The dilemma of Norwegian sovereign wealth funds


Norway has the largest sovereign wealth fund in the world with some $1.4 trillion in assets under management. That’s $244,000 for every man, woman and child in this country of 5.4 million people. Lucky Norwegians! Its official name is Government Pension Fund Global and it is managed by Norges Bank Investment Management (NBIM), which is part of the Norwegian Central Bank. The NBIM falls under the Ministry of Finance (MoF). In 2021, the fund posted a return of 14.5% for $177 billion, the second highest return ever.

On August 10, 2021, the Department of Finance issued a mandate for a review of NBAM’s active management strategy. This review was conducted by Prof. Rob Bauer from Maastricht University and the European Center for Sustainable Finance (ECCE), Prof. Charlotte Christiansen from Aarhus University-CREATES and Prof. Trond Døskeland from the Norwegian School of Economics. On January 10, 2021, they published “A Review of the Active Management of Norway’s Government Pension Fund Global”. This 117-page in-depth analysis with a clear set of recommendations was delivered to MOF on January 3, 2022. When asked why this group decided to take on this assignment, Døskeland explained that “NBIM has a fiduciary responsibility to generate returns for its beneficiaries. At the same time, due to its size and influence, it also has a responsibility to influence corporate behavior in a way that ensures it will be able to do so in the long term. It invests in more than 9,000 companies around the world and is well placed to do so. Amanda White of top1000funds wrote an excellent summary of the report.

This mandate followed a December 19, 2021 letter sent by NBIM to the Ministry of Finance which endorsed the recommendation of an expert group “that Norges Bank’s responsible investment be assigned an overall long-term objective of zero net issue of the companies in which the fund is invested. Norges Bank supports such a goal. There is the notable irony that the source of NBIM’s money is the lucrative Norwegian oil fields discovered off their coast in 1969. The Ministry of Finance has yet to respond to the panel’s recommendations. In the meantime, NBIM is not a member of Climate Action 100+ (a global group of 615 investors with $60 trillion in assets under management fighting climate change) or the Net Asset Owners Alliance. -Zero convened by the UN (69 members with $10.4 trillion in assets under management). .

The letter also stated that “active ownership is singled out by the panel as the most important tool for addressing climate risk in the fund. Norges Bank shares this view. The ownership activities go directly to the fund’s main source of climate risk, which is the companies in which we invest. The expert panel realized the obvious fact that a fund of this size cannot achieve net zero by simply divesting from high carbon emitting companies. That said, NBIM yields and excludes based on certain sectors (e.g. tobacco, nuclear weapons, cluster munitions and anti-personnel landmines) and company-specific ESG criteria (e.g. ethics, human rights abuses and flagrant corruption).

One of the issues I found particularly interesting in the report is that the authors highlight a potential conflict of interest between active ownership and active returns. An active portfolio manager who is underweight a stock (i.e. short relative to the benchmark) loses when the commit succeeds.

As an illustration, the report gives the hypothetical example of NBIM engaging with a chemical company to improve its environmental management system to encourage the company to be better prepared for future legislative changes. If the engagement is successful, it can have a positive impact on the company’s share price in the long run, especially if done in coordination with other institutional investors. All investors in this company, including those who have not committed, will benefit from the rise in the share price. This shows that engagement is primarily targeting companies with upside potential on ESG topics (and potentially even beyond).

Now suppose that NBIM has invested in this chemical company, but with a weight lower than the reference weight. One reason could be that the stock picking team has doubts about the viability of its overall business model. A successful engagement with this company will increase the return of the Fund’s portfolio (all other things being equal), but the active return relative to the benchmark will be negatively affected because the weighting relative to the benchmark is negative. If the company performs well, it hurts the alpha and therefore the active return metric.

Of course, it is also possible that active management and active ownership are mutually reinforcing. For example, the active management team may think a fossil fuel company is a good buy, so they overweight the stock and the mission team succeeds in reducing the company’s carbon emissions. If this drives the stock price higher, active yields will benefit.

I have no idea of ​​the balance between conflicting situations and mutually reinforcing situations. I guess NBIM’s desire to reduce carbon emissions from its portfolio companies means there will be more firsts since climate change is a system-level problem that NBIM needs to address. Overall, to the extent that reducing carbon emissions improves a company’s long-term value proposition, the more effective NBIM is in driving its portfolio companies to net zero carbon emissions to ensure their long-term viability, the more difficult it will be to achieve active returns better than a benchmark. The report notes that “focusing on achieving long-term zero emissions goals may be at odds with fully utilizing the potential to reap active returns.”

To address this fundamental tension, the report offers this suggestion:

“The Ministry of Finance should clarify the mandate of NBIM regarding the objectives and prioritization of active ownership strategies, as well as clarity on what is delegated to NBIM and what is contained in its mandate. Especially in the case where an additional objective is defined (for example, long-term zero emissions objectives for the companies in the portfolio of the Fund), clarity on the governance and the objectives of the active ownership process is crucial.

Christiansen elaborated on this recommendation, noting: “The first step should be for the Ministry of Finance to decide if and how it will incorporate the recommendation of the climate panel into the mandate. He must then have an open discussion with NBIM about potential conflicts of interest. »

I would add to this the question of how performance is measured and evaluated in the different teams. If portfolio managers have substantial bonuses based on active returns and engagement teams receive them based on reduced carbon emissions, this conceptual conflict will manifest as internal conflict. What incentive does each team have to work with the other when pursuing goals that conflict with the other? I don’t know about NBIM’s compensation structure, but I’m sure they must be aware of it. I’ll see what I can find on this.

The report also makes two important points about the differences in the roles and the nature of the people who occupy them. First, he notes that “active management teams focus on stock selection” whereas an “active ownership strategy involves interaction with other stocks in the portfolio.” As a result, “active management teams are unlikely to have the same view of these companies as those in the largest active positions.”

On the second point, the knowledge, the state of mind and the culture of the people in each team are different. This makes it even more difficult to achieve the necessary integration in the management of potential conflict. NBIM needs to approach the problem conceptually, understand this integration challenge, and put the right incentives in place to succeed. But this internal integration is not enough. Bauer notes that “effective ownership strategies require close coordination with other institutional asset owners and senior executives with a long-term mindset and supportive culture.”

Hats off to the MoF for commissioning the NBIM Active Management Strategy Report. Congratulations to the authors of the report for a frank and constructive analysis. I look forward to hearing what the MoF decides to do with its recommendations.


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