Norway’s approach to wealth management has served the country well. Should Parliament increase the equity share of the reference portfolio of the “Oil Fund”?
KNOWLEDGE @BI: Norway's sovereign wealth fund
The economic gains from the establishment of the Norwegian ‘Oil Fund’, have come from applying core insights to improve the risk-return trade-off for the nation’s total wealth.
A government-appointed committee with two BI professors presented its recommendations for the strategy of the fund on Tuesday October 18th 2016. Here is an abridged version of a VoxEU.org column written by Espen Henriksen to summarize the report.
The Norwegian sovereign wealth fund (the GPFG or, colloquially, “the Oil Fund”) is the world’s largest at more than USD 850Bn.
A committee appointed by the government (“The Mork Committee”) presented its recommendations on the composition of the strategic reference portfolio on Tuesday October 18th, 2016.
The economic gains from the establishment of the Norwegian sovereign wealth fund have come from applying core insights to improve the risk-return trade-off for the nation’s total wealth. This has facilitated high and stable public and private consumption and investments, and it testifies to the soundness of the accumulated body of research in financial economics. The committee’s recommendations for the strategy of the GPFG going forward built on the same core principles.
The committee analyzed the bond-equity allocation of the financial portfolio in light of:
- the asset side of the national balance sheet;
- the liability side of the national balance sheet, in particular government expenditures;
- risk premia in financial markets; and
- political experiences handling idiosyncratic and systematic risks
The asset side
The committee focused a subset of the asset side: the combined financial wealth outside Norway and outstanding oil and gas reserves. The remaining oil and gas reserves have been substantially reduced in the last ten years since the last assessment of the bond-equity allocation.
Since a globally diversified portfolio of equities and bonds is much less risky than the value of oil and gas reserves, the risk associated with financial wealth and oil and gas reserves combined, has been reduced.
Conditional on the assumption that the current allocation was optimal when that decision was made, then the bond share of the financial portfolio should be decreased and the equity share should be increased.
The liability side
The liability side of the sovereign wealth fund is the net present value of future private and government expenditures. Since the unconditional expected rate of return of the financial fund is channeled into the domestic economy through an annual transfer to the government, the level and dynamics of government revenues and expenditures are particularly important.
Everything else equal, the equity share of the financial portfolio should decrease in share of the government’s budget financed transfers from the fund. Today, almost one-sixth of government budgets are covered by the transfer from the sovereign wealth fund. This is a much larger fraction than ten years ago.
Conditional on the assumption that the current allocation was optimal when that allocation decision was made and the spending rule is unchanged, then the equity share of the financial portfolio should be decreased and the bond share should be increased.
Expected returns on any portfolio may be decomposed into a risk free component and expected compensation for risk exposure. The expected rate of return of the current reference portfolio has declined as a result a declining interest rates.
Changes in expected returns due to changes in the risk free rate should not have any implication for risk taking and hence the bond-equity allocation. Excessive risk taking in search for yield is a grave fallacy.
Idiosyncratic and systematic risks
Rigorous systematic strategies based on the accumulated body of financial knowledge have not only delivered a constrained-optimal risk-return trade off. It is also profoundly democratic since it is based on open, non-rival knowledge, which may be anchored with all constituencies. The committee’s report is an example of this.
Further, insignificant exposure to opaque markets and unlisted assets and low idiosyncratic, operational risk allow for higher systematic market risk and a higher equity share than what would otherwise have been advisable.
The committee agreed on the analysis, but was split in its recommendation. Both the agreement and disagreement are instructive and strengthen the report.
The disagreement highlights a crucial insight and one of the most important challenges going forward. The entire committee agrees that fiscal policy must be adapted to the fact that an increasingly share of government budgets will be financed by returns of volatile financial wealth.
The majority believes that such changes in fiscal policy are feasible and recommends to increase the equity share to 70 percent. A minority of the committee believes that such changes in fiscal policy are less likely and hence recommends to decrease the equity share to 50 percent.
This underscores the crucial insight from financial economics that spending decisions and allocation decisions should be considered in conjunction. It communicates to the politicians that they ought to approach fiscal policy and financial portfolio composition as a joint decision.
This article is an abridged version of a VoxEU.org column published on on October 18th, 2016.
VoxEU.org – Centre for Economic Policy Research's (CEPR's) policy portal – was set up in June 2007 to promote "research-based policy analysis and commentary by leading economists".