.

In the first report on the active management of the Fund five years ago, Professors Ang, Goetzmann and Schaefer raised the important question of how to approach systematic risk factors in the management of the Government Pension Fund Global. Over the few past years, both the Ministry as the owner of the Fund and the Bank as the manager have devoted significant resources to this topic. Many of these systematic strategies have large investment capacity and are therefore of interest to an investor with a large asset base. Both the Ministry and the Bank agree that harvesting of such factor premia should be done as part of the operational management of the Fund rather than through a complex set of benchmarks. Managing exposure to systematic risk is an important part of our management assignment. We manage the Fund’s overall exposure to systematic factors with an aim to earn long run returns.

The second report from Professors Ang, Brandt and Denison presented here today, takes the discussion about the management of the Fund one step further by proposing an alternative to the traditional asset class approach to portfolio construction and investing. A move in this direction may allow the Fund to exploit additional investment opportunities and capitalise on the Fund’s characteristics. The model discussed provides a consistent and coherent framework for analysing and benchmarking investment decisions across both public and private markets. The report provides an excellent basis for discussion of the framework for the management of the Fund, like the previous report did five years ago.

In the following I will look more closely at the role and design of broad market indices and reflect on the way forward. The key message is that a passive strategy is not an option for the management of the Fund.

Investment management is all about making choices. What, how, why and when may have a profound impact on investment returns and future value. The framework for the management must ensure that we, on behalf of future generations, make the best choices.

We learn in business school that investors should hold a well-diversified market portfolio. But, what is the market? And, is it possible to buy the market?

The market portfolio is the only portfolio that can be held by all investors at the same time. This theoretical portfolio includes all assets: not only stocks and bonds – but also everything else from residential real estate to human and public capital.
The market portfolio represents the total wealth of the entire world. In reality, the market portfolio is unobservable. The true market portfolio exists only in theory. It is not possible to buy the market. Any index will merely be a proxy to the market. Index providers make a number of choices in their design of these proxies. One obvious challenge with the indices from leading, global index providers is that none of these includes private investments. Let me illustrate this by using the Fund’s real estate portfolio as an example.

Chart 2: Midtown Manhattan

This is Midtown Manhattan, presumably the largest, most liquid real estate market in the world with a number of large, public transactions every year. If you were to construct an index for real estate it ought to be possible to do so for this market. It is not.
An indexing strategy would imply that you as an investor bought a small slice of all buildings in Manhattan. Obviously, this is not possible.

Chart 3: GPFG in Midtown Manhattan

You choose to invest in a selected number of properties. How do you benchmark the Fund’s investments in real estate? Which of the properties in this picture do you compare them to? And how do set about making the comparison?
One approach is to use private market indices. These private market indices pool experience from different institutions and are not investable. An alternative to these indices could be to move towards the Opportunity Cost Model as recommended by Professor Ang and his colleagues. This idea is worth exploring in more detail.

Another challenge with the available indices is that they do not represent the full economy. First, they are not truly global. Index providers exclude countries.

Chart 4: The world according to FTSE

The Fund’s strategic benchmark for equities is based on the FTSE Global All-Cap index. As can be seen from this chart, a number of countries have been excluded, for various reasons. Some of these countries, such as Qatar and Kuwait, have fairly developed capital markets.

Chart 5: The world according to Barclays

On the fixed income side, the pattern is the same. The global indices are not truly global. Countries are excluded from global bond indices for a variety of reasons. A country’s sovereign rating may be below investment grade. Its currency may not be fully convertible. Foreign investors may face capital controls, as in the case of Brazil.

Within the countries that are included, the omission of private investments tilts an index in certain directions. This presents another challenge with these indices.

Chart 6: Listing differs across countries

The ration of share of listed to unlisted companies vary across countries, from between 50 and 60 percent in the UK and the US, to around 20 percent in Italy, France and Spain and to below 10 percent in some Eastern European countries. An index tracking strategy will be tilted towards the countries to the left in this chart.

The degree of listing also varies across economic sectors[1]. Our analysis of the US market shows that if you invest in a market weighted portfolio of US public companies you end up investing more in capital intensive industries such as oil extraction and utilities at the expense of agriculture, retail and various other services.

It may not come as a surprise that index providers exclude certain countries and segments and that the indices therefore do not represent the full set of opportunities. More surprising perhaps is the fact that these indices do not fully represent the listed market either. One example is the adjustment for free-float. So, what is the free float of a company? The free float of a company represents the portion of a company’s shares that is readily available for trading. Shares owned by governments, employees and company founders are assumed not to be readily available for trading. In the free float adjustment, these shares are removed by the index provider and the stock enters the index with a lower weight. Over the past decade, free float weighting has become the norm for constructing market capitalisation indices. 

Free float adjustments are far from an exact science. Reliable shareholder data are not always available. The adjustment for free float comes across as somewhat opaque, and index providers treat the same stock differently with respect to free float. I will illustrate how the adjustment for free-float alters the geographic and industry composition of a global equity index.

Chart 7: Free-float differs across countries

The portion of shares that float freely varies between countries. An investor tracking a free float adjusted global equity benchmark will  therefore be underweight emerging markets stocks and overweight US stocks compared to a market weighted portfolio of the same universe. The portion of shares that floats freely also varies between sectors introducing tilts to the portfolio[2].

Index providers make different choices. These differences are not negligible. One way to measure the degree of difference is to estimate the so-called tracking error between two indices claiming to track the same universe. The focus on these differences should not be interpreted as a critique of the index providers. They are fairly open about how they create their indices.

Chart 8: Equity indices differ

In this chart we compare two global equity indices. At the height of the financial crisis the tracking error between the global equity indices from MSCI and FTSE peaked at around 60 basis points, before gradually levelling off towards 12 basis points today.

Chart 9: Fixed income indices differ

We find the same pattern when comparing two indices that aim to represent the opportunities for global fixed income investments. Here the differences are even greater. There is no particular reason to assume that one of the indices is a better approximation to the market than others. The mandate for our management of the Fund does, however, tie the portfolio closely to one particular index provider and through this the choice of index becomes important.

Chart 10: Returns on indices differ

In this chart we compare the historical return difference between FTSE’s and MSCI’s global equity index offering. The first years of this sample the return differential was quite substantial.

Chart 11: Returns on indices differ

In some years, the differences between the returns on the indices more than outweighed the excess returns we generated in our management. Index construction is a user driven process. As the index tracking industry has grown in size, liquidity and tradability have become even more important features[3]. This development may explain why the return differences between the indices have become smaller in recent years. The indices may have converged towards an industry practice where liquidity and tradability are key which in turnay have served to push the indices even further away from a market weighted portfolio of the same universe. 

The global indices are approximations to the global market portfolio, be it for listed equities or bonds. These proxies are designed through a series of discretionary choices made not only by the index providers, but also by rating agencies, exchanges and country analysts, since some of these decisions are outsourced by the index providers.  The global indices are designed to cater for the needs of an investor requiring daily liquidity. The Fund has no such needs. The differences between the Fund and the typical index investor provide an important basis for a strategy that deviates from indexing. An obvious question is whether a greater share of the Fund should be invested in less liquid assets. Today, the Fund’s investment universe is restricted to public markets, with the exception of private real estate.

The framework proposed by Professor Ang and his colleagues may facilitate a gradual introduction of additional private investments to the Fund’s universe and a consistent way to benchmark and analyse different investment opportunities. A new framework for the management of the Fund may also facilitate a development where we as manager of the Fund take a greater responsibility by defining a tailor-made reference portfolio. Indices from the leading index providers do not necessarily represent the best starting point. In this presentation I have illustrated this by pointing to a number of decisions the index providers make – and showed that these decisions do not necessarily support the overall objective of the Fund.

Return variation in the reference index currently accounts for more than 99 percent of the variation in the total return on the Fund. Instead of accepting the choices taken by the index provider, we can design a starting point which is better suited to the Fund’s characteristics. We can improve diversification by adding new countries and segments, and implement and maintain factor risk strategies in scale.

The Bank has proposed[4] to replace the current strategic index with one made up of 60 percent listed equities and 40 percent fixed income.  The strategic index expresses a set of broad market exposures reflecting the owner’s risk tolerances;it does not equal the complete set of investment opportunities. This change would clarify the role of the strategic index in the management of the fund.

Chart 12: Selected Discussion Notes

Our investment strategies are founded on academic insights, empirical evidence and practical experience from financial markets. Over the few past years we have published a series of Discussion Notes, covering issues we believe to be of high relevance for our management of the Fund.

Chart 13: Mission statement

In the management of the Fund, Norges Bank aims to safeguard the international purchasing power of the Fund for future generations. We will continue to do this as prudently, efficiently and transparently as possible learning from external experts and academics such Professor Ang and his colleagues. We will continue to strive for excellence in all aspects of our management assignment.

Thank you.

[1] This chart is based on data all US companies have to file with the IRS for tax purposes. Accounting practices may vary between private and public companies.

[2] View NBIM Discussion Note 5/14 on Free Float Adjustments in Global Equity Portfolios.

[3] MSCI’s Global Investable Market Indices (GIMI) mission statement reads: “…The GIMI are intended to provide: exhaustive coverage of the investable opportunity set with non-overlapping size and style segmentation, (with) a strong emphasis on investability and replicability through the use of size and illiquidity filters.

[4] Norges Banks’s letter to the Ministry of Finance on the framework for our management of the Government Pensions Fund Global, 13 January 2014,