How Norway’s SWF Plans to Benchmark Real Assets

The world’s biggest sovereign wealth fund has published proposals to overhaul its benchmarking process in preparation for entering infrastructure markets for the first time.

Norges Bank Investment Management (NBIM), which runs the $846 billion Norwegian Government Pension Fund—Global, has also formally recommended that the country’s finance ministry permit doubling the SWF’s real estate allocation and buy infrastructure assets.

“The index represents a strategy that the manager is expected to depart from if this helps improve the trade-off between expected risk and return.”“The benchmark model is not well-suited to the fund’s investments in unlisted assets,” NBIM wrote in its submission to the ministry. “NBIM’s proposed changes aim to address the challenges this presents, while also retaining the key features of the current division of responsibility between the ministry and NBIM.”

Currently, the fund’s equity and bond allocations are benchmarked to major indexes, but its direct investments in property do not have a formal performance comparator.

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Under the new proposals, NBIM would remove its fixed 5% allocation to unlisted assets. Instead, it would adopt a “holistic” approach, measuring risk and return for the whole portfolio relative to a benchmark of equity and bond indexes.

Citing similar approaches by top-tier pension and sovereign funds—including the Canada Pension Plan Investment Board, Singapore’s GIC, and the New Zealand Superannuation fund—NBIM said this would allow the performance of unlisted assets to be measured on excess return above a simple equity/bond split.

“The benchmark is no longer a strategy that the manager is expected to follow closely, but—through the size of the equity allocation—an indirect expression of the owner’s tolerance of variations in returns,” NBIM explained in its submission. “In this model, the index represents a strategy that the manager is expected to depart from if this helps improve the trade-off between expected risk and return in the portfolio.”

NBIM added that “only small adjustments” to its systems would be necessary to adopt the new approach.

In separate submissions to the Norwegian ministry of finance, NBIM recommended doubling its target allocation to real estate to 10%, with the ability to vary this by up to 5 percentage points above or below the target. It plans to reduce fixed-income investments to facilitate the move, should it be approved. Within this 10% target, NBIM proposed including infrastructure investments.

The formal request follows research published by NBIM last month, which made the investment case for a real estate allocation of up to 15% of its portfolio.

Don’t give up on risk parity just yet, argued Cliff Asness in his latest blog post.

The AQR founder defended the recently maligned strategy, explaining away recent performance as part of normal market movements.

“This has been a long and painful relative period for risk parity,” Asness wrote. “But it has not been one that’s historically unprecedented or even unusual.”

Risk parity is designed to offer an edge over “a more traditional equity-dominated allocation,” Asness said, through superior diversification. But, he argued, “better diversification and a modestly higher Sharpe ratio does not always win.”

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Therefore, Asness wrote that it is important to keep a long-term perspective when examining performance. In absolute terms, Asness found that risk parity strategies have grown steadily since 1947, despite drawdowns along the way, with cumulative excess returns reaching 500% by 2015.

“Drawdowns in real life always seem to feel longer and induce more pain than you’d imagine looking back,” Asness wrote. “This is true for risk parity and all of investing.”

Risk parity’s relative performance compared with a 60/40 allocation was less stellar, but still positive, due to “better diversification, in particular making assets like bonds and commodities count as much, but not more than, equities,” Asness wrote.

Recent losses, meanwhile, were caused by a strong equity bull market, a sharp downturn in commodities, and the superiority of US stock market performance over the global equity portfolio implemented by risk parity approaches.

“While recent times have been difficult versus history and versus the zero line, they are well within the bounds of historical experience,” Asness wrote. “While we certainly wish recent times were better for strategic risk parity, we don’t see any evidence that would change our long-term view.”

While it may be challenging to hold onto what seems to be a losing strategy, Asness argued that investors need a better reason to deviate than the realization of “painful results that we, unfortunately, expect to see from time to time.”

“Deciding what is reasonable, allocating to it, then sticking with it… is one of the hardest but most important parts of our jobs,” Asness concluded.

asness risk parity Source: AQR’s “Putting Parity Into Perspective”