The ‘Oil Fund’, Norway’s sovereign wealth fund, is the world’s largest at more than $850 billion. The economic gains from the establishment of the fund have come from applying core insights to improve the risk-return trade-off for the nation’s total wealth. This column presents the recommendations of a government-appointed committee for the strategy of the fund going forward that build on the same core principles.
The prudent approach to asset management reflects the investment strategy adopted when the fund was established. The discovery of large oil and gas resources off the continental shelf in the late 1960s represented a significant increase in the asset side of the national balance sheet. The value of these new assets fluctuated with the world price of oil and gas. This lead Norway to establish a sovereign wealth fund to deploy the lessons of financial economics to manage this risk and maximise the nation’s wealth. The first deposit to the sovereign wealth fund was made in 1996, and subsequently the government’s proceeds from oil and gas extraction have been traded for equity and bonds on world markets, thereby converting oil and gas reserves into a claim on the production of the global economy. This strategy was a straightforward application of the most fundamental lesson of financial economics: risk sharing and diversification (e.g. Merton 1971, and many others). And it has made Norway wealthier as a consequence of the improvement in expected returns relative to risk. Norway has also carried a part of global equity risk. This was not only profitable ex ante, but has also proved profitable ex post. The recent collapse of world energy prices, which lowered the value of Norway’s outstanding oil and gas assets, would have been much larger if national wealth hadn’t been diversified – instead, it was partly offset by an increase in the value of the foreign equity portfolio.
Decisions on how to manage the financial part of national wealth, i.e. the GPFG, have also been a reflection of respect for rigorously tested scientific insights. When the sovereign wealth fund was established there was limited asset-management experience within the public sphere. The basic strategy and trade-off between bonds and equities closely followed the capital-asset pricing model (Sharpe 1964, Lintner 1965, Mossin 1966) and the canonical model for dynamic asset allocation of Mossin (1968), Samuelson (1969) and Merton (1969). Using these as guiding models, the equity share of the portfolio was set to 40% in 2000 and increased to 60% in 2007.
The management of the financial portfolio is grounded in respect for competitive international financial markets, understanding of arithmetic, and awareness of principal-agent challenges in delegated asset management (Samuelson 1974, Sharpe 1991). Negligible scope for speculative, discretionary bets means that the returns of the fund have followed value-weighted global markets closely. Years before index management came into vogue, the financial part of Norway’s national wealth was managed as a de facto index fund.
Being large makes this particularly profitable, as there are considerable economies of scale to systematic strategies in listed, transparent markets. For a large fund, this further improves expected returns net of costs.
Index funds whether explicitly or implicitly seem to get better of the active ones..