Lessons from Norway

Norway's economy was transformed in the 1970s with the discovery of large oil deposits in the North Sea. Norwegians have a well-deserved reputation for sound stewardship of their oil wealth, which has led to the creation of one of the world's largest sovereign wealth funds. This fund is a sophisticated market participant with ample resources to hire the best investment talent money can buy. Factor in the traditional Scandinavian virtues of thrift and insightful analysis, and the fund appears well-positioned to achieve its stated goal to be "the best managed fund in the world." However, the fund performed poorly relative to its benchmarks in 2008, which prompted the Norwegian Ministry of Finance to hire an international team of experts to investigate. The results were published in a 220-page document that provides a detailed analysis of the fund's approach to investing. ¹

The Norwegian sovereign wealth fund has an internal staff that outsources its investing duties to a carefully vetted group of money managers, each hired to invest in specific asset class. All of these managers are active investors, meaning that they strive to outperform their relevant benchmarks through security selection or market timing. This differs from a passive approach, in which money managers are content to capture market returns, usually through the use of index funds.

Interestingly, the Norwegian fund, despite having its assets managed by active managers, was found by the outside experts to function, in aggregate, like a giant index fund. Over 99% of the fund's performance could be explained simply by its asset allocation. Even the 0.9% of the fund's performance that was attributable to active management could be largely explained by exposure to systematic risk factors, such as liquidity and volatility, rather than the skill of the individual active investment managers. In other words, approximately the same performance could have been achieved simply by holding passively managed funds (i.e., index funds) in similar proportions to the active managers' holdings.

The main lesson here is that investment performance is primarily determined by portfolio structure. Asset allocation has a much greater effect on future returns than the decision to invest actively or passively. If you do choose active management, you have to work awfully hard to derive even the smallest benefit. The Norwegian fund hired the most highly regarded active managers and negotiated the lowest possible fees for their services, yet it was difficult to attribute any durable advantage to their approach. Active management is not an attractive option for our clients because its higher costs and lower tax efficiency would quickly negate any potential incremental gain in performance. By eschewing active management, we can focus on things that add value for our clients, such as sound asset allocation, tax efficiency, and minimizing expenses.

Please feel free to contact me at any time if you have any questions or comments.

Jeffrey J. Brown, MD CFA

¹Ang A, Goetzmann WN, Schafer SM. Evaluation of active management of the Norwegian government pension fund - global. Research paper, December 2009. (http://www.regjeringen.no/upload/FIN/Statens%20pensjonsfond/rapporter/AGS%20Report.pdf)

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