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

We refer to the Ministry of Finance's letter of 27 June 2013 asking Norges Bank to provide analyses and assessments of the Bank's management of the Government Pension Fund Global as part of the documentation to be presented by the ministry to the Storting in spring 2014. We enclose four reports in which the Bank discusses:

• Performance and risk, with particular emphasis on the past five years
• Experience with the management of the real estate portfolio
• Experience with environment-related mandates
• Evaluation of objectives and strategies in the strategy plan for 2011-2013

In its letter of 27 June, the ministry also asked the Bank to assess experience of, and opportunities for, exploiting potential synergy effects between active ownership and active management. Norges Bank will integrate this assessment into its consultation response concerning the strategy for responsible investment of the fund, cf. the ministry's letter of 29 November 2013.

Norges Bank's Executive Board aims to adopt a new strategy plan for Norges Bank Investment Management (NBIM) early in 2014. The plan will be submitted to the ministry in accordance with section 7-1 (1) of the mandate for the management of the fund. In connection with the submission of the strategy plan and in light of developments in the management of the fund and experience with work on enhancing its management, the Bank will assess whether the current limits for the management of the fund are appropriately designed and suited to the management strategies used in its operational management, as requested in the ministry's letter of 27 June. In addition, we will discuss how reporting can be enhanced as a consequence of developments in the Bank's strategy for the operational management of the fund.

The following summarises the main points of the four reports now being submitted to the ministry.

 Performance and risk

The aim of the enclosed report[1] is to analyse returns and risk in the fund's equity and fixed-income portfolios. The analysis covers the period from 1998 to 2013[2] with the emphasis on the past five years. Return series are measured in the fund's currency basket and are time-weighted, and the relative return is reported as the arithmetical difference between the returns on the actual portfolio and the actual benchmark index. We would draw attention to the following key points from the report:

• Both absolute and relative returns have been positive. Since 1998, the annualised absolute return has been 5.49 per cent and the annualised relative return has been 0.31 percentage point. Since 2009, the fund has produced an annualised return of 11.6 per cent in absolute terms and 1.19 percentage points in relative terms.
• Absolute and relative returns have been positive for all of the sub-periods analysed except for the period around the financial crisis.
• The realised risk-adjusted return shows that our management of the fund has improved the trade-off between risk and return relative to the benchmark index.
• Exposure to systematic risk factors is analysed using two market-based methods. Both methods attempt to estimate the value of a constant exposure to a given risk factor. Estimates of this kind do not provide a complete picture, as the fund's exposure to systematic risk factors varies over time. The results must therefore be interpreted with care.
• Our analyses show that gross excess return is a good expression of net value creation through active management.

The fund's return over the past five years has been favourable both in absolute terms and relative to the indices the fund's return is measured against.

 Experience with the management of the real estate portfolio

The Ministry of Finance decided in 2010 that up to 5 percent of the Government Pension Fund Global should be invested in real estate, and NBIM made its first unlisted real estate investments in 2011. As at 30 September 2013[3], real estate investments amounted to 0.9 per cent of the fund's total investments, or 42.4 billion kroner. The enclosed report[4] provides a detailed overview of these investments and the Bank's organisation of these activities, including the management model and legal structures. We would draw attention to the following key points from the report:

• Investments in unlisted real estate differ significantly from investments in listed shares and bonds. One key aim in the initial phase has been to build an organisation with a well-functioning team and a solid infrastructure that is capable of handling a large portfolio of international property investments.
• The strategy in the initial phase was to invest in properties in core markets: first in Europe and then in the US.
• We have generally invested alongside local partners through joint ventures. Our partners have local market knowledge and currently handle the operation of the properties. All of the fund's investments in unlisted real estate have been made through subsidiaries of Norges Bank.
• We attach importance to implementation being tailored to investment opportunities and complying with the requirements of the mandate from the Ministry of Finance.
• We are taking our time to phase real estate into the fund, and this process has featured a responsible build-up of resources, systems and rules to achieve our goals in an orderly manner with no critical incidents. We will draw on this experience in the further development of this investment area.

The start-up of real estate management has been a success to date, but, as expected, it has taken time to build up these investments.

Experience with environment-related mandates

The Ministry of Finance decided to establish a separate programme for environment-related mandates following the evaluation of the fund's ethical guidelines in 2008-2009, and NBIM has awarded mandates with a particular focus on environment-related investments to both internal and external managers since 2009. These investments are subject to the same profitability requirements as the fund's other investments. The enclosed report[5] summarises the Bank's experience with these environment-related mandates. We would draw attention to the following key points from the report:

• At the inception of the programme, the potential for environment-related mandates in the fund's various asset classes was considered, and we chose to concentrate the programme’s investments in listed equities.
• The environment-related investment universe is complex with no clear-cut definition. Environment-related companies can be found in many different industries, each of which may have very different characteristics. In addition, some environment-related companies are part of large multinational conglomerates. It is a matter of judgement whether the environment-related part of a conglomerate is, or will become, large enough to justify an investment under the programme for environment-related mandates.
• The risk in this segment of the market is particularly associated with rapid technological change, a rapid influx of new players and an unpredictable policy framework, including changes in public subsidies and regulation.
• The period since the start-up of environment-related mandates has coincided with a global financial crisis. This increased volatility in the segment and adversely affected investors' risk appetite.
• The segment is relatively small, but we can handle the current level of investments in environment-related mandates.
• The fund’s environment-related mandates returned 8 per cent in the period 2009-2013, while the overall stock market as measured by the fund's benchmark index for equities returned 50 per cent during the same period.[6]

Environment-related investments are well-suited to active management but did not contribute to the fund's favourable return during the period.

 Evaluation of objectives and strategies in the strategy plan for 2011-2013

The Executive Board's strategy plans for NBIM cover a three-year period and express Norges Bank's overall objectives for investment management during that time. The strategy plan for 2011-2013 was adopted by the Executive Board on 15 December 2010 and was submitted to the Ministry of Finance as required by the mandate for the management of the fund. The plan was also published on NBIM's website.

The plan has its point of departure in the mission for the Bank's management of the fund, which is to safeguard and build financial wealth for future generations. The main goals for 2011-2013 were to:

• Implement an investment strategy built on the fund's defining characteristics and the owner's target of absolute return, with strategies that are long-term oriented, scalable and focused on underlying value.
• Simplify our organisational and technological infrastructure, obtaining an efficient and robust execution platform.
• Strengthen the investment culture across NBIM, while maintaining our risk awareness.
• The enclosed report[7] provides an overview of NBIM's performance against these goals during the strategy period. The most important results can be summarised as follows:
• We have moved the organisation towards a long-term return focus and launched real estate investments.
• We have simplified the portfolio and technical systems and reduced the number of external service providers, resulting in lower management costs.
• We have strengthened our investment culture through improved and more concentrated investment analysis, and improved our public disclosure and openness about the management of the fund.

During the 2011-2013 strategy period, NBIM paid more attention to achieving a high absolute return in the long term, strengthened its investment culture and increased transparency in the management of the fund.

 Norges Bank's overall conclusions

The reports can be summarised as follows:

• The fund's return over the past five years has been favourable both in absolute terms and relative to the indices the fund's return is measured against.
• The start-up of real estate management has been a success to date, but, as expected, it has taken time to build up these investments.
• Environment-related investments are well-suited to active management but did not contribute to the fund's favourable return during the period.
• During the 2011-2013 strategy period, NBIM paid more attention to achieving a high absolute return in the long term, strengthened its investment culture and increased transparency in the management of the fund.

Yours faithfully

 Øystein Olsen                                                                        Yngve Slyngstad