The Norwegian dilemma

This is the fund, established in 1990 by those abstemious Norwegians, to do with their North Sea oil and gas revenues precisely what the British did not do with theirs - channel the surplus from the government's hydrocarbon revenues into a fund that "is saving for future generations in Norway", as the fund's website puts it, adding: "One day the oil will run out, but the return on the fund will continue to benefit the Norwegian people."

And how. The current value of the Oil Fund, which is bigger even than China's and Saudi Arabia's sovereign wealth funds, works out at about £130,000 per citizen. That means, according to the Norwegian government's rules that restrict the amount that can be drawn from the fund to 4 per cent a year, it can generate about £5,250 of spending per person. In a country where per capita output runs at about £56,000 that might not sound much. Yet think of it as a lifetime's annuity to be lavished on every man, woman and child and, in today's money value, it works out at about £420,000.

True, the fund's size seems overwhelming (see tables 1, 2 and 3). For example, the market value of its equity investments alone equals almost a fifth of the value of all the domestic companies that are quoted on the London Stock Exchange. Alternatively, the fund could buy the world's biggest company - Apple (US:AAPL) - and still have about £150bn to spare.

Despite this gargantuan size - or maybe because of it - arguably Norway's Oil Fund is failing to deliver. Since the start of 1998 - when the fund started investing in equities as well as bonds - its returns have generated compound annual growth of 5.6 per cent (see table 4); that figure is expressed in the basket of currencies that the fund uses to calculate its global buying power. Yet, after adjusting for inflation and the modest costs incurred by its manager, Norges Bank Investment Management, a subsidiary of Norway's central bank, the fund's real return drops to 3.7 per cent - just short of the government's target.

 

Table 1: Norway's oil fund - the basic numbers
30 Sep 2016	£bn	%
Fund value	689	100
of which:
Equities	418	60.6
Bonds	250	36.3
Property	21	3.1
£1=Nk10.33

 

Table 2: Where the money comes from
1996 - 2016	£bn
Net inflow of new capital	331
Minus: management costs	-3
Add: return on investments	283
Add: depreciation of krone	78
Current value*	689
*As at 30.9.16

 

Table 3: Putting the fund in context
30 Sept 2016	No. holdings	Market value (£bn)
Norway Oil Fund	9,050	418
FTSE Global All-Cap index	7,738	34,576
London Stock Exchange	1,547	2,208
Berkshire Hathaway	-	448
Royal Dutch Shell	1	158
Notes: Oil Fund's equity holdings only; LSE - domestic co's only

 

Missing a mark by 0.3 per cent might seem trivial. However, it matters because the fund deals with huge sums of capital whose investment horizon is theoretically forever and even in practical terms will stretch to many decades. When long-term compounding gets to work, an annual shortfall of 0.3 per cent, which works out at about £2bn today, becomes £85bn a year after 20 years. The people of Norway would notice that.

As to why the fund is undershooting, bad luck is a factor. With the benefit of hindsight, it's clear that the fund started investing in equities at the wrong time - 1998. That year was almost the peak of the ultra-long bull market in equities that had started in late 1974. Thereafter, it hasn't always been downhill but, in comparison with the previous 18 years, the 18 years 1997-2015 have been mediocre for share prices. After its first four years, the Oil Fund's equity holdings had posted cumulative losses of 18 per cent. The manager has since clawed those back and - with the volatility that is typical of share prices - the equity portion of the fund has produced superior returns to those from its fixed-interest portfolio - 5.3 per cent annual growth compared with 4.9 per cent.

But some of the fund's problems may be of its own making. In particular, it limits its investments to listed securities (with a bit of real estate) with a big bias towards the developed world in general and Europe in particular (see table 5). Of its 9,050 equity investments - that figure alone is hard to grasp - 91 per cent are in developed markets with the remainder in emerging markets apart from a 0.3 per cent slither in frontier markets.

Its exposure to Europe is heavily overweight and the UK, where the fund has 457 holdings, is especially favoured. At the end of 2015, the fund's internal benchmark index, which the actual fund almost replicates, had a weighting of 11.5 per cent for UK equities compared with just 6.9 per cent for the UK in the FTSE Global All-Cap, the index on which the fund builds its own benchmark. By contrast, US shares are under-represented. The internal benchmark has a weighting of 36.6 per cent compared with 52.9 per cent in the FTSE index.

 

Table 4: Five-year performance
All assets
	Return (%)	Relative return (%)
2011	-2.5	-0.1
2012	13.4	0.2
2013	16.0	1.0
2014	7.6	-0.8
2015	2.7	0.5
1998-2015	5.6
Equity investments
	Return (%)	Relative return (%)
2011	-8.8	-0.5
2012	18.1	0.5
2013	26.3	1.3
2014	7.9	-0.8
2015	3.8	0.8
1998-2015	5.3
*Percentage points, relative to internal benchmark (see text)

 

Table 5: Where the equity fund is invested
Region	Weighting (%)	Sector	Weighting (%)
Europe	39.3	Financials	23.4
North America	37.3	Consumer goods	14.5
Asia & Oceania	21.2	Industrials	13.6
The rest	2.3	Consumer services	11.0
		Healthcare	10.7
		Technology	9.0
		Oil & gas	5.4
		Others	12.4
As at 31.12.15

 

So - predictably enough - the equity fund is full of the global great and good, as tables 6 and 8 show. The biggest single equity holding is in Swiss foods manufacturer Nestle (SIX:NESN), where the investment is worth about £4.7bn - enough to take over J Sainsbury (SBRY), for example. Other big names to figure prominently are Apple, Alphabet (US:GOOGL) and Microsoft (US:MSFT).

The fund's manager justifies this by saying in its '2014-2016 Strategy' document that "we believe that the fund, in principle, should be invested as broadly as possible in all countries and markets". However, it does not explain what the principles are that lie behind this unless they naturally follow from "an objective to secure the highest possible real return with an acceptable risk". And somehow that means "the key constraints are an investment universe limited to public investments in fixed income and equities and private real estate". Sure, as the fund manager also acknowledges, "high demands on public transparency... may put additional constraints on our management of the fund". Even so, the impression is that the manager's approach is about as conventional as 'big-ticket' fund management gets and that may be partly because in Norway the fund - by dint of its size and its common ownership - remains controversial.

True, the fund does carry a load of ethical constraints. Thus it maintains a list of companies in which it won't invest - currently about 120; this includes a block of 52 coal-processing companies that were excluded at the start of this year. Some of the 120 are well-known names. Predictably, there is British American Tobacco (BATS) and Imperial Brands (IMB) for tobacco processing. The UK's Serco (SRP) is there for "producing nuclear weapons", as are Boeing (US:BA) and Airbus (Euronext:EAD). Wal-Mart Stores (US:WMT), the world's biggest company by revenue, is black-marked for violation of human rights, as is miner Rio Tinto (RIO) for causing environmental damage.

 

Table 6: Top 10 holdings by market value
	Sector	Value (£bn)	Stake (%)
Nestlé	Consumer goods	4.73	2.43
Apple	Technology	3.85	0.81
Roche	Healthcare	3.24	1.66
Novartis	Healthcare	3.14	1.65
Alphabet	Technology	2.82	0.65
Microsoft	Technology	2.82	0.78
BlackRock	Financials	2.59	5.59
HSBC	Financials	2.52	1.98
Royal Dutch Shell	Oil & gas	2.42	2.01
Prudential	Financials	2.33	4.89

 

Table 7: Top 10 Holdings by stake
	Sector	Value (£m)	Stake (%)
Great Portland Estates	Financials	331	9.62
Gecina	Financials	602	9.54
Shaftesbury	Financials	289	9.4
Smurfit Kappa	Industrials	451	9.16
Vonovia	Financials	926	7.82
UPM-Kymmene	Basic materials	630	7.69
Capital & Counties Prop's	Financials	342	7.63
Deutsche Wohnen	Financials	530	6.88
Cninsure	Financials	30	6.81
Linde	Basic materials	1,475	6.66

 

Not that these exclusions are necessarily a bad thing. Ethical considerations aside, their exclusion from the fund's benchmark index (as well as the fund) lowered its cumulative return by 1.2 percentage points in the period 2006-15, making it a slightly easier target to hit.

Even so, a different approach could produce better results. Sony Kapoor, who runs a London-based think-tank, Re-Define, has been a consistent critic of the way the Oil Fund is run. In a report for Norwegian Church Aid, he wrote that the fund's "sclerotic returns are the direct result of the Ministry of Finance's decision to invest more than 90 per cent of the portfolio in slow-growing mature economies". He says this means the fund is exposed to the "concentrated risks of ageing populations and over-indebtedness faced by mature economies", adding that "inadvertently (it has) taken on a lot of risk for very little return".

Granted, by being so heavily invested in listed securities the fund carries minimal amounts of so-called 'liquidity risk' (ie, being unable to sell holdings when markets panic). Yet this matters little to the fund since its long-term investment horizon and its apparently undemanding requirements for income mean it should never need to sell in a hurry. That being so, Mr Kapoor reckons the fund could do much better by focusing on three related areas where liquidity is unimportant - developing economies, venture capital and renewable energy.

In order to do this, the fund should be split into two, he suggests. One part will be a continuation of the fund as it is now. The other part - the new growth fund - will focus on developing economies via infrastructure projects and private equity deals. Only by doing that, he says, can the fund capture promising opportunities in developing countries. Mr Kapoor suggests that the growth fund should target $30bn (£24bn) of such investments each year with the aim of building a $200bn fund.

There are two further reasons why the fund should take this approach. First - and paradoxically - because its capital comes from Norway's oil and gas revenue, it already has a massive exposure to the fortunes of the conventional hydrocarbon industry. Why, therefore, does the fund have big investments in major oil companies? Royal Dutch Shell (RDSB), for example, is its second-biggest holding in the UK (see table 8) and its ninth biggest overall, while its £2.1bn investment in Exxon Mobil (US:XOM) is its 11th biggest holding. Such investments only concentrate risk.

The solution should be to dilute exposure to oil and gas by diversifying into renewable energy projects, which would become more valuable as the price of carbon emissions rose, exactly the opposite to what would happen to the price of, say, Royal Dutch shares. In addition, it would be sensible if the fund was better protected against meaningful government policies to tackle climate change, such as higher carbon taxes or tougher emissions quotas, since these would target many of the heavy industries in which the fund is invested. More exposure to renewables would do that.

Second, there is also a risk to its reputation that the Oil Fund must address - that one day it may be unacceptable for the fund to have holdings in companies that are perceived as 'polluters' in much the same way that the Oil Fund already prohibits itself from investing in big miners and users of thermal coal. Alternatively, it may become effectively obligatory for a sovereign wealth fund, such as Norway's, to have a requisite exposure to a broad spread of socially-responsible investments. The fund needs to address these risks now, before the potential to do damage becomes real.

But the reputational risk spreads wider than that, suggests Mr Kapoor. The leak of the so-called Panama Papers in May revealed that the Oil Fund had channelled some of its real-estate investments through tax havens in Luxemburg and Delaware and that it also has investments in companies that use tax havens. "We estimate that about 10 per cent of the fund's total investments are exposed to an aggressive use of tax havens and avoidance strategies that may not withstand full public scrutiny," said Mr Kapoor at the time.

Certainly, the run-ins between European tax authorities and Apple, Alphabet and Microsoft - all in the fund's 10 biggest holdings - are well known. For a body that is a guardian of public money and which takes its role as a responsible investor seriously, these are delicate matters. Norwegian Church Aid suggests that the fund should add "aggressive tax avoidance" to "gross corruption" as a factor that prohibits investment in guilty companies.

 

Table 8: Top 10 UK holdings by value
	Sector	Value (£bn)	Stake (%)
HSBC	Financials	2.52	1.98
Royal Dutch Shell	Oil & gas	2.42	2.01
Prudential	Financials	2.33	4.89
GlaxoSmithKline	Healthcare	1.67	2.06
Lloyds Banking	Financials	1.61	2.56
SABMiller	Consumer goods	1.57	1.97
BG Group	Oil & gas	1.49	3.67
Vodafone	Telecommunications	1.43	2.02
BP	Oil & gas	1.42	1.81
Barclays	Financials	1.30	2.93

 

Table 9: Top 10 UK holdings by stake
	Sector	Value (£m)	Stake (%)
Great Portland Estates	Real estate	331	9.62
Shaftesbury	Real estate	289	9.4
Capital & Counties Prop's	Real estate	342	7.63
Land Securities	Real estate	726	6.45
Telecity	Technology	195	6.33
Tesco	Consumer services	918	6.24
British Land	Real estate	608	6.23
Derwent London	Real estate	289	5.86
Balfour Beatty	Industrials	124	5.51
Prudential	Financials	2,325	4.89

 

The fund does not respond directly to such things. But it does listen and, for example, in December it published discussion notes both on investing in renewable energy and in infrastructure in developing economies. Both papers were sensible, informative and restrained - and absolutely non-committal. Yet it would be no surprise if, eventually, the fund did extend its remit to invest in such things. Come to that, in future it may become a more active investor, might develop its own venture capital arm, might even become the sole owner of projects that produce annuity-style returns.

All these things are logical and possible. Just don't expect them to happen anytime soon. That's how it is with the Norwegian Government Pension Fund Global - it's big; it moves slowly and it turns about as easily as a supertanker in a fiord.