The idea of a country establishing an investment portfolio with the proceeds of a temporary revenue stream is nothing new. It is the model used by many sovereign asset managers around the world, such as those of Norway and the Gulf economies. In such economies, the revenue stream from extraction of natural resources (notably, oil and gas) is not expected to be permanent, so the intention is to build up a fund for when the resource revenue declines and, eventually, dries up. In Norway, for example, around half of oil reserves have been extracted over the last fifty years and, if extraction continues at the same pace, the reserves are expected to last only another fifty years.1 There are, however, different ways in which the accumulated assets can be used by sovereign asset managers.
Sovereign asset managers can be seen as falling into one of five broad categories:2 investment sovereigns (which do not have liabilities), liability sovereigns (which have liabilities either currently or in the future), liquidity sovereigns (normally commodity exporters which seek to manage assets to stimulate their economies during a commodity downturn), development sovereigns (which seek to drive local economic growth) and central banks (which have historically concentrated on the management of foreign exchange reserves but have taken on a greater role as sovereign asset managers in recent years).
The Norwegian sovereign wealth fund, for example, is currently both a liability sovereign (as it has future liabilities) and a liquidity sovereign (as short-term economic management is its secondary goal). In the early days of oil and gas extraction, however, the proceeds were used primarily to develop the economy: it was a development sovereign. In 1996, the Norwegian oil fund was established. On behalf of the Ministry of Finance, the fund is managed by Norges Bank (Norway’s central bank), and it is now one of the largest sovereign wealth funds in the world, owning around 1% (by value) of listed global equities.
Diversifying oil with style
One important issue facing an oil (or other resource)- rich economy is that global economic growth and inflation, and hence developments in asset prices, are often closely correlated with the oil price. As a case in point, two recent oil shocks, both of which saw oil prices fall by 76%, have been accompanied by sharp falls in equity markets: in the second half of 2008, the peak-to-trough decline in oil prices was from USD 145.6 to USD 34.6, representing a -76% change. At the same time, the MSCI World index lost 34% of its value and the nominal yield of US 10-year Treasuries shrank by 175 bps to 2.19%. The second major oil price collapse lasted from 19 June 2014 to 20 January 2016 with another -76% change (from USD 115.5 to USD 27.8). Over that period, the MSCI World index fell 14% and US 10-year nominal yields declined by 54 bps. This raises a concern that achieving diversification of oil exposure by investing in market factors such as equity and credit may be far from optimal. Of course, government bond investments are a natural candidate to diversify all of the above asset classes. Yet their associated absolute return proposition is weaker given the prevailing low yield environment.
To thoroughly address the question of diversifying exposure to oil, one needs to combine major sources of risk and return that permeate capital markets and determine the pricing of assets. In this vein, market factors related to equity and credit, duration or commodity risk are obvious contributors to any global multi-asset risk model. In complementing this set of factors, the literature has put forward the notion of style factors that help explain the crosssection of many asset classes. Figure 1 features four equity style factors, including quality, value, momentum and low volatility. By design, these style factors invest according to firm characteristics that are ultimately associated with distinct return patterns. All considered, style factors are long-short factors and thus do not carry significant equity market risk.
For instance, value investing looks to buy relatively cheap securities while selling more expensive ones, often leading to a pro-cyclical return profile. Conversely, momentum investing rests on the observation that past price trends tend to continue. Consequently, momentum strategies are far more active when seeking to capitalize the price differential between winner and loser stocks. Given the return profiles of these two salient style factors (value and momentum), one may ask which other factors could act as more natural diversifiers with respect to significant equity or commodity risk exposure. In this regard, quality investing looks to invest in companies that excel in terms of a number of metrics associated with high balance sheet quality. A related, yet distinct, route is to directly enforce a defensive low risk profile by focusing on low volatility names. Additionally, shorting the broad market then allows capitalizing the low volatility effect, which relates to the empirical evidence of risk-adjusted outperformance of low volatility companies. Both defensive style factors, quality and low volatility, tend to be particularly strong when broad equity markets suffer.