Ethics and investing

An opening remark (somewhat off-point, but so what)

The Norwegian sovereign wealth fund has a reputation for ethical conduct. Is this one of the reasons for making the report public? Ethics seem to be prevalent in many aspects of Norwegian society.

Norwegian coach Bjørnar Håkensmoen gave Sara Renner a ski pole after hers was broken when a competitor stepped on it during the cross country team sprint at the 2006 Winter Olympics. Norway's competitor ended up fourth, implying that this selfless act of sportsmanship may well have cost the Norwegian team a medal. Renner gave Håkensmoen a bottle of wine as a thank you, while other Canadians responded with phone calls and letters to the Norwegian Embassy. Canadian businessman Michael Page donated 8,000 cans of Maple Syrup to the Norwegian Olympic Committee to show his gratitude. Source: Wikipedia

Who is this Norwegian fund?

The Government Pension Fund - Global is a so-called sovereign wealth fund, that is to say a fund owned by a state (in this case, the state of Norway) that invests worldwide in financial assets for the ultimate benefit of the local population. On SWF’s, see Wikipedia ; there is an association of SWF’s. 
 
The sovereign wealth fund of Norway (the GPF) is the second largest in the world. Founded in 1990, it currently has assets of US$ 445 billion.

The mission of the GPF

SWFs are typically created when governments have budgetary surpluses and have little or no international debt. This excess liquidity is not always possible or desirable to hold as money or to channel it into consumption immediately. This is especially the case when a nation depends on raw material exports like oil, copper or diamonds. SWFs may be created to reduce the volatility of government revenues, to counter the boom-bust cycles' adverse effect on government spending and the national economy, or to build up savings for future generations. One such fund is the Government Pension Fund of Norway.Source: Wikipedia
 
Why a review of its governance?

Since its inception the fund has been looking for good returns while also following ethical principles, an approach uncommon for most return-hungry bottom-line focused institutional investors. But the 2008 financial crisis severely shook the fund:

In the years before the crisis, making the world a nicer place was not at odds with making money. The fund comfortably beat the investment benchmarks set for it by Norway’s government. But that all came to a crashing halt in 2008, when the fund’s value slumped by almost a quarter; its equity holdings dropped by around 40%. The absolute fall was no worse than those of many other large investors, yet it prompted soul-searching in Norway. This was partly because losses were far larger than expected for what was thought to be a low-risk investment strategy, and partly because the fund had made some ill-timed bets on banks, including Lehman Brothers. Source: The Economist

It is in this context that three finance professors, from Columbia, London Business School and Yale, received their mandate from the Ministry of Finance of Norway. On the status of the review of the governance of the fund, see the website of the Ministry of Finance.

Issues addressed in the report

The report doc.1548, to properly assess the fund manager's performance, found it necessary to review the basic issues of modern portfolio investment:

Is the market efficient?

The report gives an easy to read definition of the of the efficient market theory, before later examining the validity of the theory in practice.

In simple terms, the Efficient Market Theory asserts that, at all times, the price of a security reflects all available information about its fundamental value. A consequence of the theory is that, if true, it is impossible for an investment manager – and hence the clients of the manager – to consistently beat the market. The underlying principle driving the EMH is elegant and intuitive. In a large, active marketplace for publicly traded securities, vigorous competition among scores of investors will drive speculative profits to zero. The implication of the EMH for investors is that, to the extent that speculative trading is costly, speculation must be a loser’s game. Hence, an indexing strategy is bound to eventually beat a strategy that uses active management; where active management is characterized as trading that seeks to exploit mispriced assets. In the world of the EMH, there are no mispriced assets because the invisible hand of the marketplace moves faster than any single agent.p.27

Active asset management: can really beat the market?

The report provides, again in easy to understand terms, a definition of active asset management, and later reviews whether it is economically worthwhile to pursue it.

We define active management in terms of two decisions. First, the
decision to deviate from long term strategic loadings on factors (e.g. a temporary shift from the target allocation to equities) and second, the decision to hold securities in weights that differ from factor benchmark weights. These roughly correspond to timing and selection, where the default, or the baseline case, is determined by factor portfolios. P. 106

The Ministry of Finance of Norway also retained Mercer doc.1549 to conduct a survey of the use of active management among other major institutional investors. The Mercer report gives a more precise definition of active management:

Active management is an approach to investment management which aims to outperform a particular market index or benchmark. The belief underlying the approach is that a) parts of the benchmark (for example, a sector or a stock) are "mis-priced" (being "too cheap" or "too expensive" relative to its equilibrium value) and b) that the investor has superior insight that allows it to profit from such mis­pricing net of costs. P.5

Lessons in active management: are they different for the institutional investor and individual investor

This last subject is the most interesting and most relevant part of the report for the individual investor. The assessment of the skill investment and approach of the GPF investment manager is of secondary interest to us (of course you are welcomed to read the full report as it is the main purpose of the report).