NBIM, ‘Alternative Investments’ and so-called superior returns

We’ve previously endorsed the Norwegian Government Pension Fund’s  (GPF) approach to enhancing global corporate governance. Recently, NBIM – the manager of the fund – was also instructed to allocate about five percent of its portfolio into unlisted real estate. I consider this  decision quite bad for the following reasons.

Property investments are notoriously illiquid. Currently the reserves of the GPF is used to cover the domestic fiscal budget deficit. As wee have recently seen, the deficit and need for fiscal expansive policy will usually be the highest when liquidity is the lowest. Illiquidity  implies below real value prices and as such NBIM will always be selling its real estate investments when prices are the worst (this is in a longer term perspective when oil revenues are actually smaller than the budget deficit)

It was the Yale endowment fund under management by David Swensen that started advocating that long term investors such as the GPF should allocate more of its investments to illiquid assets or ‘alternative investments’ such as real estate because the should – theoretically – bring excess returns. Moreover since they are not fully correlated with other securities risk will be lowered. The empirical evidence for this is ambiguous at least.  Yale’s endowment fund ant others following similar strategies suffered heavy losses during the crisis of 07-09, forcing colleges like Harvard and Princeton to cut back on spending and research. For a university with a more or less constant expenditure rate this is bad, for a country when expenditure has to be increased when the values of your investments fall, its worse. Even though alternative investments seem to deliver superior returns when the market is rising they do most probably not if one takes the whole market cycle into account and the correlation with other asset classes is surprisingly strong due to the systemic nature of the financial market. Even if two assets are not correlated at all, if the price of one collapses, leveraged investors of both will sell the other to cover their liabilities and index investors, just like NBIM, will also be forced to sell to maintain their previous ratio of investment. If the financial crisis has thought us one thing it is how incredibly close to 1 the correlation of most assets are in times of distress – and that’s what really matters.

NBIM should be allowed to focus on what it knows best; investing in bonds and stocks.