Meld. St. 17 (2011–2012)

The Management of the Government Pension Fund in 2011

2 Investment strategy of the Government Pension Fund Global

2.1 Background to the investment strategy

2.1.1 Introduction

The Government Pension Fund shall support government saving to finance the National Insurance Scheme’s expenditure on pensions and support long-term considerations in the use of state petroleum revenues. Long-term, safe management of the Fund helps to ensure that both present and future generations can benefit from Norway’s petroleum wealth.

The Government Pension Fund is an instrument for general saving. The Fund does not have clearly defined future liabilities. The investment objective is to maximise the purchasing power of the fund capital, given a moderate level of risk. The adoption of responsible investment practices supports this objective.

This chapter discusses the GPFG investment strategy. The GPFN investment strategy is discussed in chapter 3.

2.1.2 The main features of the investment strategy

The GPFG investment strategy is derived from the Fund’s special characteristics and assumptions regarding the functioning of the financial markets. Over time, the Ministry of Finance and Norges Bank, in their respective capacities as the owner and manager of the Fund, have developed an investment strategy with the following characteristics:

  • harvesting risk premiums over time,

  • diversification of investments,

  • exploitation of the Fund’s long-term horizon,

  • responsible investment practices,

  • cost efficiency,

  • a moderate degree of active management, and

  • a clear governance structure.

The management of the GPFG is based on the principle that risk must be accepted to secure a satisfactory expected return over time. In the financial markets, investors who are willing to take risks are rewarded with higher expected returns. This expected additional return is referred to as a risk premium. The aim for the management of the GPFG is thus not to minimise fluctuations in the Fund’s returns. Such a strategy would produce a significantly lower expected return.

The GPFG has a higher ability to bear risk than many other investors. Among other things, this is because the Fund has no clearly defined future liabilities, and a long investment horizon. The appropriate risk level for the Fund will depend on the risk tolerance of the owners, represented by the political authorities. The support given by the Storting in 2007 to the Government’s plan to increase the equity portion to 60 percent has helped to define the acceptable level of risk for the Fund.

When investmentsarediversified across many securities, the total risk may become smaller than the risk associated with each individual investment. The risk which cannot be eliminated by diversification is referred to as systematic risk. An important insight from financial theory is that risk premiums are linked to systematic risk. This means that the expected return on an investment is largely determined by the contribution of the investment to the systematic risk of a portfolio, and not by the risk associated with the individual investment. Accordingly, diversifying risk can reduce portfolio risk without reducing the expected return. This improves the ratio between expected return and risk.

The GPFG’s investments are spread across several asset classes. The investment strategy means that around 60 percent of the fund capital is invested in equities. The remaining capital is invested in fixed income, with the exception of a share of up to 5 percent invested in real estate.

The Fund’s equity and fixed income investments are spread across markets in many countries. In each market, the investments are distributed among a series of individual companies and issuers.

Sections 2.2 and 2.3 respectively discuss changes to the GPFG’s fixed income benchmark and plans to amend the geographical distribution of the equity benchmark. Together, these changes will help to ensure that the GPFG’s investments are spread even more widely across different countries and regions.

The GPFG has a very long time horizon. It is unlikely that the state will need to withdraw large sums from the Fund in the short term. Moreover, the Fund does not depend on short-term financing, and is not subject to regulations which could force sales at undesirable points in time. Broad support for the long-term investment strategy strengthens the Fund’s ability to maintain the strategy even in periods of great unrest in the markets.

The long horizon makes it easier to endure fluctuations in the return of the Fund from year to year. This long-term nature supports the decision to invest 60 percent of the Fund in equities. The equity investments are expected to provide substantial contributions to the return over time, but they also entail increased fluctuations in Fund performance.

The Fund’s rules for rebalancing mean that the equity portion is maintained also in periods when equity prices have fallen a great deal. The discussion on the rebalancing rules in section 2.5 indicates that also this part of the long-term investment strategy is a way in which to benefit from the Fund’s long time horizon.

The investment strategy is based on assessments of expected risk and return in the long term. Expected real return for the Fund in the long-term is discussed in more detail in box 2.1

Boks 2.1 Real return on the Government Pension Fund Global

The fiscal policy guideline means that the use of oil revenues in the national budget will increase gradually over time, approximately in line with the real return on the Government Pension Fund Global (GPFG). The fiscal policy guideline will guide the use of the state’s petroleum revenues for many decades to come. Accordingly, the expectation of a 4 percent real return is intended to apply for a period which is long enough to contain many upturns and downturns in the financial markets.

Real return since 1997

For the period 1997 to 2011, the real return on the GPFG was 2.7 percent per annum on average. If we also include the real return so far in 2012 (up to the middle of March), the average real return increases from 2.7 percent to just above 3 percent. The average return over this 15-year period is well within normal fluctuations if the expected return is 4 percent.

Figure 2.1 shows average annual real returns during rolling 15-year periods from 1900 to 2011, on a portfolio comprising 60 percent equities and 40 percent long-term government bonds. The average real return was 4.8 percent over the period 1900 to 2011, although the average during 15-year periods has varied considerably.

Figur 2.1 Average annual real returns during rolling 15-year periods from 1900 to 2011, for a globally diversified portfolio comprising 60 percent equities and 40 percent long-term government bonds.1 The horizontal line shows the Ministry’s estimate of the exp...

Figur 2.1 Average annual real returns during rolling 15-year periods from 1900 to 2011, for a globally diversified portfolio comprising 60 percent equities and 40 percent long-term government bonds.1 The horizontal line shows the Ministry’s estimate of the expected long-term real return on the GPFG. Percentages

1 The country distribution is largely identical to the distribution in the GPFG’s benchmarks for equities and fixed income.

Kilde: Dimson, Marsh and Staunton, Global Returns Data (2011), and Ministry of Finance.

Fixed income

In previous reports to the Storting, the Ministry of Finance has presented analyses of the long-term real return on the GPFG; see Report No. 10 (2009–2010) to the Storting – The Management of the Government Pension Fund in 2009, Report No. 20 (2008–2009) to the Storting – On the Management of the Government Pension Fund in 2008 and Report No. 16 (2007–2008) to the Storting – On the Management of the Government Pension Fund in 2007. The Ministry’s estimate of the long-term real return has been slightly above 4 percent. Estimates of future real return are subject to substantial uncertainty. The estimate is based on an unconditional expected real return on government bonds of 2.5 percent. An unconditional expectation is not based on current market prices and interest rates, but rather on what can be expected in a normal situation, that is in a situation in which the economy is in equilibrium.

If the real interest rate in such a situation is lower than the economic growth rate, economic theory points out that the capital stock in the economy can be too high, and consumption too low. If a state can borrow at such a low interest rate, it can maintain a budget deficit before interest without increasing its debts as a proportion of GDP. This may tempt countries to increase their borrowing, which in turn will reduce the savings available for productive investments, and thus increase the capital return. It can therefore be questioned whether a situation in which the real interest rate is lower than economic growth represents long-term equilibrium. However, the assumptions on which such arguments rest are uncertain; see Bliss (1999).

Historical analyses show that the real interest rate level may deviate considerably from the economic growth rate over long periods. A study by Escolano et al. (2011) has shown that, during the period 1966–2010, the real interest rate on government bonds in developed countries was around 1 percentage point higher than the average economic growth rate.

Many factors can influence the real interest rate, including economic growth and savings behaviour. Over time, economic growth will depend on population growth and productivity growth, and on changes in resource access and environmental factors. Future savings behaviour is uncertain, and will be affected by many factors, including demographic trends like ageing. McKinsey (2010) expects reduced willingness to save, combined with large global investment needs in the years ahead, to push the real interest rate up in the long term. Turner and Spinelli (2011) have written that the real interest rate must be expected to rise in the future, to a level above the economic growth rate. On the other hand, other studies, including Ikeda and Saito (2012)and Descoches and Francis (2007), have concluded that the real interest rate will stay relatively low in the long term, amongst other things because of ageing.

A significant proportion of the GPFG’s fixed income investments are renewed every year, as loans mature and money is reinvested in new fixed income. In the short to medium term, however, the expected real return on the Fund’s fixed income portfolio will be affected by current observed interest rates. At the end of 2011, real interest rates in the bond market were very low, both compared to the historical average since 1900 and compared to the level in 2010, when the Ministry last presented an estimate of the expected real return.

Olsen (2012) has pointed out that a real interest rate of between 0 and 1 percent indicates an expected real return for the GPFG of less than 4 percent.

Figur 2.2 Real interest rate on US 10-year government bonds, from 1900 to 2011. Nominal interest rate less an estimate of expected inflation. Percentages

Figur 2.2 Real interest rate on US 10-year government bonds, from 1900 to 2011. Nominal interest rate less an estimate of expected inflation. Percentages

Kilde: Antti Ilmanen, AQR Capital Management.

Figure 2.2 shows the development in the real interest rate on US 10-year government bonds from 1900 to 2011. The figure shows that real interest rates have varied considerably over time, but also that one has to go back to 1949 to find a real interest rate on US government bonds as low as at the end of 2011.

The low interest rate levels at the end of 2011 were due to several special circumstances:

  • Since 2007, the global economy has undergone the strongest downturn since the Second World War. Investors have reacted by selling risky investments like equities and buying government bonds. This has resulted in very low yields on bonds.

  • To stimulate economic growth, central banks have reduced their policy rates to almost zero. In addition, they have bought bonds to press down long term interest rates. It is reasonable to assume that this has increased demand for bonds and reduced bond yields.

Under these circumstances one should be cautious in drawing conclusions about the future real interest rate based on the current, low interest rate level. For a discussion of the uncertainty concerning the future real interest rate; see, for example, Turner (2011).

Equities

60 percent of the GPFG’s capital is invested in equities. Risk is higher in the equity market than in the fixed income market. Investors will normally demand a premium for the extra risk in the form of a higher expected return on equity investments. However, the size of this equity premium is uncertain.

The Ministry has defined the equity premium as the return on equities in excess of the return on long term government bonds. The Ministry has previously estimated the expected equity premium at 2.5 percent in the long term. Over the period from the Fund’s first equity investments in 1998 to the end of February 2012, the realised equity premium has been negative. During this period, the GPFG’s equity benchmark has provided an annual return which is, on average, 0.6 percentage points lower than the return on the fixed income benchmark. The realized historical equity premium over the period from 1900 to 2011 shows large fluctuations.

The size of the expected equity premium has been the subject of debate in both academic circles and among investors. Ibbotson (2011) distinguishes between four different methods for estimating the expected equity premium:

  • Historical returns

  • Consensus estimates

  • Demand models

  • Supply models

The historical returns show the additional return investors in the equity market have actually earned. According to data from Dimson, Marsh and Staunton (2011), the annual equity premium on the global index was 3.8 percent in the period 1900-2011. A weakness of the historical return is that the time period over which the return is measured may not be representative of future returns. However, Goyal and Welch (2008) have found that predictions of future premiums based on the historical equity premium are as good as predictions produced by other, more complicated methods.

Several studies have presented consensus estimates of the expected equity premium based on surveys. In their study, Fernandez (2011) et al. asked academics, analysts and companies in 56 countries about what equity premium they estimate that investors required on their equities investments in 2011. With the exception of Malaysia (4.5 percent) and Japan (5.0 percent), an average equity premium above 5 percent was reported in all of the countries. In the US, the average equity premium specified by the respondents was 5.5 percent. The study asked what risk premium was required to invest in equities today, not what the expected equity premium will be in a long-term, normal situation. It is therefore most correct to view the reported equity premium as a conditional risk premium given the current situation. In a study by Welch (2008) from 2007, 400 finance professors in the US estimated that the annual expected equity premium would lie around 5 percent for the next 30 years. In March 2012, the average expectation among chief financial officers in the US was an annual return on the S&P-500 index of 6.9 percent in the next 10 years.

Demand models try to determine the expected equity premium based on what investors demand for taking on extra risk, while supply models estimate the expected equity premium based on what companies give investors in the form of cash flows. The return on a share can be split into dividends, growth in company earnings and repricing of the company. Dividends and growth in company earnings have been the most important factors underpinning historical returns. Historically, the long term real growth in companies’ earnings has been close to per capita GDP growth; see, for example, Arnott and Bernstein (2002).

The realised equity premium has been very high compared to observed fluctuations in consumption and normal estimates of investors’ risk aversion. In the economic literature, this phenomenon is referred to as the «equity premium puzzle». One possible explanation for this puzzle is that the realised return has been significantly higher than what investors actually expected. Several studies have used a supply model to estimate what equity premium investors had reasons to expect over time, given the information available at the time an investment was made; see Fama and French (2002). The analyses indicate that positive shocks have dominated during the period, particularly since the Second World War. These results suggest that the expected equity premium should be lower than the historical equity premium. This is one reason why the Ministry has estimated that the expected equity premium will be 2.5 percent. Dimson (2011) et al. assume that the long-term expected equity premium for a global equity index is around 3 to 3.5 percent, relative to bills. The expected equity premium is lower than the historical equity premium because the expected earnings growth is assumed to be lower than the historical average.

In chapter 6 of this report, the components of the supply model are used to analyse the most important causes of the relatively low return on equities since the Fund began investing in equities in 1998. The analysis shows that the growth in earnings has been higher than the historical average during the period, while dividend yields have been somewhat lower. The low return can largely be ascribed to changes in the valuation of equities. The ratio between price and earnings has fallen. This may indicate that investors are demanding a higher expected return in the equity market now than in 1998.

Other sources of returns

Around 10 percent of the Fund is invested in bonds issued by companies. This is expected to raise long term real return. Five percent of the Fund will gradually be invested in real estate. The return on the property portfolio is expected to lie between the return on equities and the return on fixed income. In addition, active management is expected to make a positive contribution to returns over time.

Summary

The average annual real return achieved by the GPFG, 2.7 percent, lies well within normal fluctuations around an expected figure of 4 percent.

Currently, real interest rates are very low, also in a historical context. This is partly due to the strong downturn in the world economy since 2007, and partly to the desire of central banks to stimulate economic growth. In the Ministry’s view, the extraordinary circumstances in the current situation indicate that caution should be exercised about amending the estimates of the expected real return on the GPFG based exclusively on current, low real interest rates. An analysis of expected returns in the equity market supports this conclusion.

1 In this box, all return figures are calculated as geometrical averages (growth rates).

2 Dimson, Marsh and Staunton, Global Returns Data (2011).

3 It is unclear whether the reported equity premiums in this questionnaire are calculated as arithmetic or geometric averages.

The GPFG also exploits its long-term nature by investing in assets which are less liquid. The Fund’s investments in real estate are an example of this.

The GPFG shall adopt responsible investment practices that promote good corporate governance and take social and environmental factors into account, in accordance with international best practice. Responsible investment practices support the goal of achieving a good return over time. Responsible management is also important to secure the support of the Norwegian people for the management of the Fund. The Fund’s role as a responsible investor is expressed, for example, in the guidelines for observation and exclusion of companies which do not comply with minimum ethical standards. The Council on Ethics for the GPFG advises the Ministry on the observation and exclusion of companies based on these guidelines.

Norges Bank manages the Fund’s ownership interests in various companies in order to promote greater alignment of interests between the companies and the GPFG as a long-term investor. The work done in relation to the exercise of ownership rights, exclusion and observation in 2011 is discussed in more detail in section 4.4.

Both the Ministry of Finance and Norges Bank, in their respective capacities as the owner and manager of the Fund, participate in international forums in which best practice for responsible investment is discussed and further developed. In 2011, the Ministry joined other large investors in participating in an international research project focused on the long-term consequences of climate change for global capital markets. The project investigated the potential consequences of climate change for the GPFG’s investment strategy; see the discussion in Report No. 15 (2010–2011) to the Storting – The Management of the Government Pension Fund in 2010 and in section 2.6 of this report.

Priority is given to ensuring that the management of the Fund is cost efficient. Comparisons with other large funds show that Norges Bank’s management costs are relatively low. The size of the Fund allows the exploitation of economies of scale. Over time, management costs as a proportion of the fund capital have fallen; see the discussion in section 4.1. The economies of scale will probably be even greater in unlisted markets, as Norges Bank can build up its own expertise and secure access to the most efficient investment structures. Norges Bank’s investments in real estate in collaboration with leading, established bodies are one example of this.

The mandate for the GPFG contains general frameworks for management activities, in the form of benchmarks indices for equities and fixed income and limits for deviating from these benchmarks. Within these frameworks, Norges Bank is to seek to achieve the highest possible return after costs. The frameworks imply a moderate degree of active management of the Fund.

The Fund’s benchmarks are based on leading, easily accessible indices. They largely reflect the investment opportunities in the global equity and fixed income markets. The return on the benchmarks reflects the general trend in the financial markets. In the large, well-functioning global financial markets, new public information is quickly reflected in prices. The management of the Fund is therefore based on the principle that, over time, the risk of the Fund will generally reflect developments in the benchmarks set by the Ministry. The space given to active management must be viewed in light of this fact.

Norges Bank has three types of active management strategy. The Fund must be invested in accordance with the benchmarks in an efficient manner. This includes the efficient transfer of new capital into the Fund and the minimisation of unnecessary transaction costs as a result of changes in the benchmark. Moreover, Norges Bank expects its managers to analyse individual equities and bonds to identify investments they consider to be underpriced, and which they expect to deliver good returns over time. Industry knowledge and knowledge about individual companies are important components of this strategy. Finally, Norges Bank makes investment decisions after analysing systematic risk factors. Such risk factors are described in more detail in sections 2.7 (for equities) and 2.2 (for fixed income). Section 4.1 describes the role systematic risk factors play in the active management of the Fund.

In its efforts to develop the operational management of the Fund further, Norges Bank is giving emphasis to improving the ratio between risk and return. This includes making greater use of the Fund’s size and long-term nature. Norges Bank aims to exploit the long-term nature of the Fund, for example by investing in companies in which it may take a long time for the underlying value to appear and to produce the expected return. A further objective is to ensure that the Fund’s managers analyse fewer companies than before, and rather conduct more thorough studies to identify good long-term investments. A new tool for Norges Bank’s management of the Fund is operational benchmark portfolios. These are discussed in more detail in sections 2.7 (for equities) and 2.2 (for fixed income).

The management of the GPFG is based on a clear governance structure in which the Storting, the Ministry of Finance, Norges Bank’s executive board and Norges Bank Investment Management (NBIM) have different roles and responsibilities. Duties and authorisations are delegated downwards in the system, while reports on results and risk are made upwards; see the more detailed discussion in Report No. 15 (2010–2011) to the Storting. The management of the GPFG should be organised to ensure the greatest possible:

  • facilitation of professional, cost-effective management,

  • specification of clear guidelines and predictable framework conditions,

  • alignment of interests between the owner and the manager,

  • facilitation of good communication with the public about the management of the Fund,

  • robustness in the face of future challenges (ever-larger fund, larger ownership interests in individual companies, possible trend towards illiquid assets presenting greater governance challenges, etc.),

  • focus on the Fund’s role as an instrument of fiscal policy,

  • focus on factors that have been important in the international debate concerning sovereign wealth funds, including transparency about the purpose of the investments, and

  • compliance with what is internationally regarded as best practice.

Establishing and maintaining a governance structure which safeguards all of these considerations is challenging. In the view of the Ministry, the current structure has functioned well thus far.

Boks 2.2 New letters and reports concerning the GPFG investment strategy which are discussed in this report

  • Letter from Norges Bank of 26 January 2012 concerning rules for rebalancing of the benchmark index.

  • Letter from Norges Bank of 1 February 2012 concerning emerging bond markets.

  • Letter from Norges Bank of 2 February 2012 concerning a strategic benchmark index for equity investments.

  • Report by MSCI on global equity allocation.

  • Report by Professor C. Harvey on the allocation to emerging market equities.

  • Norges Bank has also prepared several discussion notes as background information for the advice it has given. These are available on www.nbim.no.

The letters are appended to this report. The reports are available on the Ministry’s website (www.government.no/gpf).

2.2 New strategic fixed income benchmark

2.2.1 Introduction

The management of the fixed income investments of the Government Pension Fund Global (GPFG) has been based on a strategic benchmark containing around 11,500 bonds. The benchmark has been composed of nominal and inflation-linked treasuries, government-related bonds, corporate bonds and securitised bonds in a total of 11 currencies. The currency weightings have been fixed in the proportions 60 percent European currencies, 35 percent North American currencies and 5 percent currencies from Asia/Oceania 1.

Within each of the three currency regions, different segments of the fixed income market, and individual bonds, have had an index weight corresponding to their share of the value of the total fixed income benchmark. This method is called market value weighting, and means that the benchmark has an equally high stake in all bond issues within the same geographical region.

The Ministry already wrote in Report No. 10 (2009–2010) to the Storting – The Management of the Government Pension Fund in 2009 that there were several weaknesses in the fixed income benchmark. In Report No. 15 (2010–2011) to the Storting – The Management of the Government Pension Fund in 2010, the Ministry stated that, in light of, inter alia, the experiences gained during the financial crisis, it had conducted analyses of the risk and return properties of various segments of the bond market in order to re-evaluate the management of these investments. Among other things, the review was based on a report by Professor Stephen Schaefer and consultant Jörg Behrens, which was published along with the Report to the Storting.

The analyses showed that fluctuations in returns on broadly composed fixed income indices can be explained by developments relating to a few systematic risk factors. The opportunity to diversify risk is thus more limited in a portfolio of bonds than in an equity portfolio.

In Report No. 15 (2010–2011) to the Storting, the Ministry also described a proposal by Norges Bank to simplify the benchmark by eliminating the sub-segments government-related bonds and securitised bonds. Norges Bank recommended a benchmark comprising 70 percent treasuries and 30 percent corporate bonds. The Ministry wrote that the proposal to simplify the benchmark could be implemented without material changes to expected risk and return, and that consideration would be given to implementing such changes in the course of 2011.

Last year’s Report to the Storting also contained a new assessment of the GPFG’s distribution across geographical regions. Until now, the GPFG has invested over half of its capital in European equities, fixed income and real estate. The reason given for the high European portion was that it reduces the Fund’s exchange rate risk. As Norway imports most from Europe, it was initially assumed that Norway could protect the purchasing power of the Fund by investing considerable amounts in European markets. In the Report to the Storting, the Ministry concluded that the long-term exchange rate risk appears to be smaller than previously expected. It was considered that the portion invested in Europe should therefore be reduced over time in favour of larger portions in the rest of the world.

The Ministry wrote that it would continue to work on establishing a new geographical distribution, and also consider starting to implement such changes in 2011.

This Report to the Storting presents the result of the Ministry’s work on a new benchmark for the fixed income portfolio, and the consequences of the adjustments for the regional distribution. The Ministry has given emphasis to the need to highlight the purpose of the different parts of the fixed income investments. As a result, certain market segments have been removed from the benchmark. The new benchmark for the Fund’s fixed income investments is largely consistent with Norges Bank’s proposed simplifications, but does not, however, remove as many market segments from the benchmark as recommended by the Bank. The changes are discussed in section 2.2.2. Section 2.2.3 discusses the work done to evaluate principles for the weighting of bonds issued by different countries and companies. The starting point for this evaluation has been that weighting based on gross domestic product (GDP weighting), appears to be a natural alternative to the current market value weighting of government bonds. In the case of bonds issued by corporations, the Ministry has proceeded on the basis that market value weighting remains the best starting point. The changes to the weighting principles result in a different currency distribution for the fixed income benchmark and entail, inter alia, that the share of European bonds will be reduced over time.

The adjustments to the benchmark for fixed income have already commenced. The Ministry has changed the benchmark for fixed income in the GPFG in accordance with the discussion in section 2.2.2 such that the benchmark now has a government sub-portfolio of 70 percent and a corporate sub-portfolio of 30 percent. The Ministry has also started a gradual adjustment towards the new currency composition that follows from applying GDP weights for the government part of the benchmark and market weights for the corporate part. See the discussion in section 2.2.3. In section 2.2.4, a plan to include emerging markets in the benchmark for fixed income is presented. The implementation of such an extension of the benchmark has not started. In line with what has been the practice in previous changes of the benchmark, the Ministry will inform in more detail about the implementation when the changes have been carried out.

Section 2.2.5 contains a comparison of the old and new benchmarks. The need to amend Norges Bank’s mandate and the relationship between the strategic benchmark and Norges Bank’s operational benchmark portfolio are discussed in greater depth in section 2.2.6.

2.2.2 Clarifying the role of fixed income in the overall portfolio

The aim of the GPFG’s investment strategy is to maximize the international purchasing power of the fund capital, given a moderate level of risk. Through the GPFG’s investments in equity, fixed income and real estate, the Fund participates in global value creation. Fixed income investments primarily play two roles in the management of the GPFG:

  • They improve the ratio between expected risk and return in the Fund. This is because the value of many bonds – primarily government and corporate bonds with a very high credit rating – largely does not fluctuate in line with the return on the equity portfolio. Although such bonds have a relatively low expected return, they play an important role because they reduce the Fund’s risk. In addition, they are often easy to trade. This can contribute to maintaining a fixed equity portion of 60 percent over time.

  • They harvest risk premiums in addition to the risk premium linked to interest-rate risk. This is particularly true of the credit and liquidity risk factors. The report by Schaefer and Behrens showed that these risk factors are associated with long periods of small, but stable, positive contributions to the Fund’s return. However, they are also linked with periods featuring significant drops in value. The long time horizon on which the GPFG’s investments are based means that the Fund is well-positioned to absorb such fluctuations in value.

In Report No. 10 (2009–2010) to the Storting, the Ministry wrote that while the Fund’s equity benchmark represents the equity market well, the fixed income benchmark covers only a limited part of the investment opportunities for fixed income instruments. In accordance with Norges Bank’s advice, the Ministry has chosen to remove additional sub-segments from the Fund’s benchmark to clarify the two roles of the fixed income investments described above.

Norges Bank has analysed the fixed income market in a separate note. 2 The note contained a comparison of the fixed income investments of four other large funds. The review showed that the funds have adopted different approaches to making strategic allocations to the fixed income market, but that they typically base their decisions regarding the selection of allocations and portfolio structures on the role of the fixed income investments.

Boks 2.3 More about the bond market

A bond is a tradable loan with a maturity of more than one year. Bond issuers (borrowers) may include public authorities, banks, and other large private enterprises. The bond is redeemed by the issuer upon maturity, and during the period between issue and maturity, the holder of the bond is paid interest (called a coupon). A bond is traded in the primary market when a borrower issues a bond that may be purchased by many investors. Bonds are freely tradeable, and can therefore be bought and sold in the secondary market. Most bonds have a fixed nominal interest rate, i.e. the coupon is an amount agreed in advance. There are also other types of bond, including bonds featuring floating interest rates, zero coupons or gradual redemptions. Many bonds are backed by different forms of collateral. Bonds may also offer options, such as the right to repay the loan earlier than at maturity.

Treasuries

Treasuries in developed markets are the largest market segment in the case of both inflation-linked bonds (close to 100 percent of the market), and nominal bonds (around 50 percent of the market).

The market for government bonds is dominated by a few currencies. Almost 95 percent of nominal government bonds in developed markets are issued in Japanese yen, US dollars, Euros or British pounds. Government bonds issued in local currencies by states in emerging markets account for around 5 percent of the market for nominal bonds.

Government related bonds

The treasury segment is often limited so as only to include treasuries issued in the state’s own currency. The government related bond sub-segment encompasses, among other things, government bonds issued in foreign currency, bonds issued by municipalities and other public-sector bodies, bonds issued by businesses that are partly owned by, or that receive support from, the public sector, and bonds issued by supranationals such as the World Bank.

Inflation-linked bonds (real interest rate bonds)

Inflation-linked bonds protect investors against changes in the purchasing power of invested capital. In addition to compensation for the development of a price index, investors receive a real return which has been agreed in advance.

Securitised bonds

Securitised bonds account for 15 percent of the market for nominal bonds. Such bonds are backed by a portfolio of underlying loans, most commonly residential mortgages. The largest sub-group of securitised bonds in the US is bonds secured by a charge over residential mortgages arranged and guaranteed by federal agencies like Fannie Mae and Freddy Mac. In the US, the securitised bond market is almost as large as the treasury market. In Europe, covered bonds constitute a large market in several countries, but this market remains relatively small in comparison to the market for treasuries.

Investment-grade corporate bonds

The market for investment-grade corporate bonds is about equal in size to the market for securitised bonds.

The US is the largest, most liquid and well-functioning market for such bonds. The size of the European corporate bond market varies from country to country. For example, the French market for corporate bonds is considerably larger than the market in Germany, where private enterprises make greater use of bank loans as a source of financing.

High-yield corporate bonds

High-yield bonds account for 3 percent of the market for nominal bonds, and are dominated by bonds issued in US dollars. Such bonds are not currently included in the GPFG’s benchmark, although Norges Bank’s mandate does allow for investing parts of the fixed income portfolio in such bonds. This ensures, among other things, that Norges Bank is not forced to sell bonds which are downgraded and fall below the investment-grade threshold.

In its letter of 18 March 2011, Norges Bank proposed that the benchmark for nominal bonds should comprise 70 percent government bonds and 30 percent corporate bonds. Until now, corporate bonds have made up around 18 percent of the strategic fixed income benchmark. In isolation, therefore, an increase in the proportion of corporate bonds to 30 percent would increase the credit risk of the bond portfolio. At the same time, Norges Bank proposed removing other market segments featuring credit risk, such as securitised bonds. At the end of 2011, the market segments whose removal was proposed comprised about 23 percent of the Fund benchmark.

Inflation-linked government bonds were included in the GPFG benchmark in 2005; see the discussion in the National Budget for 2005. Since then, the proportion of inflation-linked government bonds has been about 5 percent. The Ministry considers it appropriate to retain inflation-linked government bonds as part of the fixed income benchmark. This is consistent with the conclusion in Norges Bank’s letter of 18 March 2011, where the Bank wrote:

«The proportion of nominal bonds in the Fund’s strategic asset allocation should be calculated as 40 percent less the net value of the Fund’s property investments and the market value of the Fund’s strategic benchmark for real interest rate bonds.»

In a letter to the Ministry of Finance of 6 July 2010, Norges Bank gave notice that it would return to the question of investments in real assets.

In its letter of 18 March 2011, Norges Bank proposed removing the securitised bonds sub-segment from the benchmark. The US market for securitised bonds is dominated by bonds secured on residential mortgages guaranteed by agencies like Fannie Mae and Freddy Mac. Borrowers are entitled to redeem their loans and refinance them at a lower interest rate when the interest rate level drops. This is one reason why such bonds have risen less in value than, for example, government bonds, during periods featuring falling interest rates. If interest rates fall at the same time as equity market prices fall, such bonds will be less effective at curbing the fall in the Fund’s value.

Covered bonds are primarily issued by European banks, and secured on residential mortgages or loans to the public sector. These bonds do not carry the same right to refinance at a lower interest rate, and will normally be better suited to reducing fluctuations in a portfolio of equity and fixed income. Covered bonds are more comparable to corporate bonds with the highest credit rating than with US securitised bonds.

In its letter, Norges Bank also proposed removing government related bonds because this sub-segment contains widely differing bonds, including government bonds issued in foreign currencies and bonds issued by international organisations, municipalities and companies which are partly state-owned or controlled by the state.

The Ministry has analysed the various parts of the market for government related bonds. The review shows that foreign-currency government bonds issued in developed economies and bonds issued by supranationals are sub-segments with properties similar to those of government bonds. Of these two market segments, only bonds issued by supranationals account for a significant proportion of the total bond market.

The Ministry shares Norges Bank’s view that the fixed income benchmark can be simplified somewhat, and that a 70/30 split between the government and corporate parts appears appropriate. Such a split will result in approximately the same credit risk for the fixed income benchmark as for the old benchmark before bonds in emerging markets were included. Following an overall assessment, the Ministry has chosen to exclude securitised bonds, with the exception of covered bonds. The latter sub-segment primarily relates to European bonds. The Ministry is of the opinion that it is sensible to include covered bonds in the corporate part of the benchmark. Correspondingly, government-related bonds have also been removed from the benchmark, with the exception of the sub-segment supranationals. In the Ministry’s view, the latter is a natural component of the government part of the benchmark.

Until now, the benchmark has not included corporate bonds issued in the currencies of countries in Asia/Oceania. This position will be maintained in the new benchmark. The number of currencies included in the fixed income benchmark issued by companies will therefore continue to be seven.

Figur 2.3 Sub-segments included in the new benchmark for fixed income investments. Excluded sub-segment are marked by a red line

Figur 2.3 Sub-segments included in the new benchmark for fixed income investments. Excluded sub-segment are marked by a red line

* MBS stands for «Mortgage Backed Securities».

** ABS stands for «Asset Backed Securities».

*** CMBS stands for «Commercial Mortgage Backed Securities».

Kilde: Ministry of Finance and Norges Bank.

Figure 2.3 illustrates the sub-segments included in the Fund’s benchmark as at the end of 2011, as well as the sub-segments which have been excluded from the new benchmark. Segments which have been excluded are marked with a red line. Figure 2.4 shows the distribution of sub-segments in the old and new benchmarks.

Figur 2.4 Segment breakdown of old and new benchmark. Percent of index measured by market values as of the beginning of 2012. Emerging market bonds are included in line with the discussion in section 2.2.4

Figur 2.4 Segment breakdown of old and new benchmark. Percent of index measured by market values as of the beginning of 2012. Emerging market bonds are included in line with the discussion in section 2.2.4

Kilde: Barclays Capital, Ministry of Finance and Norges Bank.

2.2.3 Market value weighting and GDP weighting

The benchmark has largely employed market value weighting within each geographical currency region.

The global fixed income market is highly concentrated on a small number of currencies, and on government bonds issued by the largest countries. The market value weighting principle means that these properties are also reflected in the benchmark. The Fund’s high proportion invested in Europe has also resulted in a concentration on the largest European currencies.

In its letter of 18 March 2011, Norges Bank wrote that the market value weighting of government bonds implies an increase in the Fund’s exposure to countries with growing national debt burdens. According to the Bank, a better approach may be to weight the portfolio of government bonds based on the production capacity (gross domestic product – GDP), which is to finance the national debt.

A general lesson learned from the development of the government bond market in recent years is that risk also needs to be diversified widely in this part of the market. The use of market value weighting means that the states with the largest debts are given the greatest weight in the benchmark. Strong increase in public borrowing in many countries, and increased uncertainty about certain states’ ability to service their debts, underline the need to reconsider the principles governing the proportions of different government bonds in the benchmark.

The Ministry agrees with Norges Bank that the size of national economies, measured using GDP, appears to be a relevant starting point for the weighting of government bonds. GDP expresses a country’s income and tax basis. Compared to market value weights, GDP weights may be a better measure of states’ ability to pay. However, the size of an economy is not a precise measure of the ability or willingness to service government debt. Indicators such as the debt/GDP, budget balance and current account balance are often used to measure a country’s fiscal strength. Nevertheless, these measures are also not entirely precise measures of the ability or willingness to service national debts.

The Ministry will include a requirement in Norges Bank’s mandate stating that the management of government bonds must be designed to take account of differences in fiscal strength. This requirement is intended to highlight that one purpose of the Fund’s investments in government bonds is to reduce fluctuations in the Fund’s total return over time.

In its letter of 18 March 2011, Norges Bank suggested using market value weights for corporate bonds, mirroring their extensive use in relation to the Fund’s equity investments. There is no direct link between GDP and companies’ ability to service their debts. Large structural differences between the markets for corporate bonds in different currencies mean that GDP weights are not particularly appropriate for this part of the benchmark. The Ministry shares this view.

Until now, the fixed income benchmark has been based on market value weights, albeit with fixed regional weightings and a reweighting rule for, inter alia, securitised bonds in the US. As a general rule, all benchmarks which deviate from the market weights principle will increase the number of transactions needed to keep the actual portfolio close to the benchmark. Therefore, if Norges Bank manages the fixed income portfolio close to the benchmark, the new benchmark will mean an increased transaction volume and increased transaction costs.

In practice, the actual portfolio will deviate from the benchmark set by the Ministry. The National Budget for 2010 set out several reasons why such deviations will arise. Among other things, it was pointed out that it may be appropriate to purchase newly issued securities before they are included in the benchmark. Equally, it may be appropriate to sell securities with maturity less than one year or with reduced credit ratings later than the date when they are removed from the benchmark.

Since the use of GDP weighting for the government part, and market value weighting for the corporate part, of the benchmark is being introduced, a rule is needed regarding how the two sub-indices are to be combined. The Ministry agrees with Norges Bank that the distribution between the sub-indices should be fixed. A fixed distribution between the government and corporate parts of the benchmark will make the Fund somewhat more counter-cyclical, in that the Fund will invest more in corporate bonds after they have performed more poorly than government bonds, and vice versa. The rules on rebalancing towards fixed weightings between equities and bonds require the Fund to purchase equities and sell bonds when equity markets are falling. Floating weightings between the government and corporate parts would mean the sale of both government and corporate bonds when equity markets fall. Since the return on corporate bonds correlates to some degree with the return on equity, this would mean the sale of many corporate bonds which have fallen in value. A fixed weight between the government and corporate sub-portfolios, by means of monthly full rebalancing, may help to reduce the need for the sale of corporate bonds in such an environment.

2.2.4 Government bonds in emerging markets

In Report No. 15 (2010–2011) to the Storting, the Ministry pointed out that global production capacity is increasingly located elsewhere than in Europe. The Ministry also wrote that it would consider whether investments in emerging markets should be increased.

The proportion invested in the four largest currencies (US dollars, Euros, British pounds and Japanese yen), in the GPFG fixed income benchmark amounted to over 95 percent at the beginning of 2012. The changes described in sections 2.2.2 and 2.2.3 will ensure the inclusion of a higher proportion of bonds issued in yen and US dollars, while the proportion of bonds issued in Euro and British pounds will fall. This will result in a more even distribution and better diversification of risk between the largest currencies and bond issuers. At the same time, the fixed income benchmark will remain concentrated on a few currencies and individual countries, as bonds issued in these four currencies will together account for around 90 percent of the benchmark.

Expansion to include several additional currencies will require the inclusion in the benchmark of government bonds issued in local currencies in emerging markets. Such an expansion was considered in 2008. At that time, the Ministry, based not least on advice received from Norges Bank, decided not to include such bonds in the benchmark. Both the Ministry and Norges Bank stated at the time that it would be natural to return to the issue at a later date.

In a letter of 1 February 2012, Norges Bank provided advice on emerging bond markets. It recommended that the government part of the benchmark should be expanded from the present 11 currencies to include all currencies included at any given time in the GDP weighted benchmark provided by Barclays Capital (the Barclays Capital Treasury GDP Weighted by Country Index), with the exception of the Norwegian krone. Such a change would currently mean an increase in the number of currencies in the benchmark from 11 to 21. All 10 of the new currencies belong to emerging economies. Norges Bank also wrote that it did not recommend expanding the number of currencies in the corporate part of the benchmark, since a number of the emerging markets for corporate bonds remain underdeveloped. Moreover, these markets are small and account for less than 1 percent of a market-weighted global index of corporate bonds and covered bonds.

Among other things, Norges Bank wrote the following:

«The objective for the management of the Fund is to achieve the highest possible international purchasing power with moderate risk. Risk is limited by diversifying investments. A benchmark index for bond investments that includes more currencies is in line with the strategic role that nominal bonds should play in the Fund.»

Norges Bank analysed the effect on risk and return of including new currencies in Barclays Capital’s global index for government bonds, from a 10-year perspective. It commented as follows:

«It can be seen there that the inclusion of emerging markets would have resulted in a somewhat higher return and helped improve the trade-off between return and risk when the analysis is performed in a common currency such as Norwegian kroner.
However, the Fund’s return is measured in international currency. A better starting point is therefore the return in local currency and in the currency basket defined by the index. In Enclosure 1, we show that introducing investments in emerging markets would have resulted in a substantially higher return with reduced volatility during this period. The improvement in the trade-off between return and risk now appears to be greater.»

Although the inclusion of emerging markets would mean a lower concentration on the largest global issuers of government bonds, Norges Bank pointed out that, overall, the government part would face slightly higher credit risk. It wrote:

«Expansion of the Fund’s benchmark index for bond investments to include all currencies included in the BCGA index will improve diversification across issuers but will entail a certain weakening of the benchmark index’s credit quality as currently rated by the large credit rating agencies. In a GDP-weighted portfolio of government bonds, the proportion of bonds with a credit rating of A or below will, in the event of such expansion, rise from 6.5 percent to 14.6 percent, and 3 percent of government bonds will have a credit rating of BBB.»

The Ministry’s assessment of government bonds in emerging markets

The Ministry has given particular consideration to the degree to which the inclusion of new markets may be expected to improve the ratio between risk and return and in the benchmark in the long-term.

Analyses of historical returns indicate that it may be advantageous for the Fund’s long-term results to include new emerging bond markets in the benchmark. However, the measurable effect on risk and return appears to be small. One reason for this is that the new currencies only account for around 10 percent of the government part of the fixed income benchmark. When measuring the effect on the entire Fund’s risk and return, therefore, it is reasonable to expect small effects on risk and return.

Returns in emerging bond markets vary more than in developed markets, and are more strongly correlated with the equity markets, particularly during weak periods. At the same time, an expansion of the benchmark will spread the investments across more bond markets. This may in itself reduce the effect on the Fund’s returns of a crisis in an individual country or group of countries. The effect of such events is difficult to estimate, as there are no available time series for historical returns over periods of several decades.

The emerging markets whose inclusion in the benchmark Norges Bank has proposed carry a slightly higher credit risk than most of the developed markets in the government part of the benchmark. The credit rating of the fixed income portfolio will therefore be weakened somewhat by the expansion. Accordingly, it is not obvious that the inclusion of emerging markets will reduce the risk associated with the fixed income benchmark or the Fund overall.

An expansion of the benchmark to include 10 new emerging markets may also be regarded as a natural further development of the Fund’s investment strategy. All 10 of the new currencies belong to countries which are already included in the GPFG’s equity benchmark. Another relevant consideration is that the government related segment has been excluded from the new benchmark, with the exception of bonds issued by supranationals. Government bonds issued by emerging economies in foreign currency have, until now, been included in the benchmark as part of this market segment. Consequently, until 31 January of this year, government bonds issued by these countries were included in the fixed income benchmark if they were issued in one of the approved currencies.

Emerging bond markets in local currencies are growing strongly. This reflects high economic growth, strengthened state finances and increased trade with the global market in several emerging markets. The proportion of emerging market bonds will increase if these markets become more important over time.

To be included in the Barclays Capital GDP weighted index, government bonds must be investment grade. Moreover, the government bonds and the local currency markets must be sufficiently liquid and investable. In addition, there must be liquid markets for future sales of the local currency, so that international investors can hedge against exchange rate fluctuations. In the Ministry’s view, the risk of including emerging markets which satisfy these criteria can be regarded as moderate, provided that investors conduct their own assessment of the operational risk associated with settlement and custodian services.

Even if the new markets are included in the benchmark, Norges Bank will evaluate relevant investment risks and operational risks before funds are invested in these new markets. This is consistent with the mandate for the management of the GPFG.

The Ministry envisages that the new currencies will only be included in the government part of the benchmark. Table 2.1 sets out the emerging markets and currencies which will be included. In aggregate, the new emerging market currencies will account for around 10 percent of the government part of the fixed income benchmark (around 7 percent of the fixed income benchmark). Based on data as of the beginning of 2012, this will reduce the overall exposure to the four largest currencies (US dollar, Euro, British pound and Yen) from 90 percent to around 84 percent.

The Ministry also envisages the inclusion of all currencies forming part of the GDP weighted government bond index provided by Barclays Capital. If the index provider changes the selection of currencies included, the GPFG’s fixed income benchmark will be amended accordingly. As for the other parts of the government sub-portfolio, the principle of GDP weighting of individual countries is to be used for the new emerging markets.

Tabell 2.1 New fixed income benchmark as of the beginning of 2012. Change in currency composition by introducing emerging market currencies. Percentages and percentage points

Currency weightings

Country

Currency

11 currencies

21 currencies

Difference

Developed markets:

America

44.76

41.97

-2.79

Canada

CAD

3.53

3.27

-0.26

USA

USD

41.23

38.70

-2.53

Europe

42.90

40.16

-2.74

Denmark

DKK

0.74

0.68

-0.06

Euro zone

EUR

33.11

31.00

-2.11

United Kingdom

GBP

6.12

5.71

-0.41

Switzerland

CHF

1.51

1.42

-0.09

Sweden

SEK

1.42

1.34

-0.08

Asia/Oceania

12.33

11.14

-1.19

Australia

AUD

2.07

1.87

-0.20

Japan

JPY

9.63

8.70

-0.93

New Zealand

NZD

0.24

0.22

-0.02

Singapore

SGD

0.38

0.34

-0.04

Emerging markets:

Latin America

1.96

1.96

Chile

CLP

0.31

0.31

Mexico

MXN

1.65

1.65

Europe/Middle East/Africa

1.98

1.98

Israel

ILS

0.34

0.34

Poland

PLN

0.78

0.78

South Africa

ZAR

0.53

0.53

Czech Republic

CZK

0.33

0.33

Asia

2.79

2.79

Hong Kong

HKD

0.36

0.36

Malaysia

MYR

0.37

0.37

South Korea

KRW

1.57

1.57

Thailand

THB

0.48

0.48

Total

100.00

100.00

0.00

Kilde: Barclays Capital and Ministry of Finance.

2.2.5 Comparison with the old benchmark

The changes described above imply that

  • the benchmark is simplified and clarified to make the role of the fixed income investments in the management of the GPFG more transparent,

  • risk is better diversified across currencies and the largest issuers,

  • account is taken of the size of the economy in the weighting of government bonds, and

  • account is taken of fiscal strength in the management of the actual government bond portfolio.

The changes are based on assessments of the consequences for long term portfolio risk and return. At the same time there is considerable uncertainty related to financial market development in the short term. In hindsight one must expect, therefore, that the timing of the changes to the benchmark may appear as more or less favourable. This timing risk is somewhat reduced by the fact that the changes will take place over time.

Within the framework of deviation from the old benchmark, Norges Bank has reduced the number of bonds in the portfolio by about 50 percent in the course of 2011. This, combined with other adjustments to the actual portfolio, means a substantial reduction in the number of transactions required in connection with the transition to the new benchmark. The inflow of new capital may reduce the need for sales further, but it will still be necessary to sell bonds to adapt the portfolio to the new composition.

Box 2.4 provides an overview of the composition of the new strategic benchmark, including the expansion with new emerging market currencies.

Boks 2.4 New fixed income benchmark

The GPFG’s new fixed income benchmark comprises two parts: 70 percent government and 30 percent corporate. Weights are fixed, and full monthly rebalancing is undertaken between the sub-portfolios.

The government part includes nominal and inflation-linked government bonds issued in countries’ own currencies, and bonds issued by international organisations1. GDP weights are used to weight the country composition for the government part of the benchmark. The GDP weights are calculated as three-year weighted averages, and are updated once a year. Full monthly rebalancing to the fixed weights is undertaken throughout the year. Bonds issued by international organisations are assigned to countries in accordance with the currencies in which the securities are issued. Since several countries use Euro as their currency, a fixed weight is set every year for such bonds issued in Euro. The GDP weights of countries in the Euro zone are adjusted downwards correspondingly. The government part of the benchmark is currently based on 11 approved currencies. In this report, the Ministry is proposing that the number of currencies in the government part of the benchmark should be increased to 21; see section 2.2.4 for further discussion.

The corporate part includes corporate bonds and covered bonds.2 Global market value weights are used for this part of the benchmark. The corporate part of the benchmark contains seven approved currencies.

1 The indices “Barclays Capital Global Treasury GDP Weighted by Country” and “Barclays Capital Global Inflation Linked” are used to select the bonds which are included in the government part of the benchmark. The internal weighting scheme for the government part adopts the methodology of the former index.

2 The “Barclays Capital Global Aggregate” index is used to select the bonds which are included in the corporate part of the benchmark (corporate bonds and the sub-segment covered bonds within Securitised). The weighting scheme adopts the methodology of this index.

Figur 2.5 New benchmark for the GPFG’s fixed income investments

Figur 2.5 New benchmark for the GPFG’s fixed income investments

Kilde: Ministry of Finance.

The main difference between the old and new benchmarks is the currency composition. The switch to GDP weighting for the government part of the benchmark will result in a lower proportion of European currencies and a higher proportion of North American and Asian currencies. In addition, emerging market currencies will be included in the benchmark. Figure 2.6 illustrates the different currency distributions as of the beginning of 2012. Over time, these weights will change in line with development in relative GDP, in the case of the government part, and market-value development, in the case of the corporate part, and in line with inclusion or exclusion of new markets.

Figur 2.6 Currency distribution in the old and new fixed income benchmark. Percent of index measured by market values as of the beginning of 2012

Figur 2.6 Currency distribution in the old and new fixed income benchmark. Percent of index measured by market values as of the beginning of 2012

Kilde: Barclays Capital and Ministry of Finance.

With a lower proportion of European currencies in the fixed income benchmark, somewhat greater variations must be expected in the Fund’s value in Norwegian krone the short-term, as the Norwegian krone tends to exhibit larger fluctuations relative to non-European currencies. Calculations show that the annual standard deviation in the return on the GPFG’s benchmark, measured in Norwegian krone, would have been around 0.3 percentage points higher than they actually were in the period 2002–2011 if the new fixed income benchmark had been used. However, variations in the Fund’s returns measured in Norwegian krone do not affect the Fund’s international purchasing power.

Both the old and the new benchmark are comprised exclusively of investment grade bonds. A comparison of the distribution of credit ratings in the old and new benchmarks reveals a small increase in credit risk. The comparison is based on credit ratings at the beginning of 2012. It is the inclusion of emerging markets in particular that leads to a reduction in the proportion of bonds with the highest credit rating and an increase in the proportion with the lowest credit rating within investment grade. The proportion of bonds with a credit rating of A or lower increases from around 24 percent to around 30 percent in the new benchmark; see figure 2.6. The inclusion of the emerging market currencies explains 90 percent of this increase.

Figur 2.7 Distribution of credit ratings within investment grade. Percent of index measured by market values as of the beginning of 2012

Figur 2.7 Distribution of credit ratings within investment grade. Percent of index measured by market values as of the beginning of 2012

Kilde: Barclays Capital and the Ministry of Finance.

A somewhat higher credit risk in the fixed income benchmark means that the fund manager has to meet more stringent requirements. Last year, in its strategy plan for 2011–2013, Norges Bank gave notice that it was building up its expertise in the management of credit risk and bonds issued in emerging markets. Norges Bank’s annual report on the management of the GPFG in 2011 reveals that the Bank’s credit risk analysis capacity was strengthened in 2011.

Norges Bank estimates the duration of both the new and old benchmarks to be about six years. Duration is a measure of the sensitivity of the fixed income benchmark to changes in the general interest rate level. A duration of six years means that an increase (reduction) in the interest rate level of one percentage point results in a drop (increase) in the market value of the benchmark of around 6 percent. Norges Bank’s calculation confirms that no material difference is expected between the interest rate sensitivities of the old and new benchmarks.

2.2.6 The management mandate and Norges Bank’s internal operational benchmark portfolio

The Ministry plans to amend the management mandate such that Norges Bank is required to take account of difference in national fiscal strength in connection with investments in government bonds; see the discussion in section 2.2.3.

The report by Schaefer and Behrens which was discussed in Report No. 15 (2010–2011) to the Storting proposed that part of the fixed income investments should form separate portfolios (referred to as satellites), with special mandates. The Ministry has not chosen this solution. Instead, it has chosen a simpler solution in accordance with Norges Bank’s advice. However, the Ministry will consider whether special reporting requirements should be introduced for the corporate part and for government bonds from emerging markets.

The inclusion of emerging markets in the benchmark will necessitate amendments to the framework for investments in fixed income with credit ratings below investment grade. The Ministry will also evaluate whether there is a need for further adjustments to the mandate in light of the planned changes to the benchmark.

In its letter of 18 March 2011, Norges Bank wrote that the strategic benchmark cannot reflect all risks to which the Fund should be exposed at any given time. Such assessments must be based on the exercise of discretion and form part of the operational management. Norges Bank has therefore established an operational benchmark portfolio within the current active management framework. The operational benchmark portfolio is intended to function as an instrument for steering and communicating the adjustments which the Bank makes in the management of the fixed income investments.

Norges Bank’s annual report on the management of the GPFG in 2011 described the operational benchmark portfolio for fixed income in more detail. The main difference between the strategic benchmark set by the Ministry of Finance and the operational benchmark portfolio for fixed income established by Norges Bank is a reduction in the number of bonds and issuers. At the beginning of 2012, the operational benchmark portfolio included around 5,000 bonds, while the strategic benchmark contained around 11,500 bonds. In the annual report, the Bank wrote:

«The key characteristics of the strategic benchmark index can be recreated with a much smaller number of securities, which helps reduce the complexity of the portfolio and the cost of management.»

Norges Bank has already introduced GDP weighting of government bonds denominated in Euro in the operational benchmark portfolio. At the same time, the operational benchmark portfolio contains additional countries and currencies. Norges Bank has included, inter alia, government bonds in local currencies from emerging markets such as China, India and Indonesia. The investments in these markets are an example of Norges Bank seeking to exploit its advantages as a large investor, see the description in the Bank’s letter 1 February 2012.

In the 2011 annual report, Norges Bank wrote that market weighted benchmarks will automatically reflect structural changes in the issuance of new securities. When defining the operational benchmark portfolio, the Bank may consider the appropriateness of such changes for the Fund. One example is changes in the issuance of bonds in different parts of the capital structure of banks as a result of new regulations for the financial sector. It is not obvious that such changes should automatically be reflected in the Fund’s investment strategy.

The operational benchmark portfolio is also intended to address technical weaknesses in the strategic benchmark. Such weaknesses may include, for example, the automatic exclusion of bonds which fall below a certain credit rating threshold, and the exclusion of bonds with less than one year to maturity.

2.3 New geographical distribution of the strategic equity benchmark

2.3.1 Introduction

The current strategic benchmark for equities used by the Government Pension Fund Global (GPFG) is distributed across three regions, with the following fixed weightings: 50 percent Europe, 35 percent America and Africa and 15 percent Asia and Oceania. As in the case of the fixed income benchmark, the reason for the high proportion of investments in Europe has been a consideration regarding the Fund’s exchange rate risk. As Norway imports most from Europe, it has been natural to think that it can protect the purchasing power of the Fund against exchange rate risk by investing most in European markets.

In Report No. 15 (2010–2011) to the Storting – The Management of the Government Pension Fund in 2010, the Ministry undertook a new assessment of the Fund’s exchange rate risk. It concluded that the exchange rate risk appeared to be smaller than previously assumed, and there was no longer a basis for such a strong concentration of the investments in Europe. In the Report, the Ministry wrote that a geographical distribution in line with market values was a natural starting point for the composition of the Fund’s equity portfolio, but that considerations of investability, concentration risk and expected risk and return in different markets also had to be included in the assessment. The Ministry also wrote that a relevant question was whether the proportion of the Fund which is invested in emerging markets should be increased by more than suggested by market trends and a downweighting of Europe.

This section presents plans for changes to the geographical distribution of the GPFG’s strategic benchmark for equities.

2.3.2 Criteria and reference points for the geographical distribution of equities

The objective of the GPFG’s investments is to achieve the highest possible international purchasing power for the fund capital, given a moderate level of risk. The geographical distribution of the investments is to support this objective by helping to ensure an optimal ratio between expected risk and return in the Fund.

The geographical distribution of the Fund’s strategic equity benchmark should support a good diversification of risk in the Fund in both the short and long term. The Fund’s long time horizon indicates that the primary emphasis should be on long-term considerations.

In the short-term, a broad geographical diversification of the investments can help to reduce fluctuations in the return on the portfolio, provided that the returns in different countries’ markets do not move completely in tandem. Analyses of historical returns indicate a reduction in the potential for reducing fluctuations in the equity portfolio by spreading the investments among countries. This is illustrated in figure 2.11, which shows an increased degree of correlation between the returns achieved in different markets. Globalisation, which is integrating the world’s economies and financial markets ever more closely together, is an important explanatory factor in this regard; see box 2.5.

Boks 2.5 Globalisation of the equity markets

Increased globalisation and reductions in trade barriers have characterised the development of the global economy in the last 20 years. Strong growth in emerging economies has gradually moved the global centre of economic gravity.

Publicly listed companies are participating in globalisation. Figure 2.8 shows that in 2011, up to half of the income of listed companies came from countries other than those in which the companies are listed. Home markets nevertheless remain of great importance.

Figur 2.8 Companies’ foreign sales as a percentage of total sales, in selected countries

Figur 2.8 Companies’ foreign sales as a percentage of total sales, in selected countries

Kilde: MSCI.

Globalisation is also reflected in the equity markets. The costs of investing internationally have fallen sharply. Ever more countries and companies have become available to international investors. While the «All Country World Index» global equity benchmark provided by the index provider MSCI covered well over 1,100 companies in 1989, the number had increased to 14,600 companies in 2011.

Over time, it has become easier for investors to spread their investments among many countries and regions. The equity portfolios of institutional investors have become more global; see figure 2.9. Nevertheless, many investors continue to invest primarily in their local regions. This may be related to the fact that investors may have certain advantages in those regions, for example in the form of reduced foreign exchange risk, advantageous tax treatment, better access to information and better protection against various forms of political risk.

Figur 2.9 Home bias1 in selected countries. Percentages

Figur 2.9 Home bias1 in selected countries. Percentages

1 In this context, home bias is defined as 100 percent, less actual international equity allocation divided by market-weighted international equity allocation.

Kilde: MSCI.

Globalisation is integrating the world’s different equity markets closer together. Price trends in different markets have become more congruent, particularly since the 2008 financial crisis; see figure 2.10.

Figur 2.10 Correlation over the preceding 36 months between the returns achieved by various regional equity markets and the global market, measured in a common currency

Figur 2.10 Correlation over the preceding 36 months between the returns achieved by various regional equity markets and the global market, measured in a common currency

Kilde: MSCI.

MSCI has developed a model which seeks to explain systematic differences in equity returns. Among other things, the model can be used to compare the importance of which country stocks are listed in with other explanatory factors, such as which industry the companies are operating in and other company characteristics which investors tend to consider. Figure 2.11 shows that which country a company is listed in remains important, even if the significance of this factor has fallen over time.

Figur 2.11 The importance of different explanatory factors in the equity market.1 Percentages

Figur 2.11 The importance of different explanatory factors in the equity market.1 Percentages

1 The proportion of the total systematic variation in returns on a broad selection of equities (cross-sectional variation) that can be explained using countries, industries and various other company characteristics.

Kilde: MSCI.

Given that the companies in the benchmark have become more international, their development becomes more dependent on the development globally. The development of companies in the same industry, but listed in different countries, may be similar. The geographical distribution of the Fund’s benchmark should ensure the necessary diversification of the investments across different sectors, such as finance, health, energy, technology, etc. Returns in different sectors have varied considerably, and individual sectors may at times experience much greater falls than the equity market as a whole.

The Fund’s long time horizon suggests that emphasis should be given to risks associated with more unique events in a country or region. Examples may include prolonged economic crises, major natural disasters and wars. Since these are events which occur rarely, it is difficult to quantify their probability. Nevertheless, it is important to take into account that such events may occur. One question is therefore whether the geographical distribution entails an excessive concentration of the investments in individual countries or regions.

The equities investments enable the Fund to participate in global economic growth and value creation. A large, and increasing, part of this growth is occurring in emerging economies. In line with this trend, the share of the global equity market accounted for by emerging equity markets has grown strongly over the last 10 years. This development reflects the increased base of new countries and companies, and high historical returns. Emerging equity markets have become more important in recent years. Moreover, investments in emerging markets have a somewhat different risk profile than investments in developed markets. Stocks in emerging markets are often less tradeable, and returns vary more than in developed markets. This makes it natural to consider the emerging markets proportion separately when discussing the Fund’s geographical distribution.

The GPFG’s special characteristics may also be significant for the geographical distribution of the Fund’s investments. The aim of reducing the Fund’s exchange rate risk has been an important reason for the high proportion of investments in Europe. Protecting the Fund’s investments against political risk may well pull in the same direction. On the other hand, investments in more remote regions and in economies which are less like the Norwegian economy may help to ensure that the Fund’s returns fluctuate a little less in line with developments in the Norwegian economy. This would contribute to a wider diversification of the risk linked to total national assets of which the Fund forms a part. Moreover, investments in emerging markets may well exploit the Fund’s particularly long time horizon and limited liquidity need.

Global market weights are a much-used principle for equity benchmarks. Such market weights mean that each individual company is included in the benchmark with a weight corresponding to the market value of the equity of each company as a proportion of the value of the entire equity market. In a market-weighted equity benchmark, the geographical distribution is determined by the companies’ market values and where they are listed. Countries with large equity markets measured in terms of market value will therefore be assigned a higher weight than countries with smaller equity markets.

In the past 10 years, it has become common to adjust market-weighted benchmarks for «free float». This involves adjusting the weightings downwards in respect of the ownership interests of large, long-term owners, and in connection with cross-ownership, because these ownership interests are not freely tradeable. The adjusted weightings provide a better measure of the capital which is available to financial investors. On the other hand, the weightings will not reflect all of the available capital. Figure 2.12 shows that an adjustment for free float is important for how the geographical distribution of the world’s share capital is measured. In emerging markets, a significant proportion of equities are not freely tradeable. Emerging markets are therefore assigned a lower weighting in a market-weighted benchmark which is adjusted for free float than in a benchmark based on full market capitalisation.

Figur 2.12 Illustration of the geographical distribution of equities under different weighting principles. Based on market prices as of December 2011. Percentages

Figur 2.12 Illustration of the geographical distribution of equities under different weighting principles. Based on market prices as of December 2011. Percentages

Kilde: Ministry of Finance, Norges Bank, FTSE and MSCI.

Risk diversification involves distributing investments across as many sources of returns as possible. One question is whether a geographical distribution based on market weights achieves this aim sufficiently well. One means of evaluating this is to make a comparison with the geographical distribution of global GDP. The distribution of global GDP reflects, to a significant degree, how the world’s productive capital is distributed among countries and regions.

Figure 2.12 shows that almost 90 percent of the world’s listed equity markets are located in developed countries, while the economies of developed countries account for about two thirds of total global GDP. This is linked to the fact that developed countries often have more developed financial sectors. As a result, a larger proportion of the capital in the country is normally listed on a stock exchange. The difference is most apparent when North America is compared with emerging markets. North America is home to around half of the world’s listed equity markets (measured by market weights adjusted for free float), but only a quarter of total global GDP. Emerging markets account for almost a third of total global GDP and 20 percent of all equity capital, but only 12 percent of the equity market after adjustment for free float.

2.3.3 External analyses and advice

In connection with its assessments of the benchmark’s geographical distribution, the Ministry has received analyses and advice from the consultancy firm MSCI and from Professor Campbell Harvey at Duke University. Both MSCI and Harvey have considered the risk and return associated with investments in emerging markets. MSCI has also evaluated the risk of high ownership interests in the US and Europe, and the risk and return properties of different weighting principles. The reports are available on the Ministry’s website (www.government.no/gpf).

In a letter of 2 February 2012, the Ministry received advice from Norges Bank concerning the strategic equity benchmark. The letter is included as Annex 3 to this report. Norges Bank has also published discussion notes on topics related to the Fund’s geographical distribution. The notes are available on the Bank’s website (www.nbim.no).

Assessments of market weights

In its letter to the Ministry of Finance of 2 February 2012, Norges Bank recommended that

«(...)the starting point in a market-weighted benchmark index is retained».

The Bank emphasised that the strategic equity benchmark should reflect the role of the asset class in the Fund. To ensure the greatest possible openness and transparency, the starting point should be leading, and easily accessible benchmarks.

Norges Bank’s proposal is based on the global market weightings being adjusted for free float. The Bank wrote that if a free-float adjustment is made, differences in ownership structure between markets will mean that a market-weighted benchmark index will have an approximately 5 percentage point lower allocation to Asian equities and a correspondingly higher allocation to American equities than the full market value of companies in these regions would dictate.

Norges Bank also wrote that empirical analysis shows that portfolios constructed on the basis of different weighting criteria to a market-weighted portfolio can offer a better trade-off between risk and return. However, the Bank takes the view that such alternative weighting criteria should not be laid down in a strategic benchmark for equities; see the detailed discussion in section 2.7.

Norges Bank’s advice is to base the regional distribution of the benchmark for equities on market weights. The Bank wrote that:

«Norges Bank recommends that the strategic regional distribution of the Fund’s equity investments moves in the direction of global market weights. The transition to a new benchmark index should take place over a long period and in stages.»

The Bank also wrote that the objective of achieving the greatest possible long-term international purchasing power is best served by broad ownership of the production of goods and services. The Fund’s geographical distribution should depart from market weights only if such a composition of the Fund helps reduce risk or increase expected returns.

Norges Bank wrote that it attaches importance to being a predictable, long-term investor, and that it shares a mutual interest with the companies and countries in which it invests in creating long-term value. This means that the rights of investors must be respected, regulatory conditions must be relatively stable, and that it must be reasonably certain that the investments are safe. As a minority shareholder, the Bank depends on good corporate governance, limited discrimination and the protection of its rights in law and legal system. Norges Bank wrote that it is possible that the Fund should assign a larger weight to Europe than other regions if these considerations are prioritised. The Bank wrote that it may be natural to view Europe as an extended domestic market for the Fund with lower risks of this kind than in other regions.

In its report, MSCI wrote that market weighting is a good, objective criteria for describing investment opportunities in the global equity market. The reasons given for this view include that global market weights are simple to calculate. In addition, the costs of maintaining such a benchmark are low. In a market-weighted portfolio, companies with a high market value will be given a high weight in the benchmark. Since equities in companies with a high market weight are often easily tradeable, this will help to ensure that the portfolio comprises equities which, on the whole, are highly tradeable. MSCI also emphasised that market weights will be effective at capturing changes in the investment universe, as new markets, with their market weights, are included on an ongoing basis.

MSCI pointed out that a weakness of global market weights is that they do not take account of the fact that individual equities or parts of the market may, at times, be overpriced or underpriced compared to their long-term values. When market weights are used, equities are given a higher weight in the benchmark when they have a high value than when they have a low value. Such weights may therefore have the consequence that «expensive» equities are overweighted and «cheap» equities are underweighted. Over time, this may result in lower returns. MSCI also pointed out that global market weighting can result in a high concentration in individual countries. The Japanese equity market accounted for over 40 percent of the global equity benchmark in 1980. This was followed by a long period of significantly lower returns in Japan than in the rest of the global equity market. The experiences from Japan are highlighted as an important reason why investors began asking for benchmarks based on other weighting principles than global market weights, such as weightings based on the distribution of global GDP.

Tabell 2.2 Historical returns and standard deviations in the US and Europe, 1970–2011. Percentages

Average annual return

MSCI US (USD)

MSCI Europe (Local currency)

MSCI US (NOK)

MSCI Europe (NOK)

1970–2011

9.5

9.6

9.0

9.6

1970–1979

4.6

5.0

0.8

4.6

1980–1989

17.1

20.9

20.6

22.0

1990–1999

19.0

15.9

21.4

16.8

2000–2009

-1.3

0.0

-4.5

-0.9

Annual standard deviation

1970–2011

15.7

15.5

17.5

15.7

1970–1979

15.9

14.3

17.2

15.4

1980–1989

16.2

15.1

19.1

14.7

1990–1999

13.4

15.2

16.9

15.4

2000–2009

16.2

17.1

17.0

17.0

Risk-adjusted annual return

1970–2011

0.60

0.62

0.51

0.61

1970–1979

0.29

0.35

0.05

0.30

1980–1989

1.05

1.39

1.08

1.49

1990–1999

1.42

1.04

1.27

1.09

2000–2009

-0.08

0.00

-0.26

-0.05

Kilde: MSCI.

MSCI was engaged by the Ministry of Finance to analyse the differences between a market-weighted portfolio which has been adjusted for free float and a GDP-weighted portfolio. In the period 1970 to 2011, a GDP-weighted portfolio produced an annual return after transaction costs which was 1.2 percentage points higher, without risk being significantly different. MSCI takes the view that the higher weighting towards emerging markets which results from GDP weighting is the most important reason for the higher return during this period.

Concentration risk

The GPFG currently has a high proportion of its investments in Europe, while global market weighting would result in a high proportion in the US. History has shown that countries or economically integrated regions may suffer special shocks which may result in long periods of weak equity market returns. Developments in Japan in recent decades are often quoted as an example of this; see above. The Ministry therefore asked the consultancy firm MSCI to analyse the risk associated with large ownership interests in the US and Europe, respectively. Among other things, MSCI evaluated the risk of events which have a low probability of occurring, but which will have a considerable impact on returns if they do occur. The Fund’s long time horizon suggests that such risks should be given emphasis.

In its report, MSCI wrote that both the US and Europe have large and broadly diversified equity markets. In both markets, companies are widely distributed among different sectors, and the weightings of even the largest individual companies are moderate. Historically, these markets have experienced smaller fluctuations than other regional equity markets.

MSCI pointed out that the American and European equity markets are closely integrated. There are many similarities between the stock price developments in the two markets. The equity markets in the two regions have produced fairly similar returns in the period from 1970 until today; see table 2.2. Periods of great uncertainty in the financial markets, or periods of strong optimism, as during the IT-bubble at the turn of the millennium, also appear to have a fairly similar effect on the markets. This is particularly so when one takes into account that the IT sector constitutes a larger portion of the market in the US, and the finance sector a larger portion in Europe.

In real terms, there appear to be many similarities between companies listed in Europe and companies listed in the US. The companies have an international orientation and large sales in other countries, although their home markets remain important, see box 2.5. The company earnings and returns on equity in the two markets have developed fairly similarly; see figure 2.13.

Overall, MSCI concluded that the two markets appear very similar. In MSCI’s view, the particular risk associated with investing a high proportion of the equity portfolio in Europe or the US is the possibility of especially negative events. As examples of such events, MSCI mentioned country-specific macroeconomic shocks and a worsening of national creditworthiness.

Figur 2.13 Valuation and growth characteristics of the US and Europe. June 1994–December 2011

Figur 2.13 Valuation and growth characteristics of the US and Europe. June 1994–December 2011

Kilde: MSCI.

Assessments of emerging markets

Emerging markets’ share of global equity markets and of the GPFG’s equity investments has increased over time, see box 2.6

Boks 2.6 Emerging markets

The term «emerging markets» is not linked to any particular region of the world, but rather to markets in countries with a certain degree of financial development. Experience indicates that the degree of economic development, measured using GDP per capita, gives a good indication of which markets are emerging. Further, it is common to distinguish between developed emerging markets, secondary emerging markets and «frontier markets».

Emerging markets make up an ever-larger proportion of global equity markets; see figure 2.14. In MSCI’s global equity benchmarks, 21 countries are classified as emerging markets, compared to 10 countries in 1989. Emerging markets accounted for around 13 percent of MSCI’s global index in 2011, compared to just 1 percent in 1988. This development has been driven by high returns, the opening up of new markets, and by the fact that equity markets are growing in size as welfare levels rise in their economies.

Figur 2.14 Emerging markets’ share of the global market. Percentages

Figur 2.14 Emerging markets’ share of the global market. Percentages

Kilde: MSCI.

Emerging markets were first included in the GPFG equity benchmark in 2000. The number of emerging markets was increased slightly in 2004. In 2007, a broad review of emerging markets was conducted; see Report No. 16 (2007–2008) to the Storting – On the management of the Government Pension Fund in 2007. As a result, the number of countries in which the Fund invests was increased substantially. The Ministry’s analyses pointed out that country risk, settlement risk and risk associated with the legal framework were higher in emerging markets than in developed equity markets. At the same time, emphasis was given to the fact that these risks were monitored by the index provider, in addition to Norges Bank’s own control measures. It was also emphasised that comparable funds also allocated a significant portion of their funds to emerging equity markets.

Since 2008, the GPFG’s benchmark has included the listed equity markets of all countries which the index provider FTSE classifies as emerging. At the end of 2011, this category comprised Brazil, Hungary, Mexico, Poland, South Africa, Taiwan, Argentina, Chile, China, Colombia, Czech Republic, Egypt, India, Indonesia, Malaysia, Morocco, Pakistan, Peru, the Philippines, Russia, Thailand, Turkey and the United Arab Emirates. Frontier markets have not been included in the GPFG’s strategic benchmark, but Norges Bank is permitted to invest in these markets as part of the active management of the Fund.

At the end of 2011, investments in emerging markets amounted to some 9 percent of the value of the Fund’s equity portfolio; see figure 2.15. This is about 2 percentage points lower than the total market share of these markets in global equity markets as a whole.

Figur 2.15 The GPFG’s investments in emerging markets. NOK billion (left axis) and as a percentage of the Fund’s equity portfolio (right axis)

Figur 2.15 The GPFG’s investments in emerging markets. NOK billion (left axis) and as a percentage of the Fund’s equity portfolio (right axis)

Kilde: Norges Bank, FTSE and Ministry of Finance.

MSCI has commented that many large institutional investors have increased their investments in emerging markets in recent years.

In its report, MSCI pointed out that emerging equity markets have, overall, produced significantly higher returns in recent decades than developed equity markets. Since 1988, investments in emerging markets, measured using the MSCI Emerging Markets Index, have produced an annual return of almost 13 percent. During the same period, investments in developed equity markets produced an annual return of around 7 percent, see figure 2.16. The difference has been particularly large in the period since the year 2000, when the return on developed equity markets was less than 2 percent per year.

Figur 2.16 Performance of emerging and developed markets, measured in US dollars. (1987=100)

Figur 2.16 Performance of emerging and developed markets, measured in US dollars. (1987=100)

Kilde: MSCI.

MSCI emphasised that investments in emerging markets carry a higher risk. Volatility in these equity markets is greater. MSCI pointed out that, historically, emerging markets have experienced several crises resulting in large equity market losses. Examples include the Asian crisis in 1997, Russia’s default on national debt in 1998 and Argentina’s currency crisis in 2002. Macroeconomic instability and dependence on foreign financing have been highlighted as important causes of these crises.

MSCI’s analysis shows that the country-specific risk is greater in emerging markets than in developed markets. MSCI stated that its indicators relating to macroeconomic risk and the quality of regulation, the enforcement of legislation, and the scope of corruption, freedom of expression, political stability and minority shareholder rights clearly demonstrated a higher risk level in emerging markets.

Overall, MSCI’s analysis shows that the ratio between risk and return, measured by standard deviations in the period since 1988, has been considerably better for emerging equity markets than for global equity markets.

MSCI pointed to high economic growth as an important explanation for why emerging markets have produced higher returns than developed markets. Over the last 10 years, many emerging economies have successfully engaged in economic and financial integration with the global economy.

MSCI’s analyses show that the development of emerging equity markets has become ever more congruent with the development of developed markets. Figure 2.17 shows that the earnings per share of companies listed in emerging markets have been close to the corresponding trend for the world’s listed companies as a whole. Figure 2.17 also shows that the price of equities in emerging markets, measured using the ratio between the price per share and earnings per share, has in recent years been on about the same level as prices in global equity markets generally. This indicates that many of the same driving forces determine developments in both emerging and developed equity markets.

Figur 2.17 Valuation and growth characteristics in emerging markets

Figur 2.17 Valuation and growth characteristics in emerging markets

Kilde: MSCI.

MSCI pointed out that emerging equity markets have become a central part of the global equity market, and that they constitute a natural part of a global investment portfolio. MSCI also wrote that giving emerging markets a higher weighting than market weighting could be an option for investors who have a good ability to bear short-term fluctuations and who wish to focus the portfolio more strongly on potential long-term economic growth. According to MSCI, the main risk associated with emerging markets is that globalisation will stop or be reversed.

The Ministry has also received advice from Professor Campbell Harvey at Duke University. Harvey analyses expected risk and return in emerging markets, and assesses how large a proportion of a global equity portfolio should be allocated to emerging markets. Harvey has analysed emerging equity markets specifically, but has not considered a potentially higher stake in emerging equity markets in light of the Fund’s overall strategy.

Like MSCI, in his report Harvey wrote that expected returns in emerging markets appear to be higher than returns in developed markets. He linked the higher expected returns with better growth opportunities for emerging markets, but also with higher risk. Larger fluctuations and higher market risk, and the fact that equities may be more difficult to trade, were highlighted as important sources of the overall risk. Harvey takes the view that political risk may provide a basis for a higher expected return, but in his opinion it is not clear that such risk is currently higher in emerging markets than in developed markets. He pointed to the debt situation in Europe in this regard.

Harvey also pointed out that there is a close connection between economic growth and financial development in many emerging countries. When the financial markets are developed, access to capital will normally improve, and the cost of capital will fall. This contributes to increased investment and economic growth. Harvey highlighted that there is a positive historical relation between economic growth and returns in emerging markets over periods of several years; see figure 2.18. According to Harvey, long-term investors should therefore invest a higher proportion in markets in which financial development can contribute to higher growth and returns.

Figur 2.18 Average growth in GDP in emerging economies and excess returns in their stock markets over five-year periods, measured in a common currency

Figur 2.18 Average growth in GDP in emerging economies and excess returns in their stock markets over five-year periods, measured in a common currency

Kilde: Harvey (2012).

Overall, Harvey took the view that a long-term investor like the GPFG is well-positioned to bear the risk associated with investments in emerging markets. He recommended that the Ministry should consider an allocation to emerging markets, as defined in the MSCI index, of around 16 percent. 3 This allocation is somewhat higher than indicated by free float-adjusted global market weights. Harvey gave particular emphasis to the Fund’s ability to hold investments for a long time and the positive relation between financial development and economic growth. According to Harvey, investments in emerging markets should not be based solely on global market weights, but also on weights which reflect fundamental indicators, such as GDP.

Harvey also analysed GDP weighting as an alternative to linking the country distribution among emerging markets to market size. He pointed out that stock prices in emerging markets can fluctuate strongly compared to other markets. There may also be a greater incidence of mis-pricing in emerging markets. Harvey wrote that linking the country distribution among emerging markets to GDP would lead investors to sell equities in markets which have risen sharply compared to the country’s GDP, and buy equities in markets which have fallen. If this strategy involves selling equities in markets which have risen too much compared to their long-term values, or buying equities in markets which have dropped below their long-term values, a higher return will be achieved over time.

In its letter of 2 February 2012, Norges Bank recommended that the proportion of equity investments in emerging markets should not be increased beyond market weights. The Bank wrote:

«Norges Bank does not recommend establishing a special allocation to emerging markets beyond what is indicated by market weighting.»

Norges Bank wrote that an analysis conducted by the Bank showed that high growth in a country does not in itself provide a basis for an unambiguous assumption of higher equity market returns. The Bank pointed out that the link between a country’s economic growth and the earnings of the country’s listed companies is weak, and that only growth in excess of expectations can provide a basis for higher future returns adjusted for risk.

Norges Bank also considered which underlying factors may result in higher risk, and thus higher expected returns, in emerging markets. The Bank wrote that risk factors can be linked to stability in governance structures, the regulation of the financial markets, the legal system and quality of legislation, the level of corruption and, ultimately, the danger of expropriation. The Bank also emphasised that, in some cases, foreign investors and the interests of minority shareholders will be poorly protected. It attached weight to the fact that, in some markets, foreign investors are subject to special rules and limitations, and that some countries do not permit full, free capital movements in their currency. In Norges Bank’s view, it is not clear that the Fund has a natural advantage as regards bearing this type of risk, compared to other Funds.

2.3.4 The Ministry’s assessment

The Ministry is of the opinion that global market weights (adjusted for free float) are a logical starting point for the geographical distribution of the GPFG’s benchmark for equities. A market-weighted portfolio reflects the capital available to the Fund in global listed equity markets, and may be regarded as the portfolio of the average global investor. Developments in a market-weighted benchmark will in the Ministry’s view properly reflect developments in the equity market as a whole. The Ministry is of the opinion that a market-weighted benchmark will be a good starting point for open, cost-effective management of the equity portfolio.

MSCI, Norges Bank and Professor Harvey all pointed out that market weighting also has weaknesses which may reduce expected returns. Such weaknesses, and means of exploiting these, are discussed in section 2.7.3. In the Ministry’s view, the Fund’s geographical distribution at the strategic level is rather unsuited to making the adjustments which are necessary to counteract these weaknesses.

The Ministry envisages changing the benchmark for equity so that the geographical distribution tracks global market weights to a greater degree. However, the Ministry has identified two considerations which may indicate that the market weights should be adjusted:

  • At current equity prices, a switch to global market weighting would mean that the proportion invested in Europe would drop by approximately half. This would be a major change. The Ministry notes that Norges Bank has recommended that the geographical distribution should approach global market weights gradually, and in several stages. The Bank has also pointed out that there may be reasons for the Fund to continue to invest a proportion in Europe in the long-term that is somewhat higher than suggested by market weights.

  • A switch to global market weighting would have entailed a very high portion invested in the US. Although the world’s companies and financial markets have become increasingly international, country-specific risk should still be taken into account in the geographical distribution of the Fund’s benchmark.

  • The equity market in the US is very broadly composed. Nevertheless, it must be expected that the performance of companies will be linked, to a significant degree, to the performance of the American economy. This may indicate that the American market should not be assigned a high proportion in the benchmark.

The Ministry notes that MSCI’s analysis shows that there are many similarities between the equity market in the US and the developed equity markets in Europe. The analyses of historical returns show that an adjustment of the distribution between these markets has had little effect on total risk and return. The Ministry therefore sees that the goal of avoiding an excessive portion in the US and the goal of avoiding an excessively sharp reduction in the European portion can be seen in conjunction. Rather than switching over entirely to global market weights for both Europe and the US, the Ministry instead envisages a more even distribution between these markets than is the case today. This means a distribution in which Europe is given a weighting which is lower than at present, but nevertheless somewhat higher than indicated by market weights. The US is given a higher weighting, which is nevertheless lower than market weights.

Currently, the strategic weight of Europe in the benchmark is set at 50 percent, while global market weighting would currently imply a proportion of around 24 percent. The Ministry envisages reducing the European proportion by around 10 percentage points from the current level.

The Ministry considers it appropriate to treat the markets in North America, i.e. the US and Canada, as one. The economies and equity markets of these countries are very closely integrated. Moreover, the Ministry plans to distinguish between developed and emerging equity markets; see the detailed discussion below. Other than an adjustment of developed equity markets in Europe and North America, the benchmark will apply global market weights. Compared to the current distribution, this will mean higher proportions in developed markets in North America, Asia and Oceania, and in emerging markets.

Overall, the new geographical distribution of the equity benchmark will result in a wider geographical diversification of the equity investments than at present. Figure 2.19 shows how the potential new geographical distribution may be, based on market rates at the beginning of 2012. Figure 2.19 also shows that it can be assumed that the sector composition will remain largely unchanged from the current position. No material changes in long-term returns are expected, although the spread of risk will improve.

The principle of market weighting implies that the geographical distribution among different regions will not be fixed, as at present, but will vary in accordance with developments in the different markets. If, for example, the growth in emerging equity markets continues, in a few years market weighting may mean a higher proportion in such markets than at present. Moreover, different price trends in different markets will influence the geographical distribution when market weighting is applied.

Accordingly, there is no basis for stating that the new geographical distribution of the benchmark for equity will mean a specific European portion. The estimates of the European portion which are presented here are based on market prices at the beginning of 2012. There is also no basis for stating that the reduction in the European proportion will be exactly 10 percentage points. Nevertheless, this provides a reasonable picture of the scope of the reduction in the European portion which the Ministry is planning. The Ministry will continue work on introducing a final rule for the European proportion, and will provide a briefing on this issue once the adaptation has been implemented. The proportion invested in Europe is to be reduced gradually over time. New transfers to the Fund will be used to implement the changes. However, it may still be necessary to sell European equities.

Figur 2.19 Illustration of current and new geographical distribution and sector composition of equities in the GPFG. Based on market prices at the beginning of 2012. Percentages1

Figur 2.19 Illustration of current and new geographical distribution and sector composition of equities in the GPFG. Based on market prices at the beginning of 2012. Percentages1

1 The distribution and sector composition will vary in line with market trends. In the figure, the proportion of developed markets in Europe has been reduced by 10 percentage points compared to the current weighting.

Kilde: Ministry of Finance.

The changes are based on assessments of the consequences for the risk and return of the portfolio in the long-term. At the same time there is considerable uncertainty related to the market’s development in the short term. One must therefore be prepared for the timing of changes to the benchmark in hindsight appearing as more or less favourable. This risk is somewhat reduced by the fact that the changes take place over time.

At the beginning of 2012, the proportion of emerging markets in the Fund’s benchmark for equity was just over 9 percent, compared to 11.5 percent under global market weighting. The switch to market weighting therefore means an increased emphasis on emerging equity markets, compared to the current distribution.

The Ministry has considered whether the proportion of emerging markets in the benchmark should be higher than the market weight. This assessment is based on the risk and return properties of investments in such markets. In the last 20 years, emerging markets have been characterised by higher returns, but also by greater risks, than developed equity markets. Overall, investments in emerging markets have improved the ratio between risk and return during this period. The increased risk partly reflects the fact that equities in emerging markets are less liquid, partly that stock prices fluctuate more, and partly that companies are more exposed to fluctuations in the world economy. There may also be greater political risk in emerging markets.

Professor Harvey took the view that the Fund’s particularly strong ability to hold investments over long periods means that the Fund is well-positioned to invest in markets which feature low liquidity and large fluctuations. Over time, such risks may produce higher expected returns. For its part, Norges Bank has pointed out that investments in emerging markets involve a risk of instability in governance structures, regulations and rights for international investors, and a risk of corruption and, in extreme cases, expropriation. The Bank therefore takes the view that it is not clear that the GPFG is better positioned to bear this type of risk than other funds, and recommends that the proportion of emerging markets should not be set higher than the market weight.

The analyses and recommendations which the Ministry has received show that opinions vary as to the relationship between returns in emerging equity markets and growth in emerging economies. Looking forward, at least some emerging economies are expected to grow much more strongly than developed economies. Emerging economies already comprise a much larger proportion of the world economy than the weight which would be given to emerging equity markets under global market weighting. An important question is whether this provides a basis for investing a higher proportion in emerging equity markets than the market weight.

The Ministry notes that Professor Harvey found that historically there has been a relationship between long-term growth in emerging economies and returns in emerging equity markets. Harvey described a development process in emerging economies in which high expected growth goes hand in hand with a high risk of crises and setbacks. Investors are paid for this risk in the form of higher expected returns. Over time, companies in emerging equity markets may produce higher returns if the emerging economies succeed in achieving growth and development.

Norges Bank has emphasised that the relation between economic growth and returns on equity is not unambiguous. The Bank examined a broad selection of both developed and emerging equity markets, and found only a weak relation between a country’s economic growth and the earnings of limited companies which are listed on the country’s stock exchanges. One reason for this may be that globalisation makes the companies more dependent on developments in the world economy, and less dependent on developments in the country in which they are listed. Another reason may be that much of the economic growth in a country occurs in businesses which are not listed on a stock exchange.

High growth is expected in many emerging economies in the years ahead. However, high expected growth is no guarantee of high future returns. Investors must be expected to be well aware of growth prospects in emerging economies, and that this is already largely reflected in the equity prices. The Ministry shares Norges Bank’s view that it is only growth in excess of expectations which can provide a basis for higher expected future returns adjusted for risk.

MSCI’s analyses show that the world’s limited companies are becoming increasingly international. Many companies which are listed in developed equity markets have invested considerable sums in emerging economies, and many companies in emerging equity markets have focused their production on sales to developed economies. This development makes it increasingly difficult to specify a particular geographical identity for a company based on the country in which it is listed. The Ministry also notes that, over time, the earnings growth (growth of profit) achieved by emerging and developed markets over time appears to have become more similar. Despite higher GDP growth in emerging economies, growth in earnings per share in the equity markets in these economies has not differed materially from the development in developed equity markets. This seems to indicate that a large part of the growth in these economies is derived from businesses that are not listed or accrue to other entities than the capital owners. In the Ministry’s view, it is therefore uncertain whether a higher weighting than the market weight of listed companies in emerging economies would mean that the Fund participates more in total global value creation and growth.

Following an overall assessment, the Ministry plans to increase the proportion of emerging equity markets in the equity benchmark to market weight. The decision to adopt market weighting of emerging equity markets must be considered in conjunction with the fact that, in this Report to the Storting, the Ministry has also stated its plans to include emerging markets in the Fund’s fixed income benchmark; see the discussion in section 2.2.

The Ministry will return to the question of the proportion of emerging equity markets at a later date. The distinctive characteristics of the Fund, for example its long time horizon and limited need to realise assets quickly, may be expected to confer advantages in emerging markets; see the discussion above. This may indicate that a somewhat higher emerging market proportion should be adopted than suggested by global market weights. However, the same distinctive characteristics may also give the Fund advantages in other areas; see, for example, the discussion in section 2.7. The Ministry will continue to work on assessing different means of exploiting the Fund’s special characteristics. The Ministry considers it natural to begin exploiting the Fund’s special characteristics in areas in which it is clearest that they will generate advantages, and which offer the greatest opportunities to improve the ratio between expected risk and return on the Fund. A new assessment of the emerging equity markets portion will be conducted within a framework of this kind.

2.4 New geographical distribution of the Government Pension Fund Global

Previous geographical distribution

The investment strategy of the Government Pension Fund Global (GPFG) is expressed through the Fund’s strategic benchmark. The benchmark is a detailed description of how the Fund’s capital shoul be invested, if Norges Bank is not to draw on its limits for deviating from the benchmark. The benchmark is split between equities (60 percent), fixed income (35 percent) and real estate (5 percent). It has also been divided into three geographical regions: Europe, America/Africa and Asia/Oceania. Within each region, the investments have primarily been allocated to countries in accordance with relative market size. The Fund’s geographical distribution implicitly determines the currency composition of the Fund.

Until now, the respective regional weights have been 50 percent, 35 percent and 15 percent for equities, and 60 percent, 35 percent and 5 percent for fixed income; see figure 2.20. In other words, more than half of the fund capital has been invested in Europe. The regional weights are the result of a trade-off between various considerations. An important objective linked to the high proportion in Europe has been to reduce the Fund’s exchange rate risk; see the discussion in section 2.3.

Figur 2.20 Previous strategic benchmark for the GPFG1

Figur 2.20 Previous strategic benchmark for the GPFG1

1 Fixed income has comprised 40 percent. Over time, real estate will comprise up to 5 percent, while the fixed income portion will be reduced to 35 percent.

Kilde: Ministry of Finance.

New geographical distribution

In last year’s report, Report No. 15 (2010–2011) to the Storting – The Management of the Government Pension Fund in 2010, the Ministry concluded that the long-term exchange rate risk appeared to be smaller than previously thought. In its assessment, it wrote that the proportion invested in Europe should be reduced over time. In the case of equities and corporate bonds, it is appropriate for the new distribution to be based on market size (market-weighting), while in the case of government bonds it is more appropriate to use the size of the economies (GDP-weighting). Sections 2.2 and 2.3 of this Report to the Storting contain more detailed accounts of the changes in the geographical distribution of the GPFG’s investments.

Figur 2.21 New strategic benchmark for the GPFG1

Figur 2.21 New strategic benchmark for the GPFG1

1 The plan is for up to 5 percent of the capital of the GPFG to be invested in real estate. These investments will result in a corresponding reduction in the proportion invested in fixed income. At the end of 2011, 0.3 percent of the fund capital was invested in real estate. All of these investments were made in Europe; see the discussion in section 4.1.

Kilde: Ministry of Finance.

Based on market values at the end of 2011, the changes imply, among other things,

  • a reduction in the European proportion totalling 13 percentage points,

  • an increase in the emerging markets proportion totalling 4 percentage points,

  • that the North American proportion will remain below market weight.

Table 2.3 shows the regional distribution of the GPFG under the previous and new benchmarks. The regional distribution under the new benchmark is based on market values at the beginning of 2012. This means that the proportions in the different regions under the new benchmark will depend on market developments and the relative development in GDP.

Tabell 2.3 Regional distribution of the GPFG under previous and new benchmarks. Measured using market values at the beginning of 2012. Percentages

Previous

New

America/Africa

35

40

Europe

54

41

Asia/Oceania

11

19

Of this:

Emerging markets

6

10

Kilde: Ministry of Finance.

2.5 Rebalancing

2.5.1 Introduction

The Ministry of Finance’s long-term strategy for the management of the Government Pension Fund Global (GPFG) specifies a fixed distribution between equities (60 percent), fixed income (35 percent) and real estate (5 percent); see section 2.4. A fixed distribution between three geographical regions has also been applied. The distribution between equities, fixed income and real estate is the result of a trade-off between expected risk and return in these asset classes in the long run. The regional weights are also the result of a trade-off between different interests; see the discussion in section 2.2 (fixed income) and section 2.3 (equities).

Market movements result in the actual assets and regional proportions moving away from the strategic weights. For example, a rise in equity prices compared to the prices of bonds will result in an increase in the equity portion. As a result, the equity portion may rise above the strategic weight of 60 percent, unless Norges Bank sells stocks to counteract this. A higher (or lower) equity portion will alter the risk and return properties of the Fund. It is therefore important to have in place a system which returns the actual weights to the strategic weights.

Rebalancing meets this need. Rebalancing is conducted both gradually using the ongoing transfers of capital into the Fund (referred to as partial rebalancing), and through the purchase and sale of securities (referred to as full rebalancing). Full rebalancing is undertaken if the deviation from the strategic weights is sufficiently large. This is referred to as conditional full rebalancing. The Ministry has laid down detailed rebalancing rules. These detailed rules have been exempted from public disclosure to prevent other financial market participants from predicting the actions of the Fund in a manner which could cause the Fund to incur unnecessary costs.

When selling securities, the Fund incurs transaction costs which reduce returns. The rules governing the size of deviations which must be accepted before full rebalancing is undertaken have therefore been formulated based on a trade-off between the need to bring the weights in the Fund back to the strategic weights and the need to save transaction costs.

The first payment into the GPFG was made in May 1996. At that time, the Fund’s investments comprised only bonds. Equities were included in 1998, with a proportion of 40 percent. In the period 1998–2001, the Fund was rebalanced through the quarterly transfer of capital into the Fund. In 2001, a switch was made to monthly transfers to the Fund. At the same time, new rules were adopted which entailed monthly, partial rebalancing and conditional full rebalancing. The rebalancing rules have remained unchanged since 2001, but were temporarily suspended in connection with the increase in the equity portion from 40 percent to 60 percent in the period 2007–2009. In a separate note, Norges Bank has analysed the experience gained from rebalancing the GPFG. 4

Section 2.2 contains a detailed discussion of the new benchmark for the GPFG’s fixed income investments, and section 2.3 contains an account of changes made to the geographical distribution of the GPFG’s equity benchmark. The changes in the investment strategy for the equity and fixed income investments suggest that the rebalancing rules should be amended. In a letter of 26 January 2012, Norges Bank gave advice on such rules. The letter is appended to this Report to the Storting.

2.5.2 The basis for rebalancing

Risk in the equity, fixed income and real estate markets varies over time. For example, figure 2.22 shows that fluctuations in the stock market were smaller in the period 2003–2007 than in the period 2008–2011. In other words, a fixed equity portion does not guarantee a stable risk level in the Fund. The GPFG’s equity portion has been chosen on the basis of analyses of how a fixed equity portion will affect risk and return in the long run.

Figur 2.22 The risk in the benchmark for the GPFG’s equity portfolio. Rolling 12-month standard deviation. Percentages

Figur 2.22 The risk in the benchmark for the GPFG’s equity portfolio. Rolling 12-month standard deviation. Percentages

Kilde: Ministry of Finance and Norges Bank.

Expected risk and return in a portfolio which is rebalanced will be different from the risk and return in a portfolio in which equity and regional weights are floating freely in line with how the markets develop. Rebalancing is therefore important to ensure that the Fund’s properties correspond with the long-term strategic choices which have been made and which enjoy widespread support.

Rebalancing involves purchasing equities if the equity market has fallen during preceding periods, compared with bonds. If the drop in the equity market turns into an upturn after rebalancing, the Fund’s results will be improved. If the equity market continues to fall, on the other hand, the Fund’s losses will increase. Thus far, the rebalancing rules have improved the ratio between risk and return in the GPFG; see section 2.5.3.

Risk is often expressed using standard deviation, which is a measure of fluctuations in returns. It is an appropriate way of measuring risk if the probability of achieving a return which is higher than the average equals the probability of achieving a return which is lower. Rebalancing to a fixed equity portion means that the equity investments are reduced during upturns and increased during downturns. The result is that the probability of achieving a very good return is somewhat lower than if no rebalancing was undertaken, and that the probability of achieving a very poor return is increased somewhat; see box 2.7.

Boks 2.7 Why investors rebalance their portfolios

Not all investors can rebalance simultaneously. When some investors buy, others must act as sellers. Many investors may wish to reduce their equity investments during bad times, regardless of expected returns. This may be due to a wish to limit potential losses or a need to move investments into more liquid assets. Such behaviour may, for example, be caused by requirements concerning the size of an investor’s equity capital. It can therefore be said that an investor who rebalances sells insurance against losses to such investors. As in connection with the sale of other types of insurance, rebalancing will generate an insurance premium in return for assuming the risk of a future loss which has a low probability of occurring but which will have severe consequences if it occurs. Accordingly, measures of normal fluctuations in returns, such as standard deviation, will not necessarily be a adequate measure of the risk associated with the strategy. Figures from Norges Bank show that standard deviation has been an adequate measure of return variations during the period for which the GPFG has invested in equities; see box 2.8.

Experience indicates that the equity markets fluctuate more during periods when prices are falling. For an investor with a short time horizon, holding a high proportion of equities in such a situation may appear to increase risk. Moreover, when the markets fall, the willingness of investors to assume risk may disappear quickly. If variation in the equity premium is due to a reduced willingness on the part of short-term investors to assume risk during weak periods, this can be exploited by a long-term investor with a more stable risk appetite. An increased risk in the short term is of minor significance to an investor with a long time horizon. In this case, rebalancing appear to provide a means for long-term investors to purchase equities «cheaply» during weak periods, without significantly affecting the risk associated with the investments in the long-term.

Nevertheless, if equity returns have a tendency to fluctuate around an average, rebalancing may not appear especially risky to an investor with broad diversification and a long time horizon. The investor can then achieve good returns when the market rises again following a downturn, as was the case for the GPFG in 2009. If, on the other hand, falling equity prices in a market reflect a weak long-term trend, the Fund’s long time horizon will not justify a rebalancing strategy. One example of this is the development in the Japanese equity market since 1990.

Norges Bank’s review of the economic literature reveals that a large proportion of the variations in equity prices over time appear to be explained by the fact that the risk premium in the market varies over time in line with economic cycles. 5 The risk premium in the equity market expresses how much compensation investors demand for assuming risk. 6 Various financial models seek to explain why the price of assuming risk can vary over time; see Cochrane (2011). 7 Investors may, for example, suffer significant drops in labour income during a downturn. They therefore wish to avoid investing in equities which fall by more than the average during downturns. This is then reflected in prices. Another example of a factor which can cause the risk premium in the equity market to vary over time is liquidity fluctuation. There is reason to assume that the risk premium depends on how liquid the equities are. Liquidity in the equity market tends to vary with economic cycles, meaning that liquidity is low during downturns.

If the risk premium varies with economic cycles, rebalancing to a fixed equity portion will mean systematically increasing the equity investments precisely when the expected returns are high. Rebalancing may therefore be a means of exploiting time-variation in the risk premium.

Time-varying risk premiums were a topic at the Investment Strategy Summit 2011; see box 2.9 in section 2.7. At the seminar, it was pointed out that the Fund’s rebalancing rules have a disciplinary effect on the Fund’s distribution among asset classes and risk-taking, are counter-cyclical, and help to exploit time-varying risk premiums. A key question is whether the GPFG could and should exploit time-varying risk premiums more than at present. The following conclusions can be drawn from the discussion at the seminar:

  • The current rebalancing rules can probably be expanded to exploit more of the potential for counter-cyclical investments in the GPFG, but it is likely that this would mean increased risk.

  • If efforts were to be made to exploit time variations in risk premiums beyond a fixed rebalancing rule, this would probably require changes to the current governance structure, including by giving Norges Bank more room to alter the Fund’s exposure to equity market risk.

  • «Buy low and sell high» is a sensible investment principle, but difficult to implement in practice.

Minutes of the seminar are available on the Ministry’s website (www.regjeringen.no/spf).

2.5.3 Rebalancing experience

Norges Bank has analysed how changes in the actual benchmark have affected risk and returns in the Fund since 1998. The Bank has also compared quarterly rebalancing with the rebalancing rules which currently apply to the GPFG.

The analyses show that rebalancing has resulted in higher returns and lower risk in the period 1998–2011; see box 2.8. They also show that going from quarterly to conditional rebalancing has increased returns, but also that it has resulted in a certain increase in the deviation between the actual and strategic equity weights. For its part, partial rebalancing has helped to reduce the deviation between the actual and strategic equity weights, albeit at the price of somewhat lower returns (0.1 percent).

Boks 2.8 Experiences of rebalancing the GPFG

Norges Bank has analysed how changes in the actual benchmark have affected risk and return in the Fund since 1998, compared with two alternative portfolios in which equities and regional weights have been allowed to float freely with market trends. The one alternative portfolio has an equity portion of 60 percent, while the other has a equity portion of 40 percent. This corresponds to the current strategic equity portion and the equity portion which the GPFG had in January 1998.

Figure 2.23 shows the development of the equity portions of the actual GPFG benchmark and of the alternative portfolio with a 40-percent equity portion in 1998, without subsequent rebalancing.

The analysis shows that the actual benchmark, which is rebalanced, has achieved higher returns (both before and after costs), than the two alternative portfolios; see table 2.4. At the same time, the returns achieved by the actual benchmark have varied less than the returns achieved by the alternative portfolios. The ratio between risk and return is a measure of the risk-adjusted return, and in table 2.4 is expressed using the «Sharpe ratio». It is clear that risk-adjusted returns are higher in the case of the actual benchmark than in the case of the alternative portfolios.

Figur 2.23 The development of the equity portions of the actual GPFG benchmark and of an alternative portfolio with a 40-percent equity portion in January 1998, without subsequent rebalancing. Percentages

Figur 2.23 The development of the equity portions of the actual GPFG benchmark and of an alternative portfolio with a 40-percent equity portion in January 1998, without subsequent rebalancing. Percentages

Kilde: Norges Bank.

Tabell 2.4 Comparison of the actual GPFG benchmark with two alternative portfolios with equity portions of 40 and 60 percent, respectively, without subsequent rebalancing. Percentages

Actual benchmark with rebalancing

Portfolio with floating weights, initial equity portion 40 percent

Portfolio with floating weights, initial equity portion 60 percent

Gross annual return

3.9

3.5

2.9

Net annual return

3.9

3.5

2.9

Annual standard deviation

8.4

11.0

13.1

Annual turnover rate1

11.7

0.0

0.0

Sharpe ratio2, gross (=A/C)

0.47

0.31

0.22

Sharpe ratio2, net (=B/C)

0.46

0.31

0.22

1 The turnover rate expresses how large a proportion of the portfolio is replaced every year.

2 The Sharpe rate is defined as the return in excess of a risk-free interest rate, divided by risk measured as standard deviation.

Kilde: Norges Bank.

Norges Bank also compared quarterly rebalancing with the current rebalancing rules. The actual benchmark was compared with a portfolio which is completely rebalanced every quarter.

The results show that the current rebalancing rules have produced a higher return than quarterly rebalancing, also after they are adjusted for differences in risk; see table 2.5. The change in 2001 from quarterly to conditional rebalancing has thus helped to increase the Fund’s returns. At the same time, it is clear that partial rebalancing has reduced the return by 0.1 percentage points. This occurred despite the fact that partial rebalancing reduces the transaction costs associated with rebalancing. Norges Bank assumes that this is due to the fact that frequent purchases of securities in an asset class which produces weak returns will reduce the total return of the Fund.1

The table shows that the deviation between the equity portion which follows from every rebalancing regime and the strategic equity portion is less when quarterly rebalancing is undertaken than under the current rebalancing rules. Partial rebalancing further reduces the average deviation from the 60 percent equity portion.

Standard deviation is an adequate risk measure if the return is normally distributed. Figures for skewness and kurtosis show that the distribution of returns has closely followed a normal distribution during the period.2

Tabell 2.5 Comparison of conditional and quarterly rebalancing of the GPFG, with and without partial rebalancing. Percentages

Actual rebalancing rules

Quarterly rebalancing

with partial rebalancing

without partial rebalancing

with partial rebalancing

without partial rebalancing

A. Gross annual return

3.9

4.0

3.7

3.8

B. Net annual return

3.9

4.0

3.6

3.7

C. Standard deviation per year

8.4

8.5

8.6

8.6

Annual turnover rate

11.7

17.7

12.2

23.2

Sharpe ratio, gross (=A/C)

0.47

0.47

0.42

0.44

Sharpe ratio, net (=B/C)

0.46

0.47

0.42

0.43

Average deviation from strategic equity portion (60 percent)

1.5

1.8

0.6

0.9

Properties of the return distribution

Skewness

-0.06

-0.11

-0.13

-0.11

Kurtosis

3.37

3.52

3.59

3.59

Kilde: Norges Bank.

1 Studies show that investment strategies which entail buying stocks which have produced a high return in the last 3–12 months and selling stocks which have produced a low return over the same period creates a risk-adjusted additional return (referred to as momentum); see Jegadeesh, N. and S. Titman (1993), “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 48.

2 The normal distribution has skewness equal to 0 and kurtosis equal to 3. Statistical tests cannot reject the hypothesis that the returns on some of the portfolios are normally distributed. Skewness describes the degree of symmetry in a distribution. A positive or right-skewed distribution has limited downside and large upside, while the opposite is true for a negative or left-skewed distribution. Kurtosis is a measure of the heavyness of the tails of the distributions. If the return series has fat or heavy tails, expected return remains that of the normal distribution, but there is a higher probability for both high and low returns. Statistical tests cannot reject the normality assumption for either of the portfolios.

2.5.4 Advice from Norges Bank

In its letter of 26 January 2012, Norges Bank gave advice on the formulation of new rebalancing rules for the GPFG. The Bank’s starting point is that the rebalancing rules should support the objective of achieving the best possible ratio between risk and return for the Fund.

Until now, the strategy for the GPFG has adopted fixed geographical weights for the Fund’s equities and fixed income investments at a regional level; see section 2.5.1. Norges Bank has pointed out that research results show that risk premiums on equities and fixed income investments vary over time. According to the Bank, the Fund’s special characteristics provide an opportunity to exploit such time-varying risk premiums by pursuing a counter-cyclical investment strategy under which an asset class is bought when the prices reflect increased uncertainty.

Norges Bank’s has pointed out that rebalancing strategies have produced higher risk-adjusted returns than strategies under which the asset weights follow market developments. The Bank takes the view that systematically returning asset classes to fixed weights through rebalancing is an investment strategy for the Fund which should be continued.

In Norges Bank’s opinion, new rebalancing rules should ensure that rebalancing is governed by rules and implemented as an ordinary part of the strategy without requiring separate decisions. Norges Bank has proposed that a publicly available rebalancing rule should be included in the GPFG’s mandate.

Norges Bank takes the view that the basis for the current regional weights is weak, and that consideration should be given to whether it is appropriate to retain the current structure. The Bank took the view that there is limited potential for exploiting variations in regional risk premiums through rebalancing. Rebalancing should therefore be undertaken at the asset-class level. According to the Bank, a rebalancing strategy which aims to maintain a fixed equity portion will seek to exploit variations in the equity market’s risk premium. Accordingly, Norges Bank has proposed a rule on the rebalancing of the Fund’s equity portion.

The strategic equity portion is currently 60 percent. A key question is how much the equity portion should be permitted to deviate from this figure before rebalancing is implemented. Norges Bank’s analyses show that rebalancing has been important for the Fund’s risk and return, but that, in isolation, the condition which determines when rebalancing must be implemented has been less important. The Bank has stated that it is difficult to set a correct level for deviations based on historical data.

Following an overall assessment, Norges Bank has proposed setting a band of three percentage points on either side of the strategic weight assigned to equity in the benchmark. This means that rebalancing will be implemented if the equity portion falls below 57 percent or exceeds 63 percent. Norges Bank has proposed that the equity portion should be rebalanced to the fixed weight of 60 percent at quarter-end if the proportion has fallen outside these limits for one day during the quarter in question.

According to the bank, a rule of this kind would mean lower transaction costs and a equity portion which is closer to the strategic weight than under the current rules. The proposal would result in somewhat more frequent rebalancing than at present, but each individual rebalancing would be less comprehensive. Norges Bank has pointed out that this would reduce the market impact and transaction costs.

Norges Bank has proposed that partial rebalancing be phased out, referring to the fact that there is uncertainty about the effect of partial rebalancing on the Fund’s total return over time. This is because periods of high or low returns in the equity market tend to continue («momentum»). It may therefore be profitable to wait for a certain period before undertaking rebalancing. The Bank’s analyses show that partial rebalancing has resulted in a poorer ratio between risk and return than a strategy which does not include partial rebalancing. Norges Bank has also pointed out that phasing out partial rebalancing would simplify the calculation of the benchmarks and ensure greater transparency about the management of the Fund. The proposal means that, when new capital is transferred to the Fund, the investments will be distributed based on the existing distribution between equity and fixed income. Currently, new capital is transferred to the asset class which has produced the weakest return in the preceding period.

Norges Bank wrote that its advice could be implemented from 1 July 2012.

2.5.5 The Ministry’s assessment

The Ministry would like to point out that the rebalancing rules have been an important part of the GPFG’s investment strategy. The rules have had the objective of ensuring that, over time, the risk in the Fund does not deviate significantly from what is established through the choice of the Fund’s long-term allocation between asset classes and regions. The rebalancing rules have something of a counter-cyclical nature, as the Fund sells assets whose value has risen relatively sharply and purchases assets which have fallen in value.

The experiences of rebalancing the GPFG have been positive. Norges Bank’s analyses show that rebalancing contributed to a better ratio between risk and return in the period 1998–2011, compared to an investment strategy which excludes rebalancing. The Ministry would also point out that there is no guarantee rebalancing rules will be equally advantageous in future.

When assessed on the basis of the ratio between risk and return, rebalancing will be profitable if returns vary around an average, for example as a result of time-varying risk premiums. Research indicates that there are time variations in the market’s risk premium.

One consequence of following a rule which means that the Fund increases its investments in falling markets and reduces its investments in rising markets is an increase in the probability of large losses. Such losses may arise if a market falls over time without rebounding, or if a permanent, lower market level is established. In such cases, rebalancing will be unfavourable. If the Fund includes a significant element of this type of risk, the measurement of risk by means of standard deviation will not be a completely adequate measure of the risk in the Fund. Nevertheless, the Ministry has noted that standard deviation has been an adequate measure of the price variation for the GPFG’s portfolio during the period the Fund has invested in equities.

Following an overall evaluation, the Ministry agrees that a systematic return of the asset classes to fixed weights by means of rebalancing should be continued, as proposed by Norges Bank.

Norges Bank takes the view that rebalancing should be governed by rules and implemented as an ordinary part of management operations. In the Bank’s opinion, the rebalancing rule should be public, and set out in the GPFG’s mandate. The Ministry attaches weight to the consideration that a publicly accessible rebalancing rule will contribute to greater transparency about the management of the Fund.

The choice of the equity portion is the decision which has the greatest significance for risk and return in the Fund. The Ministry is therefore of the opinion that it is logical to have a rebalancing rule which brings the equity portion back to the strategic weight of 60 percent. A rebalancing strategy which aims to maintain a fixed proportion of equities relative to fixed income and real estate may also be a way of exploiting systematic variations in risk premiums.

The Ministry would like to point out that the new benchmark for the Fund’s fixed income investments and plans for a new geographical distribution of equities imply a departure from a strategy based on fixed regional weights; see the discussion in sections 2.2 and 2.3. This is consistent with Norges Bank’s recommendation that there should be no more rebalancing in line with fixed regional weights. At the same time, the Ministry would point out that phasing out rebalancing to fixed regional weights may make rebalancing somewhat less counter-cyclical than the current strategy, as the GPFG will no longer buy (sell) the equity markets which have experienced the weakest (strongest) relative development. On the other hand, the new benchmark for the Fund’s fixed income investments envisages monthly rebalancing back to GDP-weights in the government part of the benchmark, and between the government and corporate parts of the benchmark.

Norges Bank has recommended that the current rebalancing regime should be simplified by phasing out partial rebalancing. It has also recommended that the band for rebalancing be set to plus/minus three percentage points. The Ministry will continue to work on the details of the formulation of the rebalancing rules, including the question of how one may secure an increased openness about the rules for rebalancing, the band width and the system of partial rebalancing. The Ministry plans to provide a more detailed presentation on the new rebalancing rules in the National Budget in the autumn of 2012.

2.6 Potential effects of climate change on the investment strategy

2.6.1 Introduction

In Report No. 15 (2010–2011) to the Storting – The Management of the Government Pension Fund in 2010, the Ministry discussed the main report from an international research project of the long term consequences of climate change for global capital markets. The study was a cooperation project involving the consultancy firm Mercer and 14 large institutional investors in Europe, North America, Asia and Australia. Several other institutions were also involved, such as the Grantham Research Institute on Climate Change and the Environment at the London School of Economics, the International Finance Corporation (part of the World Bank Group), the company Carbon Trust and a selection of experts on environmental economics from the private sector and academia.

The discussion in last year’s Report to the Storting was based on the main project report, which Mercer presented in London on 15 February 2011. In the Report to the Storting, the Ministry wrote that Mercer would prepare a separate report on the climate risk associated with the investments of the Government Pension Fund Global (GPFG), based on the results of the main report. It is this report which is discussed here.

2.6.2 Mercer’s assessment

In the report, Mercer analyses the GPFG’s sensitivity to climate risk, and opportunities to reduce risk through climate-related investments over the course of the next 20 years. The report discusses possible consequences for the GPFG’s investments in equity, fixed income and real estate in light of the results described in the main report from 2011.

Mercer writes that the analysis of the significance of climate change for funds like the GPFG is associated with great uncertainty. The effects of future climate change are uncertain, and this uncertainty is reinforced by the fact that the changes must be analysed for a period stretching several decades into the future. Mercer also writes that the analysis is limited to potential effects of climate change alone. Other long- term trends, such as demographics and the emergence of new economies and markets, may have other effects on risk and return in the capital markets. Mercer therefore stresses that caution should be exercised about attaching too much weight to quantitative analyses of the effect of climate change on the capital markets.

Rather than describing a likely development, the analysis is based on four different climate change scenarios and policy responses. The scenarios range from «Stern Action», in which all states introduce effective, coordinated measures to counter emissions, to «Climate Breakdown», in which global warming increases without material intervention by the authorities. Two intermediate scenarios are «Regional Divergence», in which only some states introduce effective measures to counter emissions, and «Delayed Action», which is characterised by few political measures in the first 10 years but drastic, global measures during the next 10-year period as a result of accelerating global warming.

The report calculates that «Delayed Action» would result in a return on the Fund in the next 20 years which, on average, is about 0.4 percentage points lower per year than a reference alternative which does not include any form of climate risk. The most important source of the reduced return is the Fund’s sensitivity to global equity markets, which will be moderately negatively affected in this scenario. In the other three scenarios, the expected return is affected less, or even positively («Stern Action» scenario).

The report contains advice on changes to the investment strategy which are conditional upon which of the four scenarios investors consider most probable. According to Mercer, if the GPFG were to place emphasis on the «Delayed Action» and «Stern Action» scenarios, it should, among other things, invest more in companies which develop or use new climate-friendly technology. This also applies to some degree to the «Regional Divergence» scenario. If, on the other hand, «Climate Breakdown» is assumed, such investments would have the opposite effect, reducing expected returns. Mercer therefore writes that investors have to evaluate the probability of the different scenarios before turning the advice into concrete investment decisions. Mercer’s own view on the probabilities of the four scenarios is that «Regional Divergence» is most likely, and «Climate Breakdown» is least likely.

Against this backdrop, Mercer recommends that the GPFG increases its investments in asset classes which are expected to perform better, relatively speaking, than other asset classes in the most likely scenarios. In addition to investments in climate-friendly technology, these assets classes are climate-friendly infrastructure, real estate and unlisted companies. Investments in forestry and agriculture and «green bonds» are also mentioned in this context. However, Mercer also points out that it may be difficult for a fund as large as the GPFG to invest in some of these markets, as they remain relatively small.

The report also recommends that the GPFG takes account of climate risk in its active fund management, in its exercise of ownership rights, and in its planned real estate investments. A further recommendation is that the GPFG closely monitors international climate policies which may affect the capital markets, and that the Fund continues to support research on the link between climate risk and capital returns.

2.6.3 The Ministry’s assessment

Analysing the potential effects of climate change is important for various aspects of the management of the Government Pension Fund:

  • The calculations of how climate change may affect the Fund’s risk in the long-term contributes to a better understanding of the Fund’s risk.

  • The discussion of new investment areas identifies the alternatives which are available for altering the link between climate change and the Fund’s expected results.

  • The advice to safeguard environmental considerations through the exercise of ownership rights and active fund management, and in the construction of a portfolio of real estate investments, supports existing measures taken in the management of the Fund.

The GPFG’s investments are spread across several asset classes, countries and sectors. This reduces the Fund’s vulnerability to different types of risk, including climate change. Mercer analyses the potential effects of climate change on returns and risk in the GPFG. Major uncertainty means that it is not possible, based on Mercer’s calculations, to draw concrete conclusions about the consequences for the Fund’s future returns. Nevertheless, the analyses are a useful contribution to efforts to improve the understanding of how climate change may affect the Fund’s risk and return.

Some of the investments recommended by Mercer, such as private equity, lie outside the boundaries of the GPFG’s permitted investments. Investments in private equity and infrastructure were considered in Report No. 15 (2010–2011) to the Storting. The Ministry concluded that it was uncertain what such investments would yield in terms of excess returns, particularly due to high management costs. The Ministry therefore stated that it would gather experience in unlisted real estate investments before potentially including new types of unlisted investments. The Ministry also stated that such investments could be considered at a later date. The Storting supported this approach. Investments in forestry and agriculture have so far not been deemed relevant for inclusion.

The advice to take climate risk into account in the active management supports the Fund’s existing management measures.

Climate change is one of the priority areas for Norges Bank’s exercise of ownership rights, and the Bank has cooperated with other investors for several years in relation to companies’ handling of climate risk. Norges Bank’s efforts are aimed at sectors which are responsible for a high proportion of global greenhouse gas emissions, and which will be particularly strongly affected by regulations which attach an economic cost to greenhouse gas emissions. This includes sectors such as mining, cement, chemicals, oil and gas, manufacturing, power production, transportation and real estate.

As a result of the evaluation of the ethical guidelines undertaken in 2009, an environment-related investment programme was introduced in the GPFG. These investments will normally amount to NOK 20–30 billion, and are among Norges Bank’s active management mandates; see the discussion in Report No. 15 (2010–2011) to the Storting. The Bank had 10 mandates under this programme at the end of 2011. Seven of the mandates were within renewable energy and energy efficiency technology, while three mandates were in water management. See more detailed discussions of the results achieved by the climate-related investments in section 4.1.

The mandate for Norges Bank’s management of the Fund’s real estate investments states that the Bank must emphasise energy efficiency and water consumption, among others. This is consistent with the advice received from Mercer.

The report by Mercer will be an important contribution to the further development of the investment strategy and the assessment of climate risk.

Mercer’s report is the result of cooperation between Mercer and 14 large institutional investors from four continents. This is the first time that these investors have come together to analyse the long-term consequences of climate change on global capital markets. However, there is a need for further research on the impact of structural environmental and societal trends on long-term asset returns. Participation in research projects will therefore continue to be a priority for the Ministry.

Research is one of the main elements of the Ministry’s responsible investment strategy. As a large owner and international investor, the Ministry can influence the research agenda on ESG-issues. The Ministry’s involvement in the Mercer report is one example of how research can be employed in the work on responsible investment practices.

2.7 Some topics for the further development of the investment strategy

2.7.1 Introduction

The investment strategy of the Government Pension Fund Global (GPFG) has been developed gradually. This has allowed broad support to be secured for the investment strategy. The experiences gained thus far show that the strategic choices have been robust during periods of significant unrest in the financial markets.

In its efforts to develop the GPFG’s investment strategy further, the Ministry draws on external advice and analyses. The Ministry also wishes to ensure that important aspects of the strategy are debated publicly. In the autumn of 2011, the Ministry and the Strategy Council for the GPFG arranged a seminar on key issues related to the future investment strategy. The seminar was intended to contribute to such debate; see box 2.9.

The choice which plays the largest part in determining the overall risk of the Fund is the choice of equity portion. Comparisons show that the GPFG’s equity portion is in line with the equity portions of other large international funds, taking into account both the listed and unlisted equities held by these funds. At the same time, the GPFG has various special characteristics which distinguish it from most other funds. The Fund has a very long time horizon, and has no clearly defined liabilities. Moreover, it is highly unlikely that the state will need to withdraw large sums from the Fund over a short period of time. These special characteristics give the Fund a greater ability to bear risk than many other investors. From this perspective, the Fund’s overall risk level currently stands out as moderate.

Much of the Fund’s risk is already concentrated on equity-market risk. This makes it natural to look for other sources of risk premiums in the further development of the strategy. By investing the fund capital in such a manner that the returns depend on several types of risk, a better diversification of risk is achieved. It is natural to emphasise forms of risk which the Fund is particularly well-positioned to bear.

The basis for adapting the investment strategy in line with the Fund’s advantages is described in more detail in box 2.10.

The management of the Fund is based on a strategic benchmark. This benchmark is largely based on the principle of market weighting. In the case of equities, this means that each individual company is included in the index with a weighting corresponding to the market value of the equities in the company relative to the value of the equity market as a whole.

In Report No. 15 (2010–2011) to the Storting – The Management of the Government Pension Fund in 2010, the Ministry described the work related to the potential of a larger role for systematic risk factors in the management of the Fund. Such risk factors are defined relative to market weights. For example, a portfolio with a higher portion of equities in small companies than indicated by market weights will be more exposed to fluctuations in the return of equities in small companies. This is called exposure to the small-cap risk factor.

Exposure to systematic risk factors has produced higher returns over time. For example, stocks in small companies have been proven to produce higher returns over time than stocks in large companies; see box 2.10. It is common to think that this additional return reflects a payment for higher risk. The additional return is therefore often described as a risk premium. By increasing the exposure of the Fund to selected systematic risk factors, the Fund may achieve higher returns over time. This is called harvesting systematic risk premiums.

In Report No. 15 (2010–2011) to the Storting, the Ministry pointed out, among other things, that the Strategy Council for the GPFG takes the view that it is appropriate for a fund with the GPFG’s long time horizon to exploit the risk premiums associated with liquidity and value. The Ministry also wrote that Norges Bank’s strategy plan for the period 2011–2013 may indicate an increase in the Fund’s exposure to the value premium. An increased focus on different sources of systematic risk is also consistent with the recommendations made in 2009 by Professors Ang, Goetzmann and Schaefer and with the report of the Strategy Council 2010.

Work on assessing the Fund’s exposure to systematic risk factors is a long-term effort. During 2011, this has included the following:

  • Less liquid investments were a topic at the Investment Strategy Summit with the Strategy Council held in November 2011; see box 2.9.

  • In its letter to the Ministry of Finance of 2 February 2012, and in separate discussion notes 8, Norges Bank has discussed how the Fund’s equity portfolio can be exposed to different risk factors. This is discussed in greater detail in sections 2.7.2 and 2.7.3.

Boks 2.9 Investment Strategy Summit with the Strategy Council for the GPFG

The Ministry of Finance makes use of a Strategy Council comprised by external members in its work with the investment strategy for the GPFG. The purpose of the Strategy Council for the GPFG is to evaluate the Ministry’s work as well as to contribute with professional input for the further development of the Fund’s investment strategy.

Professor emeritus of finance Elroy Dimson (London Business School), headed the Council’s work in 2011. Other members were Managing Director Antti Ilmanen (AQR Capital Management), Senior Analyst Øystein Stephansen (DNB) and Professor and Rector Eva Liljeblom (Hanken Svenska Handelshögskolan). In 2011, the Strategy Council was given the task to arrange a seminar on important issues for the work with the further development of the investment strategy for the GPFG. This investment strategy summit took place on 8 November 2011 with a wide attendance by the finance sector and academia.

The three main themes of the summit were less liquid investments, time variations in risk premiums and investments in emerging markets. Less liquid investments are discussed in this section, while time variations in risk premiums are mentioned in section 2.5 on rebalancing. Investments in emerging markets are discussed in sections 2.2 and 2.3.

In addition to the members of the Strategy Council, the following had a role as moderator or panel participant during the seminar: Dr. David Chambers (Cambridge University), Professor Roger Ibbotson (Yale University), Professor Andrew Ang (Columbia University), Professor Rajnish Mehra (Arizona State University), Dr. Sung Cheng Chih (Government of Singapore Investment Corporation), Professor Campbell Harvey (Duke University) and Professor Arne Jon Isachsen (Handelshøyskolen BI).

The papers and a summary of the seminar are available on the Ministry’s website (www.government.no/gpf).

Boks 2.10 The market portfolio and the investors’ distinctive characteristics

The capital asset pricing model is a well-established model for the pricing of risky assets. In the model, all investors prefer to compose their portfolios of risky assets such that they constitute a portion of the total global capital. A portfolio of such composition is the theoretical market portfolio.

The capital asset pricing model illustrates in a simple way the idea that the expected return on a stock should be higher the more risky the equity is. The starting-point of the model is that investors are able diversify their risks in a good way. The relevant risk in the model, therefore, is not the fluctuations of a stock price seen in isolation, but to what degree the return on the stock fluctuates in line with the return of the market portfolio. This is called the stock’s systematic risk.

The capital asset pricing model is based on very simplified assumptions as to investors and the functioning of the financial markets. The model has one form of systematic risk only, and this risk is reflected in the market portfolio. Thus all investors will prefer to compose their portfolios of risky assets in the same way, namely like the market portfolio. In this respect, the capital asset pricing model provides a simple recipe for fund investments in which there is no room for investors’ special characteristics.

However, research on historical equity return indicates that the capital asset pricing model does not fully describe how investors act or how the financial markets work. Over time, stocks in small companies have produced a higher return than stocks in large companies, for example. This excess return is called the size premium. It also turns out that stocks in companies in which the market value is relatively low when assessed through key figures like the company's earnings, dividends or book value have produced a different and over time higher return than stocks in companies in which the market value is relatively high. This is called the value premium. Other factors that may explain the risk and return of an investment in a systematic way have proved to be momentum, volatility and liquidity. These three factors are related to short-term historic return, short-term value fluctuations and how liquid an investment is. The explanatory factors highlighted in this section are often called systematic risk factors; see the report that professors Ang, Goetzmann and Schaefer wrote for the Ministry in 2009. The report is available on the Ministry’s website (www.government.no/gpf).

Historic equity returns may to a certain extent be explained by developments in various systematic risk factors. However, no broad agreement among investors or in academia on how stable the factors are or why they have produced a different and higher return has been established. Depending on the perspective applied, the factors are called equity characteristics, investment styles or irregularities in the functioning of financial markets.

The fact that systematic risk factors exist seems to indicate that investors have a more nuanced view of the properties and risks of investments than that which is reflected in the capital asset pricing model. On this basis, an investor may find it favourable to deviate from the market portfolio in order to take account of its special characteristics. The payment one receives in the form of a risk premium will depend on how demanding it is on average for investors to bear such a risk. Not all investors are equally suited to bear all forms of risks, however. If one is better suited than the average investor to bear a certain form of risk, one should consider to take more of this form of risk than that which follows from the market portfolio. In this manner, investors may achieve a better ratio between expected return and risk.

2.7.2 The liquidity premium

Investments which are difficult to trade (less liquid), normally have to offer a higher expected return to attract investors. The liquidity premium compensates for this. It is also linked to the fact that the value of such investments tends to fall sharply during weaker periods.

It is fairly unlikely that the state will need to withdraw large sums from the Fund over a short period of time; see the discussion in section 2.1. This means that the Fund is well-positioned to exploit that less liquid investments produce higher expected returns. The GPFG can benefit from this in several ways:

  • by investing in less liquid asset classes,

  • by investing in less liquid securities within each individual asset class,

  • by investing in less liquid securities during periods in which other investors are demanding more liquid securities.

Unlisted investments such as real estate, private equity and infrastructure are examples of asset classes which are generally less liquid than listed equity. The market for real estate is the largest and most developed of these markets. In 2008, the Ministry of Finance decided that, over time, up to 5 percent of the GPFG’s capital is to be invested in real estate.

In Report No. 15 (2010–2011) to the Storting, the Ministry considered whether the GPFG should be permitted to invest in private equity and infrastructure. At that time, the Ministry pointed out that there is significant uncertainty as regards what return investors can achieve on such investments, taking into account the risk and costs associated with them. The Ministry concluded that experience should first be gained from investments in real estate, but that the Fund’s special characteristics make it natural to return to the question of private equity and infrastructure at a later date.

Another way to increase the scope of less liquid investments in the Fund is to increase the proportion of less liquid listed equities. During the Investment Strategy Summit, Professor Roger Ibbotson pointed out that a portfolio of listed equity which systematically gives greater emphasis to less liquid stocks has produced a significantly higher return over time, without materially altering the portfolio risk properties facing a long-term investor. At the same time, Ibbotson emphasised that it is difficult to define and isolate the liquidity properties of an equity. An investor seeking to exploit the fact that a premium is paid on less liquid investments should therefore consider this premium together with other risk premiums.

A third way to harvest risk premiums is to invest in relatively less liquid securities during periods in which other investors are demanding more liquid securities. Many investors may have to sell equities after they have fallen sharply in value, for example because of regulatory requirements, as seen during the global financial crisis. Investors will then often replace equities with government bonds, which generally carry less risk and are more liquid. A fund like the GPFG can exploit this by selling bonds and purchasing equities in such situations. Developments during the financial crisis provide one example of the fact that risk premiums can vary over time. Time variation in risk premiums is discussed in more detail in section 2.5 on rebalancing.

2.7.3 Other systematic risk premiums

The starting point for Norges Bank’s analyses and assessments of systematic risk premiums is that the Fund’s strategic benchmark for equity is based on the principle of market weighting. This does not necessarily give the Fund an optimal ratio between risk and expected returns; see box 2.10. In its letter to the Ministry of Finance of 2 February 2012, Norges Bank wrote that:

«A global market-weighted benchmark index will not necessarily offer the best possible trade-off between risk and return for a fund such as the Government Pension Fund Global. The investment strategy should therefore be designed in such a way that the Fund can harvest risk premia dynamically, and the portfolio can be constructed in ways that build on its natural advantages.»

Regarding the Fund’s advantages, the Bank wrote:

«The combination of a long time horizon, no short-term liquidity requirements and a patient owner means that the Fund may be particularly well-suited to taking on certain types of risk. This will, above all, be the case in periods of great uncertainty about future returns.»

In a separate note, Norges Bank has analysed the importance of several known risk factors in the equity market. 9 In the note, the Bank pointed out that exposure to each of these risk factors has produced higher returns over time. At the same time, there is a risk of significantly lower returns over longer periods than under market weighting. The note emphasised that a strategy focused on exploiting systematic risk premiums in the equity market requires the investor to be able to bear periods of lower returns.

Norges Bank’s analyses show that there are different ways of harvesting systematic risk premiums. Doing this in an effective manner requires investment strategies which are adapted to each individual risk factor.

The note stated that there is little correlation between fluctuations in different systematic risk factors. This offers an opportunity to diversify risk. Norges Bank pointed out that simultaneous exposure to a wide range of risk factors reduces fluctuations in overall returns. This also reduces the risk of periods of very low returns.

The analyses conducted by Norges Bank also show that it is difficult to isolate each individual risk factor operationally. If there is exposure to one risk factor, there will generally also be some degree of exposure to other risk factors. The note argued that a strategy which aims to exploit systematic risk premiums must therefore take account of both direct and indirect risk exposure, and that this should be done as part of an integrated risk-taking and risk-control process.

In the analysis of the risk factor associated with liquidity, it was pointed out that this is a type of risk which the GPFG is well-positioned to bear. However, in the context of the equity market, it was recommended that this risk be assumed indirectly, through other risk premiums like size, value and volatility, because the liquidity factor is difficult to define and isolate; see the discussion in section 2.7.2.

In its letter of 2 February 2012, Norges Bank recommended that systematic risk premiums should be exploited in the management of the GPFG. The Bank is of the opinion that this can best be done as part of the operational management, rather than by changing the strategic benchmark. The Bank wrote:

«Norges Bank believes that the strategic benchmark index should not be adjusted to take account of systematic risk premia for equity investments.»

In another note, Norges Bank has analysed various alternative weighting principles for a market-weighted benchmark. 10 One example of such an alternative weighting principle is a «fundamental index». In such indices, every individual company in the index is assigned a weight corresponding to the company’s size as measured in accordance with «fundamental» variables such as turnover, earnings or the number of employees. Another example of an alternative weighting principle is equal weighting, under which each company is assigned the same weight regardless of both market value and size. The weights which are assigned under such alternative weighting principles may deviate considerably from market weights. Alternative weighting principles may be used by funds which wish to engage in rule-based management but which nevertheless do not wish to apply market weighting.

The analysis in Norges Bank’s note showed that several alternative weighting principles have provided a better ratio between risk and return than a market-weighted portfolio. To some extent, this is due to known risk premiums. For example, a fundamental index is highly exposed to the value factor, while an equal-weighted portfolio is often exposed to both the value factor and the size factor.

It may be difficult for large funds to use alternative weighting principles in their management operations. For example, an equal-weighting principle may mean having very large ownership interests in small companies. This is an important consideration in the management of a fund like the GPFG. In the note, Norges Bank analysed how much capital can be invested under various weighting principles. The analysis found that fundamental indices offer larger investment opportunities than other alternative weighting principles. This is because fundamental variables will normally indicate that larger investments should be made in companies which also have a higher market value. However, a market-weighting principle always offers the largest investment opportunities.

Norges Bank is of the opinion that alternative weighting principles should not be used in the Fund’s strategic equity benchmark. In its letter to the Ministry of Finance of 2 February 2012, the Bank wrote:

«Our conclusion is that these alternative weighting criteria should not be laid down in a strategic benchmark index for equity investments, as they are complex to calculate, require relatively frequent adjustments, and will often not be fully investable for a fund such as the Government Pension Fund Global. NBIM can develop an operational benchmark portfolio that takes account of these considerations.
Norges Bank recommends that the starting point in a market-weighted benchmark index is retained.»

In this context, Norges Bank referred to the fact that NBIM can develop an operational benchmark portfolio to meet important requirements relating to weighting criteria other than market weights. An operational benchmark portfolio is a tool which Norges Bank uses in its management operations. In its annual report on the management of the GPFG in 2011, the Bank discussed this in more detail. It wrote, among other things:

«NBIM has constructed internal operational benchmark portfolios for equity and bond investments. These reflect the types of securities that we believe represent a neutral and appropriate strategy. The benchmark portfolios are designed to avoid undesirable risk in parts of the capital market that do not fit with the fund’s size, long-term outlook and objective. The portfolios are based on groups of securities picked because of their return and risk characteristics.»

In the annual report, Norges Bank also wrote that the objective for the operational benchmark portfolio is to achieve a better ratio between expected risk and return after costs. The Bank pointed out that the strategic benchmark set by the Ministry of Finance is based on market indices provided by leading index providers. This helps to ensure that management of the Fund is transparent and verifiable. In the case of equity, the FTSE Global Equity Index Series All Cap has been chosen. As such market indices are based on a market-weighting principle, they are not adapted to the differing objectives and special characteristics of individual funds. Norges Bank wrote that the strategic benchmark specifies a direction for investment and reflects the risk tolerance of the owner. In the Bank’s view, an operational benchmark portfolio can be used to adapt the investments to the GPFG’s objectives and special characteristics.

In its annual report, Norges Bank emphasises that the limits set in the mandate issued by the Ministry can still be linked to the strategic benchmark index. Deviations between the strategic benchmark and the operational benchmark portfolio will, as in the case of other investment choices, utilise the limits for active management set in the mandate for the GPFG. However, such deviations may be larger and of a different nature, and have a different timeframe, than deviations which normally fall within so-called active management.

Norges Bank’s operational benchmark portfolio for fixed income is described in more detail in section 2.2 of this Report to the Storting.

The Ministry gives great emphasis to ensuring that the Fund’s investment strategy has a solid theoretical foundation. Even though it has long been recognised that there are several sources of systematic risk in the financial markets, there is still disagreement about what sources these are and how stable they are. There are also different views on how systematic risk premiums should be exploited in the management of the Fund. The Ministry is therefore of the opinion that it is appropriate to proceed gradually.

In Report No. 10 (2009–2010) to the Storting – The Management of the Government Pension Fund in 2009, the Ministry referred to the recommendation by Professors Ang, Goetzmann and Schaefer to amend the Fund’s benchmark to include exposure to systematic risk factors as much as possible. The analyses of the Fund’s fixed income benchmark in Report No. 15 (2010–2011) to the Storting pointed out several difficulties with this approach, based on the fact that it is difficult in practice to delimit the different risk factors. Norges Bank has recommended that exposure to systematic risk factors should not be built into the benchmark, but rather be included in the operational management of the Fund. The Bank pointed out that an operational benchmark portfolio can be developed in order to safeguard these interests, and argued that several operational considerations indicate that such an approach should be adopted. These are important contributions, which the Ministry will consider in its further work on these issues.

In its work on systematic risk factors, the Ministry is giving particular emphasis to identifying, managing and communicating exposure to such factors in a good manner. The purpose of exposing the Fund to such factors will be to improve the ratio between risk and return, and to exploit the Fund’s special characteristics. Strategies for exploiting risk premiums must be long-term and designed such that they can still be followed in periods during which expected returns fail to materialise. Norges Bank’s efforts to build up its expertise and experience relating to such strategies within the current management framework support this.

1

In currencies from Asia/Oceania, the index included treasuries only.

2

See www.nbim.no/en/press-and-publications/discussion-notes/.

3

South Korea is classified as an emerging market in MSCI’s equity index, but as a developed market in the FTSE index. If the FTSE definition is used, Harvey’s recommended emerging-markets proportion is around 15 percent.

4

See the note “The History of Rebalancing of the Fund” (http://www.nbim.no/en/press-and-publications/discussion-notes/).

5

See the note “Time-varying Expected Return, Investor Heterogeneity and Rebalancing” (http://www.nbim.no/en/press-and-publications/discussion-notes/).

6

The price of an equity investment can be expressed as the present value of an uncertain future cash flow, where the required return takes risk into account. Expected returns in excess of a risk-free interest rate are referred to as the risk premium (or equity premium).

7

Cochrane, J. (2011), “Presidential Address: Discount Rates”, Journal of Finance, vol. LXVI, NO. 4, August 2011.

8

See the notes “Alternatives to a Market-Value-Weighted Index” and “Capturing Systematic Risk Premia” (www.nbim.no/en/press-and-publications/discussion-notes/).

9

See the note “Capturing Systematic Risk Premia”, which describes various methods for exploiting systematic risk premiums in the Fund’s share portfolio. Norges Bank is focusing on the five risk premiums of value, size, momentum, volatility and illiquidity.

10

See the note “Alternatives to a Market-Value-Weighted Index”.