Monday, August 28, 2017

Norway's Giant Beta Problem?

Michael Katz of Chief Investment Officer reports, Norway’s Sovereign Wealth Fund Returns 2.6% in Q2:
Norway’s $977.4 billion Government Pension Fund Global returned 2.6%, or 202 billion kroner ($25.53 billion), in Q2 of 2017.

The fund had a market value of 8.020 trillion kroner as of June 30, of which 65.1% was invested in equities, 32.4% in fixed income, and 2.5% in unlisted real estate. Equity investments returned 3.4%, while fixed-income investments returned 1.1% for the quarter. Investments in unlisted real estate returned 2.1%, and the total return on investments was 0.3% higher than the return on the benchmark index.

“The stock markets have performed particularly well so far this year, and the fund’s return in the two first quarters was 6.5[%]. This gives a total return of 499 billion kroner, which is the best half-year return measured in Norwegian kroner in the history of the fund,” said Trond Grande, deputy CEO of Norges Bank Investment Management.

However, Grande added that “we cannot expect such returns in the future. The record-high return is primarily due to the fact that the fund has become so large.”

The returns would have been even higher, however, the kroner appreciated against the main currencies during the quarter, which decreased the value of the fund by 32 billion kroner. In the second quarter, 16 billion kroner was withdrawn from the fund by the government.

While the fund said that the returns were driven by continued healthy growth in the global economy, it added that some macroeconomic data, especially for the US economy, were weaker than the market had anticipated. Growth expectations for emerging markets were mainly unchanged from the previous quarter, while those for developed markets improved, which was due to greater optimism in the euro area.

The strongest returns came from European equities, which returned 6.3%, and accounted for 36.6% of the fund’s equities at the end of Q2. The UK, which was the fund’s largest market in Europe with 9.7% of its equity investments, returned 3.3%, or 1.5% in local currency. North American stocks returned 0.7%, and comprised 38.6% of the equity portfolio. US stocks, which were the fund’s single-largest market with 36.4% of its equity investments, returned 0.8%, or 2.9% in local currency.

The health-care sector delivered the best return for the fund during the quarter, as health-care stocks returned 5.7%, spurred on by market expectations of stronger earnings in the sector. The fund said that the inability of the US Congress to significantly alter its health-care system’s regulatory framework was interpreted by the market as a continuation of stable operating conditions.

Industrials returned 4.9%, driven by an improved outlook for economic growth, particularly in Europe and emerging markets. Returns were strong in the industrial machinery sector, which was attributed to increased demand for construction machinery, and more stable demand for capital goods in the commodity industry.
It's been a long time since I covered Norway's giant pension/ sovereign wealth fund. Last week, I covered why Japan's GPIF is warning of index trackers run amok, where I stated this:
Japan's GPIF and CPPIB are long-term investors and they need to think more carefully about how they will construct their respective portfolios across public and private markets to ride through the coming pension storm.

In this regard, CPPIB is well ahead of GPIF but it's a lot smaller too. GPIF will have a very hard time finding solid active managers across public and private markets as the mystery of inflation-deflation unfolds.

Still, GPIF is moving as fast as possible to diversify into private markets. It recently announced it's plowing into real estate, asking asset managers around the world to submit proposals to run portions of the fund's real estate investment portfolio.

But make no mistake, GPIF's assets recently hit a record ¥144.9tn on the back on passive investments and the fund has massive beta exposure, far more than its large peers around the world. This is why the focus right now is on active managers in public and private markets.
I also coverd the great CPP/QPP divergence where I stated this:
[..] if you account for inflows and returns, and the new enhanced CPP, there is little doubt CPPIB will become a multi-trillion behemoth by 2090.

It seems crazy when you think of it but you should keep in mind by that time, world GDP will have grown significantly, increasing CPPIB's opportunity set across global public and private markets.

Also, keep in mind there are a few global pensions (Norway and Japan) that are already managing over a trillion each, and they aren't as well diversified across global public and private markets as CPPIB.

Moreover, some Canadian insurance companies manage over a trillion now, so CPPIB isn't the only large Canadian fund that will grow to become a behemoth by 2090.

How will CPPIB manage this explosive growth over the decades? The exact same way it's managed it over the last ten years, carefully and diligently diversifying across global public and private markets.
I made a mistake, Norway's fund hasn't surpassed a trillion dollars yet but it's on its way. You can read all about Norway's Government Pension Fund Global here. Suffice it to say, it and Japan's pension whale are the biggest pension funds in the world.

They're also giant beta funds, meaning their performance is overwhelmingly determined by global public equity and fixed income markets. Norway's Fund is a lot more sophisticated than Japan's in terms of where it takes its beta exposure, but beta is beta, so the Fund is vulnerable to a severe correction in global public equity markets.

What I like about Norway is the Fund's transparency and governance. You should read this presentation to understand the Fund's mission, structure and governance.

Just like CPPIB, Norway's pension fund invests for the long-term but the two organizations have taken a different approach to investing as the former invests across global public and private markets whereas the latter invests almost exclusively in public markets.

One reason, I believe, is the governance structure. Without boring you with details, there are aspects of Norway's governance I like but there is a lot more government interference in this fund, capping the compensation they need to attract qualified people to properly invest in private markets or to do absolute return strategies across public and private markets internally.

Since the financial crisis, this reliance on public equities has significantly boosted the assets of Norway's pension fund but it also leaves it very exposed to a major correction or prolonged bear market.

True, one can argue that both public and private markets are way overvalued now and both risk getting clobbered in a bear market but private markets aren't marked-to-market and as such, they're not as volatile. Also, private markets have inefficiencies which can be exploited if the deal is priced right.

All this to say, I believe Norway and Japan's pension fund are going to run into some serious trouble over the next decade and significantly underperform their Canadian peers which are more diversified across public and private markets.

Japan is right to shift the focus on active management across public and private markets going forward, and I think Norway needs to do the exact same thing.

Also, if my fears of global deflation come true, Norway, just like Canada, is in for a whole lot of hurting  because oil prices will plunge and stay low for a very long time, significantly impacting revenues.

Of course, Trond Grande and the rest of the senior managers at Norway's Government Pension Fund Global are keenly aware of the risks I'm highlighting but apart from their Treasury holdings, I doubt they're hedged for a long period of global debt deflation.

Below, Gary Shilling, the president of A. Gary Shilling & Co., spoke to Business Insider CEO Henry Blodget about the stock market, which he views as expensive, citing the Shiller P/E ratio, which is roughly 40% above its historical norm. He doesn't necessarily see them falling apart, but says they're starting at a high level.

Shilling shares his thoughts on the end of the eight-year bull market, saying that some sort of exogenous shock could derail it, as well as tightening from the Fed. He also breaks down his forecast that the 10-year US Treasury will go to 1%, noting that we're more likely to see deflation than inflation, which is beneficial to his forecast.

Unlike others, Shilling has correctly predicted deflation over inflation and even written books on this subject. I personally think he's optimistic and doesn't see the global deflation tsunami headed our way, but I agree with him, the yield on the 10-year US Tresury note is headed much lower which is why I continue to recommend US long bonds (TLT) as the ultimate diversifier.

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