The viscosity of the oil fund

I recently posted a blog about Norway and the future of Norway ("The Great Norwegian Depression?"). Although I realize that the points I made have been addressed earlier by far more cleverer people than myself, I would like to add a second part to that blog. Think of this as a sequel, where I shed some light on the diversification of one of the most important, national funds out there.

Norway's Government Pension Fund - Global (formerly The Government Petroleum Fund, which is managed by NBIM) unveiled a negative return of NOK 39 bn for Q2 despite beating benchmark indices due to active trading (trades in bonds and equities). However, with oil prices breaking through the ceiling, the net inflow was positive at NOK 46 bn (NBIM receives capital inflow from any oil activity in the North Sea). The negative returns were incurred as a direct result of (1) an increased exposure to equities (from 40% to 50%, which will be increased to 60%) and (2) turbulent markets including losses in AIG, Lehman Brothers and Bear Sterns. The negative return is within what can be thought of as acceptable volatility for the fund (within the mandate given by the Ministry of Finance). That's what Yngve Slyngstad, the CEO of NBIM, claims.

A negative return of NOK 39 bn for a fund that exited Q2 at NOK 1992 bn is a loss of less than 2% (10% on an annualized basis). A reported NOK 91 bn cheque was added to the fund in Q2 from offshore activites. If this sum is representative for any quarter, then an estimated NOK 360 bn will be added to the fund this year (that's about 15% of the total fund size). Obviously, a downward facing trend in the price of oil will affect these capital inflows negatively.

So, the question that needs to be addressed is not whether the negative return in Q2 represents an acceptable volatility in the fund. Instead finding out whether the risk could have been reduced without compromising returns is far more interesting. This is where there is room for improvement.

I've already mentioned that the capital provided to the fund stems from oil related activities. Glancing over the fund's equity portfolio (of more than 7000 companies) there is a large number of oil companies included. How is that even possible? Not only is about 15% of the fund exposed to the oil price and the oil activity through income from the state, but the returns of the fund itself is exposed to oil activities around the globe through the equity investments. It reminds me of all the employees who had their income and their 401(k) retirement packages, all put in the same Enron-basket.

First, let me make a few comments about diversification. Diversification is good since it reduces risk, no doubt about that. However, researchers have found that correlation between international stock indices (the FTSE100 and the CAC 40 for instance) increases dramatically in cases of stock market crashes. That poses a conundrum; it is in times of crisis where the diversification effect is most needed!

One could argue that there is a geographic, diversification effect since the inflow of capital stems from oil activities in the North Sea, while the returns from the investments are from foreign companies. That argument doesn't hold as oil is traded in an international market and thus affects all countries equally. What about maximizing the diversification effect of the equity portfolio - if oil companies were excluded, then one wouldn't have an optimal portfolio composition? That is true, but it makes a fatal assumption. The assumption that portfolios should be optimized individually, with regards to risk. Investor behavioralists call that a bias - forgetting to diversify the total portfolio.

So what should NBIM or rather the Ministry of Finance do? First things first. Stocks are cheap, no doubt about that and Buffett is buying ("Be fearful when others are greedy, be greedy when others are fearful." I recommend you read his contribution in the New York Times about a month ago). Since NBIM has an infinately long investment horizon, they should vacuum the markets for equities in order to reach their 60% target. After all, Buffett has proven himself numerous times before.

Secondly, they should review their portfolio strategy with regards to diversification. In other words, set new investment guidelines for the fund managers that excludes/limits oil companies. There may be some politics involved when excluding some of the world's largest companies from the investment map, but the fund's goal is not to please fat cats nor engage in politics.

Thirdly, limiting the investments to equities and bonds raise a whole new set of problems (this is a political issue and is not decided by NBIM) . One of the most successful funds to this date, is the The Yale Fund (the model was developed by David Swensen and Dean Takahashi) which has yielded a return of 17% the last ten years. There are pros and cons to all investments strategies, but this strategy is proven. The fund invests in about six different asset classes. And what is the foundation of the model? Diversification. What is it that NBIM is lacking? Diversification.

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This blog is intended for the interest of the readers only and the blogger bears no liability as a result of investments undertaken from advice given in this blog. I have used citations that are accurate to the best of my knowledge, information that is correct and I apologize in advance for any spelling errors.