- Norway's government will let its oil fund raise equities' share to 70% from 60%
- Annual real-rate expectations are lowered to 3% from 4%
- In particular, bonds are foreseen to perform considerably worse than in the past
- Investors should investigate the arguments for these moves
- Once again, Norwegian funds might be source of inspiration for private investors
Nature has made Norway rich and beautiful - oil tanker
in front of Norwegian mountains. Photo: Shutterstock
By Clemens Bomsdorf
Take risks, but be prepared for when the good times are over – that’s basically how one could summarize the guideline update for the Norwegian oil fund, one of the most respected XL investment vehicles internationally .
“This will help ensure that future generations may also benefit from these revenues,” says prime minister Erna Solberg
We have already earlier argued that other long-term investors could take the oil fund as a blue print (click here to read the first
in our series of articles, continue here
). Hence the decision should be put under the microscope as the arguments for undertaking those steps are thought-provoking.
Annualised and annual return of the oil fund 1998-2016 (in %, click to enlarge)
Established in the mid 1990s, the fund takes care of Norway’s long-term wealth by investing the national oil and gas business’ profits in global financial markets. As of February 21, it had a volume of more than NOK7.5 trillion
, roughly EUR160,000 per head. It is managed by the Norwegian Central Bank's investment unit NBIM, which makes the daily investment decisions.
The central bank, Norges Bank, from time to time comes with suggestions as to how to optimise its guidelines.
Increasing equities' share in several steps
The recent move, to be presented to parliament at the end of March, is rooted in a submission by Norges Bank
, which had wished to increase the equity share in the portfolio to 75% (from currently 60%
) and suggested to decrease the expected annual real rate of return to 3% (from 4%).
The government announced it will increase the share of equity slightly less, to 70%, and to lower the expected annual real rate of return as demanded to 3%.You can see the full details on the government's website
Data source: Norges Bank, chart: Saxo Bank
These two measures represent a significant step showing that future yields are expected to be considerably lower than anticipated earlier.
The fund spreads its investments broadly and aims at being a rather passive investor, making not strategic, but financial investments (again, read our earlier series
on the fund to learn more).
Hence, it does not expect to really do better than the market. Intentionally decreasing its expected real rate of return by a quarter can therefore only be seen as a quite clear scepticism towards broad future market gains.
The not so bright future of bonds and real rates
“The yield on inflation-linked bonds is a good indicator of the expected real return on virtually risk-free bonds. Since 2006, the yield on these bonds has fallen by almost 3 percentage points,” states the submission by Norges Bank
only to later conclude “[b]ased on our analyses, we estimate an expected average annual real bond return of 0.25% on a ten-year horizon and 0.75%on a 30-year horizon.” Read this article
to become aware of the low level of real rates also earlier.
Reminder of a stock chart: Monica Bonvicini's art work "She lies"
in the Oslo Fjord, close to the renowned Opera. Photo: Shutterstock
An investment mix consisting of 40% bonds and 60% equities would hence lead to an annual real rate of return of 2.1% within 10 years and 2.6% within 30 years, i.e. equities are assumed to perform 3 percentage points better at 3.25% and 3.75% p.a. respectively. (Norges Bank calculates with a 40% share of bonds. However, one should keep in mind that it already nowadays aims at investing only 35%-40% in fixed income and an additional up to 5% in real estate.
An increase of the share of equities in the portfolio to 75% as suggested should lead to 2.5% average annual real rate of return for a 10-year period and 3% for a 30-year period, according to the submission. Though the government only wants to include the share of equities to 70% it still sees a 3% real annual return.
Lowering expectations to only 3% annually
Obviously every investor with a similar horizon, i.e. long term, and similar investment strategy, i.e. internationally and almost solely equity and fixed income, as the Norwegian oil fund (see in particular this article
to find out how surprisingly similar private investors can be to the largest sovereign wealth fund) should think about how to learn from the Norwegian changes.
The Norwegian reasoning as such could give food for thought for all kind of investors as it comes with clear indications about how they view the markets’ future.
This is how the Norwegian Finance Ministry sees the
“Returns in financial markets also vary more over time than other revenues. With the current size of the oil fund, fluctuations in the value of the fund may be considerable from one year to the next. Fiscal policy and the Norwegian economy must be shielded from these fluctuations in the years ahead,” he says, adding that “[c]ombined with high oil prices and healthy returns, the fiscal rule has brought considerable fiscal leeway.“
What the hell is handlingsregelen?
And what is the fiscal rule, or handlingsregelen as it is in Norwegian? Introduced by former prime minister and now Nato head Jens Stoltenberg, it says that the government’s use of the fund for budgetary issues is restricted.
“Petroleum revenues are gradually phased into the economy, approximately in pace with the expected real return on the Government Petroleum Fund”, stated a white paper
. The expected real return rate was then seen at 4%, but definitely one then did not foresee how much the fund would grow as the oil price during some periods was extremely high.
This fiscal or budgetary rule was also applied to keep inflation down, something a private investor usually does not have to worry about when thinking about how to spend his money (well, the likes of Bill Gates or Warren Buffet might be excluded here).
What the head of Nato knows about finance
What should be considered by everybody though will be outlined below.
Before getting to this, let’s make clear one general difference (despite all the similarities) between a private investor's depot and the oil fund. The latter is fueled by revenues from the resource sector – the money put in the oil fund should be compared to the profit (usually steaming from labour income) a private person invests for long-term reasons. At the same time the Norwegian government may annually spent 4% (in the future 3%) of the fund’s value.
A private investor that invests long term usually would not tap into his fund while at the same time paying into it. Extraordinary gains or circumstances might, however, make people deviate from that rule. Also of course those that have saved for retirement and now want to fuel their pension spendings with their fund equivalent would act like that (and usually not paying anything in any longer, but just tapping into it).
When Jens Stoltenberg, now head of Nato, governed Norway
he introduced the fiscal rule for the oil fund. Photo: Shutterstock
And now for two issues:
1. If returns get lower, the possible money that could be spent by not re-investing the real return decreases. In Norway, thanks to the healthy development of the fund, the government has increased its oil spending to 8% of GDP (while still sticking to the fiscal rule).
Lesson to learn: Having got used to such high inflows, it might become difficult to adapt spending behaviour if the annual return plunges.
2. The risk of a considerable decrease of the funds' value soars with the level of spending (and to a lesser extent the equity share). Olsen sees the likelihood for a 50% fall within 10 years rising by 200%.
“The yellow bars illustrate a scenario where oil revenue spending in the initial year increases to 4% – a familiar figure. In that case, the risk of having to draw down the fund increases considerably. The probability of a 50% decline in the fund increases threefold,” he says.
Lesson to learn: A (higher) spending naturally reduces the fund’s volume. In case of a plunge in share prices, it adds to the value decrease.
Olsen's warning is probably meant for smaller coalition partner FrP which would like to spend more of Norway’s oil money.
Hey big spender (but it might not last)
“My main message concerning this issue [is that] first, fiscal policy must be decoupled from financial assets subject to considerable volatility. Second, it would be unwise to increase oil revenue spending from today’s level even if the fund continues to grow,” he says.
For private investors takeaways are much less strict:
First, you should only increase your consumption with (unexpectedly high) gains from financial investments if you are prepared to accept the future could bring lower returns and a subsequent decrease in your spending power.
Second, if you regularly take out a fixed percentage from your investments as a long-term investor be aware that increasing this rate comes with a higher risk of the fund losing value during volatility. This particularly applies to the retired that are still long-term dependent on the fund and whether they want to keep its volume stable – for example in order to hand on money to children or charity.
Work and labour income are comparable to the
Norwegian resources still in the ground. Photo: Shutterstock
We could add a third piece of advice, which actually should be the first step when planning your investments: Just as the Norwegian oil fund does, you establish a budgetary rule and define whether you want to spend financial gains (which would mean the investment is not solely long term anymore) and if so define which share of the funds value you want to use annually (the higher it is, the lower will be potential future gains).
You could also, like Norway, define a percentage and add a fixed maximum (or one in relation to an annual income) - that would stop you from tapping into the fund too much when it gets really large. In the case of Norway, such rule could for example have said that while 4% might be taken from the fund annually, the value must never exceed 5% of GDP.
Don't underestimate your work income and its potential volatility
One thing should not be forgotten. As Norway still has resources in the ground, also their assumed value plays a role when it comes to investing the oil money.
“Changes in Norway’s overall petroleum wealth also warrant a lower allocation to bonds. Apart from the oil fund, this wealth consists of oil and gas still in the ground. There has always been a considerable risk from having a large share of the nation’s wealth linked to a single commodity," says Olsen. " But this share has fallen. Only a decade ago, oil and gas reserves made up two-thirds of Norway’s petroleum wealth."
"Today that share has dropped to about a third. Our aggregate wealth has become more diversified, which means we can tolerate slightly higher volatility in our financial wealth.”
Similarly every investor still drawing a work income should keep in mind that the money he deals with is not all he has. Future income will usually also be labour income. Taking into consideration that its value can change as well with job shifts, unemployment, sabbatical leave and so on is important, too.
Morning has broken in Kirkenes, Northern Norway. Photo: Shutterstock