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The Statens Pensjonsfond, Norway's sovereign wealth fund, combines the oil profits from its 2/3 stake in Statoil with an aggressive, 60% equities investment strategy.

The Pensjonsfund is massive, has a very long investment horizon and is actively managed.

Norway's Finance Ministry recently hired three well known professors to analyze the Pensjonsfond's stewardship of Norway's $525 billion. The results were surprising.

The Pensjonsfond

Norway has just 4.9 million people, which translates into Pensjonsfond assets of over $100,000 per person. Compare that to the pitiful $8,300 per person in Treasury IOUs held by the U.S.'s Social Security Ponzi scheme and you may want to move to Norway, the world's third happiest country (after neighbors Denmark and Finland).

Pensjonsfond Assets 2009 2010
(Click to enlarge)

The Rise of Sovereign Wealth

As a side note, Norway is not alone in running these huge sovereign wealth funds.

Top 10 Sovereign Wealth Funds
(Click to enlarge)

To the extent that these sovereign wealth funds follow Norway from bonds to equities, an increasingly large portion of the world's equities will be controlled by nation-states. Perhaps a future essay topic … but for now as individual investors we have something to learn from Norway.

Norway Is Aggressive

Norway distinguishes itself from run-of-the-mill sovereign wealth funds by being aggressively committed to equities. Norway's 60% split towards equities translates into $315 billion, or a cool 1% of the world's $35 trillion in liquid equities. No wonder they're so happy.

To manage this mountain of money, the Statens Pensjonsfond complements its staff of 249 with hundreds of money managers from across the globe, selecting the best and brightest based on the quality of their analysis, their historical performance and their personal charm – or whatever else one looks for when hiring active managers.

"The Best Managed Fund in the World"

Given the Pensjonsfond's nearly limitless resources, their unlimited investment horizon and their native Scandinavian smarts, one could imagine the Pensjonsfond fulfilling its ambition "to be the best managed fund in the world."

But basically they're active managers, just the sort I regularly criticize.

So, How'd They Do?

In 2008 the Norwegians lost 23.3%, trailing their benchmark by 3.4% and prompting the Finance Ministry to hire three distinguished professors to analyze the fund's strategy and performance: Andrew Ang (Columbia Business School), William N. Goetzmann (Yale School of Management) and Stephen M. Schaefer (London Business School).

The trio's conclusion was shocking: Norway wasn't running an actively managed fund at all. Once adjusted for risk, the fund's return to their active management was statistically indistinguishable from zero.

In other words: despite their best efforts, they were just running an index fund. The reason they trailed their benchmark is that they were using the wrong benchmark.

The Wrong Benchmark

Imagine you have just been hired by the Pensjonsfond. You want to beat the overall market, make your reputation and buy a nice lake house in Lillehammer to helicopter to on weekends.

You know that small and value beat large and growth during most periods. Using your toolset – fundamental analysis, charting, tea leaves, whatever – you find small value companies to buy and sell.

Looking back after most five year periods, you would have beaten the broad market. Are you a genius stock-picker or not? The answer depends on which benchmark you set your results against.

Pick Your Benchmark

If you buy only small value stocks, is it fair to compare your results to the whole market, which is dominated by large companies, or to other small-value stocks only? The answer your boss chooses makes a big difference to your dream of weekending in Lillehammer.

Take a look at the past 50 years of returns, comparing the whole market to small cap value only:


(Click to enlarge)

Clearly, if you just heavied-up on small value, then in most periods you would have "beaten the market" even if you did only a mediocre job choosing your stocks simply because small value stocks on average outperform the whole market.

To see this small/value performance for yourself, check out ETFs such as:

  • VBR - Vanguard Small Value ETF. Tracks the MSCI US SmallCap Value Index.
  • IWN - iShares Russell 2000 Value Index Fund. This will deliver the same returns as the Russell 2000 Value lines in the graphs above.

Now do it with $500 billion

Any portfolio of this magnitude is going to be complicated and identifying an appropriate benchmark is tough but important work. Here's what the three professors had to say:

By far the most important influence on the performance of the Fund is the choice of benchmark. This accounts for over 99% of the total variance of the Fund's returns so the contribution of active returns to the overall Fund performance has been small. However, a significant fraction of even the small component of total Fund returns represented by active returns is explained by exposure to a limited number of common factors. The overall behavior of the Fund is therefore very similar to an index fund with a small overlay of exposures to systematic factors such as credit, value-growth, liquidity, volatility, etc.

Translation: "Guys, you're running a giant index fund. You may think your 100,000 person-hours of fundamental analysis are doing something, but they aren't."

The Professors' Advice to Norway

They go on to give some politically-worded advice:

Our recommendation is that these exposures [to risk factors such as small value] are, in general, appropriate but that they should be brought into the benchmark and that the Fund's average exposure to these factors should be a "top-down" decision rather than emerging as a byproduct of "bottom-up" active management.

Translation: "If you're running an index fund, why not run one that deliberately and strategically captures risk factors such as small-value instead of relying on the random outcome of a wasteful active management process?"

Beating Norway

The Pensjonsfond learned two lessons from the professors' full report:

  • Active management doesn't work, even when you have resources far beyond any individual investor, investment bank, or corporation anywhere on the planet.
  • Taking a top-down approach to asset class targeting is the appropriate, intelligent, strategic alternative.

While it remains to be seen whether Norway's entrenched active money managers will lose their jobs as a result of this report, as individual investors we have a far greater ability to respond to new information and deliberately choose a strategy that works best for our own wealth.

ETFs For a Top-Down Approach

To do the asset class targeting that the professors recommend, combine market-cap weighted allocations with some small and value allocations, using a combination of domestic, international and emerging market ETFs.

  • Domestic: VBR and IWN as detailed above.
  • International Developed Markets: SCZ (iShares EAFE Small Cap) and EFV (iShares EAFE Value) are good ways to add portfolio tilt.
  • Emerging Markets: EWX (SPDR S&P Emerging Markets Small Cap) is good. EMVX (GlobalX Russell Emerging Markets Value) was just started in January of 2011 and to my knowledge is the only Emerging Markets Value ETF.
Source: Norway's $525 Billion Sovereign Wealth Fund Essentially an Index Fund