Interview with Professor Collin-Dufresne

Question: Like sovereign wealth funds elsewhere, Norway's fund has been upping its real estate portfolio over recent months. The fund also invests in 9,000 companies and has investments in 75 countries, according to its website. Should modern financial techniques be used to allocate resources that come from oil?

Answer PCD: Clearly, modern asset allocation techniques can help the fund achieve some target expected return while minimizing risks. The fact that much of its future resources come from oil should also affect how the fund invests its resources. The most common assets for investors include stocks, bonds, cash and alternative investments such as commodities, real estate, and currencies. The main insight of modern portfolio theory is that one should seek to hold as broad and diversified a portfolio as possible.

Question: Should sovereign funds be managed in a similar way as any other kind of portfolio?

Answer PCD: In many ways they should. However, these funds also have some specificities. First, they expect to receive future endowments, which are often tied to natural resources or to a country’s GDP. This means these funds have an implicit risk-exposure that should be managed. Second, these funds may have some desired consumption targets, either because of known fixed pension liabilities, inherited habits, or desired infrastructure funding, for example. These imply some potential liability management component to the allocation decision. Third, these funds tend to have a longer horizon than most investors, which implies that the risk-bearing capacity of these funds may differ from that of the rest of the market. Fourth, these funds tend to be very large, which implies that rebalancing is more likely to generate price impact, i.e. larger trading costs. All these features have to be taken into account when choosing an optimal portfolio for a SWF.

Question: Currently the Norwegian government targets a 60/40 equity/bond allocation for the GPFG fund and 4% annual consumption. Do you find this target optimal?

Answer PCD: In general, I think it is very good that Norway adopts clear and transparent rules for their target allocation. Leaving it to the discretion of one or a few people would be fraught with many pitfalls. The 60/40 rebalancing rule has proved to be very profitable for the fund as it helped them rebalance and benefit from the rebound in equity markets after the crisis.

This 60/40 target is also optimal under certain assumptions. Unfortunately, these assumptions do not match well the situation of the fund.

As an example, the current portfolio strategy ignores the future endowments to the fund, which in Norway, are tied to the country’s future oil revenues. This has two consequences for the allocation decision. First, the fund should compute its desired target for its financial wealth in terms of its desired exposure for its total wealth, where total wealth is defined as the sum of its financial wealth and the present value of its future income. By some estimates the latter component is more than one third of the total wealth. Clearly, if the present value of future labor income was risk-free, i.e., “cash-like,” then this implies the fund already holds 1/3 of its total wealth in cash. To achieve a 60 percent exposure to equity for its total wealth, its desired target in its financial wealth should actually be 90 percent (since 2/3*90%=60%)!

Second, since these future expected inflows are not risk-free but tied to the country’s oil revenues, the fund actually has an implicit exposure to oil and stock markets that should affect the target portfolio choice for the financial wealth.

Simply put, if one third of the fund’s total wealth is highly correlated to oil prices, then it seems sensible to reduce the allocation in the target portfolio to the oil sector. Their current target allocation rule does not take these elements into account. 

Question: The Norwegian sovereign fund has participation in almost all Swiss companies listed in the stock exchange and the GIC funds of Singapore owns 9% of UBS. These sovereign funds have more control on companies and their vote has real consequences. The Norwegian funds rejected Julius Baer’s remuneration plan and more recently the shareholders of the French Company Renault declined the remuneration package of Carlos Ghosn (CEO). Should we be concerned by the expansion of these sovereign funds and by the fact that they increase the acquisition of a stake in worldwide companies?

Answer PCD: The recent crisis has to large extent been a failure of corporate governance. In a world, where all investors hold diversified portfolios, no-one has a sufficiently vested interest in exercising corporate governance, but free-rides on the hopes someone else will do the job. This coordination problem has contributed to the lack of discipline imposed on firms’ management. In that sense it is a good thing if SWF hold large toe-holds in companies and decide to be actively involved in governance. It is also fitting that these SWF have a long investment horizon and thus that their actions might help with the so-called “short-termism” of markets. However, one has to be careful that this governance is exercised with sufficient independence from political powers, which might otherwise introduce other unwelcome distorsions for the economy.

Question – Saudi Arabia would like to increase its current new sovereign fund to $2000 billion. With this amount, this country would control 10% of the investment capacity of the world. Since Saudi Arabia gets its significant income from oil like Norway, should the government have an investment strategy similar to the Norway ones?

Answer PCD: Like Norway, Saudi Arabia is an oil-exporting country, and this raises a number of issues for its economic policy. In fact, Saudi Arabia has most of its human capital investment concentrated in petroleum-related industries. In addition the country’s economic structure is highly dependent on natural resources that do not require skilled labor, making economic growth highly vulnerable to fluctuations in the demand and pricing for these natural resources. Therefore, even more than Norway, the new Sovereign fund of Saudi Arabia should gear its efforts toward hedging against dependence on petroleum revenue, and think hard about its objective function and risk-bearing capacity.