May 29, 2014

The Vikings Return to America

A new report on Norway’s pension fund points toward a Canadian model for active investment management.


At close to $900 billion, Norway’s Government Pension Fund Global is one of the largest investment funds in the world, holding approximately 1 percent of all equities around the world. On a per capita basis, it represents about $185,000 per citizen. The fund is remarkable not only for its size, but also for its commitment to socially responsible investing and transparency.

To fulfill its commitment to operate the fund with transparency and prudent long-term management, Norway conducts a mandatory review every four years. Professor Andrew Ang, who conducted the 2009 review of the fund, was once again tapped to review the fund’s management and performance and recommend adjustments to its management strategy. In a new 2014 review, Ang worked with Michael Brandt of Duke University and David Denison, formerly of the Canada Pension Plan Investment Board (CPPIB).

The authors find that active management activities have added value since the 20072008 financial crisis. The 2009 review recommended that the fund consider large-scale harvesting of smart beta, or factor-risk premiums. In the current review, the team evaluates the fund’s efforts in this dimension and call them an “excellent development . . . that capitalizes on the Fund’s comparative advantages.”

The team made three primary recommendations:

Model Governance after the Canadian Pension Plan
The team’s key recommendation is that Norway use the Opportunity Cost Model of active management as pioneered by CPPIB, which has also been adopted by other large investors including GIC, one of Singapore’s sovereign wealth funds.

“If you have one dollar, you can invest it for next to nothing in index equity and bond portfolios,” Ang explains. “If you instead take that dollar and give it to your favorite active-management firm or illiquid, private-market project, you want to know that you are obtaining a superior risk-return trade-off that you cant obtain simply by investing in equities and bonds.” In other words, do private equity, real estate, or infrastructure offer better returns net of fees than cheap index funds? CPPIB holds all of its actively managed investments to this standard.

“Any active investment that deviates from this mix of equities and bonds has to be benchmarked against the opportunity costs of the public-market securities used to fund that investment,” Ang explains. At CPPIB, each active deviation from the chosen benchmark (based on a designated index of public equities and bonds) has to cover its costs and beat the benchmark portfolio. “The opportunity cost model raises the bar and accountability for active management and it provides a self-consistent benchmark because it really is an opportunity cost — the cost of foregone investment opportunities in simple equities and bonds.”

Greater Transparency
The team recommends that the fund, already one of the most transparent investors in the world, become even more transparent. Long-term investors make money through four stages of the investment process: diversification, rebalancing, taking on factor exposures or risks, and security selection. The report recommends greater transparency to further bolster public support for the fund. “If youre on taking on risk, you want to see where that risk is being applied, and where it is coming from. You want to measure the value created at each stage of the investment process.”

Increase Risk Taking
The team recommends that the fund increase the amount of risk taking in the actively managed portions of the fund, including increasing exposures to private market investments. “But it's not just a simple matter of increasing overall risk,” Ang emphasizes. “It’s understanding the portion of risk that really matters, which is downside risk, and you really want to control that.”

Norway is typically regarded as a standard setter when it comes to sovereign wealth fund governance for its transparency and emphasis on socially responsible investing. As it weighs the team’s recommendations, other large funds are likely to follow, casting a spotlight on Canada’s Opportunity Cost Model. “Norway is often regarded as a shining example — which it is,” Ang says. “But the Norway model is based on traditional asset class portfolio construction techniques. The Canadian model takes this to the next level.”

Andrew Ang is the Ann F. Kaplan Professor of Business, academic advisory board member for the Program for Financial Studies, chair of the Finance and Economics Division, and a senior scholar at the Jerome A. Chazen Institute for International Business at Columbia Business School.

Read the Research

Ang, Andrew, Michael W. Brandt, and David F. Denison. “Review of the Active Management of the Norwegian Government Pension Fund Global.” Ministry of Finance, Norway, January 20, 2014.