Norges Bank’s active management of the Government Pension Fund Global

We refer to the Ministry’s letter of 31 August 2009 where Norges Bank is requested to submit analyses and assessments of active management as part of the supporting documentation to be presented to the Storting (Norwegian parliament) in spring 2010. The Ministry also requested that Norges Bank prepare a business plan building on the general advice and assessments the Bank makes. In this letter and the enclosure, we present Norges Bank’s view of active management and describe the key features of the strategy pursued by the Bank.

The Government Pension Fund Global is an important instrument of economic policy. It is important for stabilisation policy. When the state’s petroleum revenues are invested abroad through the fund, the Norwegian economy is shielded from the effects of fluctuations in oil prices. It also helps to give the country a more diverse industrial structure which is less dependent on petroleum activity. The fund makes it possible to transfer parts of the wealth held by the state in the form of petroleum resources into savings and investments in global financial markets. If, averaged over the business cycle, the state spends only the expected real return on the fund each year, future generations will also be able to benefit from this wealth. The Ministry has estimated the expected real return to be 4 per cent.

For a large, well diversified fund such as the Government Pension Fund Global, the expected return will depend on the desired level of risk. The single most important decision in the design of the strategy is the fund’s allocation to equities. The strategy established by the Ministry is based on an assessment of the fund’s long-term investment opportunities. The choice of a strategic allocation to equities of 60 per cent is believed to provide a solid return in the long term but also implies a relatively high tolerance of short-term fluctuations in return.

The Ministry expresses its long-term investment strategy through a detailed benchmark portfolio for the various asset classes in the fund. The choice of this benchmark portfolio largely determines the return the fund will generate over time.

Norges Bank’s role is to generate the highest possible return after costs within the constraints set by the mandate from the Ministry. Through our management of the fund, we aim to build a portfolio which achieves the best possible trade-off between expected return and risk. This is reflected both in the operational management of the fund and in the advice we give the Ministry on the fund’s investment strategy.

An active management strategy is predicated on time-varying investment opportunities in the markets. With time-varying investment opportunities, the benchmark portfolio will not represent the “correct” portfolio at any time. Norges Bank’s active decisions have a limited impact on the overall risk of the fund.  They do, however, aim to increase the return somewhat given the level of risk that the owner has decided to accept.

The fund’s owner and Norges Bank as operational manager have common interests. This is a particular strength of the management model for the Government Pension Fund Global. In financial markets there is often a conflict of interests between savers looking to make money on their investments and managers looking to make money from their clients. The Government Pension Fund Global’s owner has a long-term approach which makes it possible to establish an active investment strategy that sets us apart from the average investor. Stability in the regulatory framework makes it possible to sustain periods of unexpected movements in capital markets and large fluctuations in results.

The fund’s two most important distinguishing characteristics are its long-term investment horizon and its substantial size. In the enclosure, we show that active management can turn these characteristics to the fund’s advantage.
 
Norges Bank recognises that the performance of its management task requires a high level of ambition. Our goal is to safeguard and build financial wealth for future generations through a skilled investment management organisation.

Our management task can be divided into five parts. We invest new capital in the markets at the lowest possible cost. Once capital is invested in the markets, it needs to be managed in order to maintain the market portfolio in a cost-effective manner. We also attempt to increase the return through active investment decisions and through active ownership. Finally, we advise the Ministry on the long-term investment strategy for the fund. It is Norges Bank’s assessment that the mandate must include a stated objective of the highest possible return to ensure the best possible quality in the performance of all aspects of its management task.
 
When this objective is translated into expectations for managers, departments and individual employees, everyone will be required to contribute to raise the quality of the factor inputs into the management of the fund. The risk management and control functions are strengthened within such a framework, and we believe that, on balance, this reduces the operational risk of the management of the fund. An organisation that aims to be average will achieve mediocrity.

As a major shareholder in many companies, we have a responsibility to exercise our ownership rights appropriately. Successful active ownership must be based on the principles of good corporate governance. This is achieved through long-term dialogue with individual companies and builds on knowledge of each company’s operations and management structure. This knowledge is generated through our active investment management. The potential for results from active ownership increases with the quality and competence of our active investment management. In given situations, active ownership can help to bring the management of a company more into line with our intentions and so realise underlying value in the company which the fund can profit from through active management.

A passive, uninformed approach to operational decisions is an alternative without a sound theoretical or practical justification. Direct costs would be somewhat lower with this approach than with the current model. However, we would not be able to match the return on the benchmark portfolio. As a result, Norges Bank cannot recommend a passive strategy for the management of the fund.

The scope and orientation of active strategies will, over time, be determined by results. In 2001, Norges Bank set a target of annual value added through active management of 0.25 percentage point. This target was quite ambitious given the relative risk associated with the fund’s management. After 12 years of active management, our assessment is that the experience has largely been positive. The annualised annual excess return relative to the benchmark portfolio currently stands at 0.22 percentage point, which is close to the target. This performance confirms that active management can make an important contribution to the overall return on the fund over time. Assuming an unchanged regulatory framework, Norges Bank will retain this target of an annual excess return of 0.25 percentage point.

Our organisation of active investment decisions has been based on a high degree of specialisation and diversification within a structure with delegated authority. We consider this to be essential for a manager hoping to succeed with active investment decisions based on analysis of companies and securities.

During the recent financial crisis, variations in our results were larger than we anticipated, and we have learned from this experience.  Our annual report on the management of the Government Pension Fund Global in 2008 stated the following about our fixed income management:

“Although the portfolio was diversified across different types of bond and different regions, and the active strategies had low correlation in normal markets, the financial crisis revealed that these strategies had shared exposure to underlying systematic risk. Large positions built up in a situation when liquidity and credit premiums were low turned out to fall simultaneously in value when the market was driven by large shifts in the valuation of these risk factors.”

By underlying risk, we mean that different positions which appear to be independent can end up being driven by the same dynamics in extreme markets. In the communication of our investment strategy, we had attached considerable importance to the diversification of risk in our management and included insufficient caveats for the possibility of this independence being undermined in special situations. The scale of the financial crisis was beyond what we could have anticipated. Since March 2009, the relative return on our management of fixed income securities has been very high, as credit premiums, liquidity premiums and fear in the market have fallen back towards normal levels. The financial crisis showed that the independence of active investment decisions needs to be assured both through quantitative risk management and through more robust qualitative evaluation of underlying risk.

Active management will expose the fund to systematic risk factors to a greater or lesser extent. The management and control of systematic risk must therefore be part of our management task. Some systematic risk factors may result in high short-term return variability. It is important that a strategy which aims to profit from systematic risk is properly communicated, understood and anchored in the management structure. In the long term, the exclusion of such opportunities will probably be a cost for the fund. Strategies of this kind can improve the trade-off between expected return and risk. Norges Bank must therefore take an active approach to systematic risk. We will seek to increase exposure to systematic risk factors when premiums are high, and reduce it when premiums are low, rather than the opposite.

Norges Bank currently has three main strategies for active management. We take active decisions to ensure cost-effective management of the market portfolios of equities and fixed income instruments. We refer to this strategy as management of the market portfolio. Another key area is where we take on risk in individual companies, known as fundamental, or company-specific, strategies. Active management entails exposure to systematic risk. We take an active approach to this type of risk as part of our overall portfolio management. These three main strategies for active management will be retained.

We expect the risk in the management of the market portfolio and the company-specific strategies to dominate results in the immediate future. The management of the market portfolio is expected to make a stable contribution to results in normal markets. The contribution from company-specific strategies is expected to be relatively evenly distributed around the mean. Active strategies for the management of systematic risk can improve the expected trade-off between return and risk, but can result in greater variations in results in the short term.

In 2009, the Executive Board further strengthened the framework and rules for the Bank’s investment management activities, which are organised as a separate unit: Norges Bank Investment Management (NBIM). Besides the Government Pension Fund Global, NBIM also manages the Government Petroleum Insurance Fund and Norges Bank’s foreign exchange reserves. The investment mandate for the Executive Director of NBIM lays down rules for what the fund can invest in and how much risk NBIM can take in its management of the fund. The Executive Board also establishes the principles for risk management at NBIM. These principles are based on a common framework with risks divided into four different categories: market risk, credit risk, counterparty risk and operational risk. In each of these categories, the Executive Board sets more concrete operational limits in the investment mandate for the Executive Director of NBIM. The monthly, quarterly and annual reporting from NBIM to the Executive Board reflects the guidelines in the investment mandate.

Norges Bank’s view of its active management of the Government Pension Fund Global can be summarised as follows:

• The Ministry’s long-term investment strategy largely determines what return the fund will generate over time and the risk associated with the management of the fund. Our active management aims to increase the return somewhat given the level of risk that the owner has decided to accept.
• There is no neutral reference to which we can relate passively or mechanically when implementing our assignment. The operational management of the fund consists of a stream of many different decisions, each of which has substantial economic consequences. These decisions need to be taken on an informed and analytical basis. 
• An explicit goal of achieving the highest possible return is necessary to ensure the best possible quality in the performance of all aspects of the management task. The scope and orientation of these active strategies are established by Norges Bank’s Executive Board, which sets limits for the risk that the management organisation can take. These limits restrict the size of the fluctuations that can be expected in the return from active management in normal periods. These limits will also restrict fluctuations when uncertainty prevails in the markets. 
• It is possible to create value by analysing individual companies and securities. To succeed in this, we need to exploit economies of scale, cost advantages, bargaining power and capacity. Investment opportunities vary over time. Given a stable regulatory framework that ensures a long-term investment horizon, we can exploit opportunities that short-term investors cannot. This will improve the trade-off between return and risk. Long-term investment strategies must be properly communicated and anchored in the governance structure, but hold the greatest potential for active management. 
• As a major shareholder in many companies, we have a responsibility to exercise our ownership rights appropriately. Successful active ownership must be based on the principles of good corporate governance. This is achieved through long-term dialogue with individual companies and builds on knowledge of each company’s operations and governance structure. This knowledge is generated through our active investment management. The potential for results from active ownership increases with the quality and competence of our active investment management. 
• After 12 years of managing the fund, our assessment is that the results of active management have largely been positive. Experience suggests that active management could make an important contribution to the return on the fund in the long term.

Yours faithfully

Svein Gjedrem                                  Yngve Slyngstad

Enclosure: Norges Bank’s assessment of the theoretical and empirical basis for active management and our strategy for the management of the Government Pension Fund Global (pdf 1Mb)