In this report, the Ministry of Finance presents results and assessments relating to the management of the Government Pension Fund in 2010. Assessments of the Fund’s future investment strategy are also presented, and an account is given of the efforts made to develop the framework for management further.
The Fund achieved a good result in 2010. The return on the Government Pension Fund Global (GPFG) was almost 10 percent, while the Government Pension Fund Norway (GPFN) generated a return of almost 15 percent. This followed very good results in 2009, and means that the considerable declines in value experienced during the financial crisis have been more than compensated for by the gains made during the subsequent upturn. The active management operations of the GPFG and GPFN also achieved good results.
The financial crisis in 2008 resulted in a fall in value which was substantial, historically speaking. However, the subsequent recovery has also been unusually strong and rapid. When the period 2008–2010 is considered as a whole, the Fund has generated a total return corresponding to more than NOK 260 billion. If the risk level of the Fund had been reduced in 2008 or 2009, the recovery during the upturn following the financial crisis would not have been as strong. Significant uncertainty still attaches to the future development of the financial markets, and we have to be prepared for new periods of unrest.
The experiences gained during the financial crisis underline the need to ensure that there is broad-based support for important aspects of the management of the Government Pension Fund. Such support is a precondition for long-term, safe management. The ability to pursue a long-term strategy is important, particularly when there is unrest in the markets.
Accordingly, the emphasis in this report is on providing an account of the basis for the Fund’s investment strategy and on presenting perspectives for the further development of the strategy in the future. The starting point for the strategy work will continue to be to achieve the highest possible international purchasing power subject to a moderate level of risk.
The Pension Fund is managed on behalf of the Norwegian people. Shared ethical values must form the basis for the responsible management of the Fund. Generating good long-term returns for the benefit of future generations is a fundamental obligation. Solid financial returns over time depend on a sustainable development in economic, environmental and social terms, and on well-functioning financial markets. In this report, an account is given of the efforts made in the area of responsible investment practices, including the exclusion mechanism, the exercise of ownership, and environmental investment efforts.
The investment strategy must be based on an understanding of how the markets in which the Fund invests work, and what distinctive characteristics the Fund has in its capacity as an investor. There are clear differences between the two parts of the Fund in this regard: the GPFN is a relatively large investor in a small capital market, while the GPFG is, in relative terms, a minor investor in large, international markets. Chapters 2 and 3 discuss the work done on the investment strategies of the GPFG and GPFN in more detail.
Looking towards 2020 – some perspectives relating to the GPFG
The GPFG looks set to grow significantly in the years ahead. It is expected that, in the period to 2020, the Fund will grow to approximately double its current size. At the same time, the investment strategy is gradually being adjusted. A portfolio of property investments is currently being built up. Given the target allocation of 5 percent of the Fund, this portfolio alone may amount to an estimated NOK 300 billion at the end of this decade.
The Fund’s strong growth and large size alone comprise an important starting point for the further development of the Fund’s management. Size can be an advantage in many contexts. Among other things, economies of scale in asset management ensure that the Fund can maintain a low level of costs compared to other investors. As a result, the Fund can secure profitability in investments which are not profitable for others. These cost advantages are particularly important in the case of investments for which the management costs are generally high, for example investments in private markets.
At the same time, this type of investment is subject to limitations regarding how much the GPFG can sensibly invest. Many of these markets are too small for the Fund to build up investments on a large enough scale to affect the Fund’s total returns and risk to a significant degree. The benefits of establishing several new investment areas, which individually will be relatively small, must therefore be weighed up against the cost of increasingly complex management in the form of an increased need for governance systems and follow-up.
Chapter 2.3 of this report discusses whether the GPFG should invest in private equity and infrastructure. Both comparisons with other funds and the GPFG’s long time horizon and size make it natural to consider such investments by the Fund.
Investments in private markets are challenging, and are different in many respects from investments in listed equities and fixed-income instruments. Moreover, the management costs are high. The Ministry of Finance and Norges Bank are currently building up expertise through investments in the largest and most developed private market, the private real estate market. The desire first to gain experience from one private market, combined with the fact that there is considerable uncertainty about the returns that can be achieved on such investments given their risk level and costs, means that it is not natural to permit such investments at this stage. However, the perspectives for the further development of the GPFG’s strategy which are set out in this report make it natural to return to this question later.
Another aspect of the Fund’s size is the increasing importance of being able to maintain the strategy over time. The Fund is so large that it is difficult to make significant changes to its investments in the short term. The strategy must therefore be robust in the face of various market conditions.
Chapter 2.4 discuss the geographical distribution of the GPFG’s investments. Today, the Fund is distributed according to fixed weights for three regions: Europe, America/Africa and Asia/Oceania. More than half of the Fund’s capital is invested in Europe.
As we have traditionally imported much of our goods and services from Europe, it has been natural to assume that we protect the purchasing power of the Fund against currency fluctuations by also investing substantial amounts in the European securities markets.
The review in chapter 2.4 indicates that the exchange rate risk in the GPFG is relatively small, and less than previously thought. Accordingly, there no longer appears to be a basis for the Fund’s current relatively strong concentration of investments in Europe. The Fund’s investments in emerging economies have increased significantly in recent years. The global economic centre of gravity is gradually shifting, and not least emerging economies are expected to account for an increasing share of both global production and securities markets in the future. Over time, it will be natural for this also to be reflected in the Fund’s investments.
Although the GPFG looks set to grow significantly in the years ahead, the inflows to the Fund will gradually decline. Around 2020, the annual withdrawals from the Fund made to cover the oil-corrected budget deficit in the state budget are expected to become larger than the inflows of new money to the Fund. The Fund will continue to grow, because the returns on capital look set to exceed the net withdrawals from the Fund. The risk that net withdrawals which are large in relation to the Fund’s capital will have to be made over short periods of time will remain limited. The Fund will continue to have a considerable ability to bear risk. However, smaller inflows may nevertheless make investments with high direct returns in the form of interest payments, dividends or rent revenues more attractive than before.
The Fund is already a major owner in the global equity market. On average, the GPFG owns around one percent of all listed equity in the world. In many companies, ownership is spread across a very large number of individual owners. Accordingly, in many companies, even an ownership share of around one percent can make the Fund one of the largest individual owners. Projections for the Fund for the period to 2020 provide reasons to believe that the Fund’s ownership shares will continue to grow. This, however, does not alter the Fund’s role as a financial investor. Whether an investment is strategic or financial depends on the objective the investor has for his or her investments, and how the investor utilises his or her influence through his or her actions. The GPFG is a financial owner with a clear objective of achieving the higher possible return over time, subject to a moderate level of risk.
It cannot automatically be assumed that the managers of the companies in which the Fund invests will always have congruent interests with the Fund in its capacity as owner. Further, it cannot automatically be assumed that large owners of individual companies will act in a manner that safeguards the Fund’s interests as a minority owner. The active exercise of ownership is therefore a necessary part of efforts to protect the Fund’s economic interests. The Fund’s management cannot be built on the assumption that this important work will be adequately taken care of by other owners.
The GPFG’s investment strategy has been developed gradually, over several years. Emphasis has been given to exploiting the Fund’s distinctive characteristics and risk-bearing capacity. Decisions concerning the allocation to equities and other parts of the strategy have determined the risk of the Fund to a large degree. Now, it is natural to consider whether the strategy can be developed further to ensure an even better trade-off between expected returns and risk, subject to a risk level which shall continue to be moderate. This report contains a separate review of the Fund’s investments in fixed-income instruments. The purpose of this review was to identify relevant risk factors for this part of the Fund’s investments, and to consider alternative ways of managing the portfolio that better exploit the Fund’s distinctive characteristics. This is discussed in more detail in chapter 2.5 of this report.
Some risk must be assumed in the management of the Fund..
Analyses of different types of risk are a key part of this year’s report. The purpose of these analyses is to understand the risks associated with different investments, so that we can spread the risk associated with the investments better and exploit the Fund’s distinctive characteristics within the framework of long-term, safe management.
The choice which has the greatest influence on the Fund’s total risk over time is the choice of equity portion. The equity portion is chosen based on the insight that the Fund is able to bear risk and is willing to accept significant fluctuations in the Fund’s results from year to year. Together with the increase in the Fund’s equity portion, the decision to invest in real estate has meant a reduction in the proportion of the portfolio invested in nominal fixed-income securities, which experience has shown to be vulnerable to unexpectedly high inflation. Nevertheless, compared to other funds, the GPFG has a larger proportion of its capital invested in nominal fixed-income investments, and a smaller proportion invested in other assets than equities and fixed-income instruments.
The objective for the GPFG’s investments is to achieve the highest possible international purchasing power for the Fund’s capital over time, subject to a moderate risk level. Avoiding risk is not an objective for the management of the Fund. On the contrary, risk-taking contributes to returns over time. The Government Pension Fund has a large ability to bear fluctuations in the Fund’s returns from year to year. The investment strategy is therefore not aimed at minimising short-term fluctuations in value. A strategy focused exclusively on this would produce significantly smaller expected returns over time.
A separate category of risk is «operational risk». This is risk which is not linked to market movements, but to errors or other undesired events in the actual conduct of management. Such risk does not generate a profit in the form of higher expected returns, but reducing it will often be associated with costs. The starting point for the management of the Fund is that this type of risk shall be low. However, in managing operational risk, the expected costs of undesired events must be weighed against the costs of avoiding them. It is not reasonable or sensible to adopt an objective of avoiding undesired events at any cost. Operational risk management is discussed in greater detail in chapter 4.2.
…but risk must be managed…
The discussion above shows that the risk involved in the management of the Fund cannot be captured in a single number. This is true both of the risks inherent in the benchmark set by the Ministry and of the risks involved in the deviations from this benchmark undertaken by Norges Bank and Folketrygdfondet to increase the return on the Fund (active management).
Some forms of risk are relatively easy to identify, measure and manage. The risk involved in active management of equities is one example of this. Other forms of risk are more difficult to identify when market conditions are normal, but may nevertheless have large effects, for example during financial crises. Some types of risk associated with fixed-income instruments had such effects during the financial crisis.
Effective as of 1 january of this year, the Ministry issued new mandates for Norges Bank and Folketrygdfondet’s management of the GPFG and GPFN. One of the things learned from the financial crisis was the importance of identifying, managing and reporting multiple types of risk. In view of this, the new mandates contain, among other things, provisions regarding supplementary risk limits. The mandates are reviewed in chapter 5 of this report.
…and communicated well
The starting point for investment activities is to weigh up risks against their expected returns. It is possible to establish probable links between risks and their expected returns using financial theory and historical experience. However, there is no definitive answer regarding what the «correct» level of risk in the Fund is. Decisions that are of great significance for the Fund’s total risk must be taken following an overall balancing exercise, in which the owners’ risk tolerance is also important. The owners of the Government Pension Fund are the Norwegian people, represented by the Storting.
A fundamental basis for this balancing exercise is that the risks involved in the management of the Fund shall be communicated in the best possible manner. Only then can the risks inherent in the management be entrenched such that the strategy can also be maintained during periods of market unrest. The analyses in this report, along with the ongoing reporting of Norges Bank and Folketrygdfondet, are intended to help secure such support. Moreover, emphasis has been given to includinga wide range of independent external advice and assessments as a basis for the further development of the Fund’s management. The new mandates for the management of the GPFG and GPFN include extensive provisions on public reporting, and new accounting standards for Norges Bank (IFRS) also require increased reporting on various forms of risk.
Governance and delegation
The analyses of risk and expected returns form the starting point for the investment strategy of the Government Pension Fund. It is also paramount that a governance structure is established for the management of the Fund that allows the strategy to be implemented successfully.
On the one hand, the governance structure must ensure that important decisions relating to fund management risk have the support of the Fund’s owners, represented by the Storting. On the other hand, there must be sufficient delegation of authority to allow day-to-day decisions in the operational management of the Fund to be made close to the markets in which the Fund is invested. Efforts are made to achieve this balance by submitting decisions that are of material significance to the Fund’s risk level to the Storting before their implementation, while the regulation of the Fund through the mandates issued by the Ministry to Norges Bank and Folketrygdfondet respectively is based, insofar as possible, on principles and frameworks.
It is important that there is a clear division of roles and responsibilities between all governance levels involved in the management of the Fund, from the Storting right down to each individual manager. Only then will the individual management levels be held responsible. It is also important to have in place good control and supervisory bodies, at all levels, and that the division of work between these bodies is clear. In its consideration of Document 1 (2010–2011) and Document 3:2 (2010–2011), the Storting clarified the division of roles and responsibilities between the two supervisory bodies appointed by the Storting to be involved in the monitoring of the GPFG – the Office of the Auditor General of Norway and the Norges Bank Supervisory Council; see Recommendation 138 S (2010–2011) and Recommendation 246 S (2010–2011). This will further strengthen the management framework.
Over time, there should be interaction between the governance system and the Fund’s investment strategy. The investment strategy must take into account the distinctive institutional features of the management of the Fund. The need to secure the support of political bodies for important aspects of management means, for example, that it is difficult to design investment strategies based on taking quick, time-critical decisions that are of great importance for the total risk level of the Fund. On the other hand, the governance system must also be capable of adapting to new investment forms that seek to exploit the Fund’s distinctive characteristics, in order to improve the trade-off between return and risk. One example of this is the new provisions concerning property investments by the GPFG. It makes no sense in relation to such investments to distinguish between active and passive management, and investment decisions must be delegated to the manager to a greater degree.
In the Ministry’s view, the management of the Government Pension Fund has been highly successful thus far. The Fund structure forms an important part of the framework for economic policy, and the building up of the GPFG has made a substantial contribution to stable economic development. The investment strategy has proven itself to be robust through periods with considerable unrest in the financial markets.
The Ministry is well satisfied with the results achieved in 2010, both by the Fund as a whole and in the active management. The governance system is being strengthened gradually. The audit and supervisory systems have been expanded. This year, the Norges Bank Supervisory Council submitted its first independent report directly to the Storting, on the supervision of Norges Bank’s activities. This will further strengthen the Storting’s means of monitoring the management of the Fund. Moreover, the Ministry has issued new mandates for the management of the Fund, with an emphasis on supplementary risk frameworks and more extensive reporting.
The Fund has a robust, widely supported investment strategy in place, as well as a strengthened framework for the management of the Fund. This constitutes a good starting point for assessing how the Government Pension Fund should be managed in the next few years. The analyses and evaluations in this report and the external advice presented here provide a basis for this assessment.