National budget 2009 - Chapter 5

The Management of the Government Pension Fund

Translation from Norwegian

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5.1 Background

 

The purpose of the Government Pension Fund is to support government savings to finance the pension expenditure of the National Insurance Scheme and long-term considerations in the spending of government petroleum revenues. A policy based on long-term management of petroleum wealth reflects a fundamental social perspective and is an overarching priority for the Government. It implies that this wealth can benefit all generations, whilst at the same time making an important contribution to stability in output and employment.

The Fund is fully integrated with the Fiscal Budget, in order for growth in the Fund to reflect actual accumulation of financial assets on behalf of the State. The pensions under the National Insurance Scheme are financed through the Fiscal Budget on a pay-as-you-go basis. A larger Pension Fund will lay the foundations for higher ongoing revenues from the Fund in future, thereby enabling the funding of increased expenditure on, inter alia, pensions. See section 3.1.4 for a more detailed discussion of the relationship between the Government Pension Fund and government pension liabilities under the National Insurance Scheme.

The Government Pension Fund is a superstructure encompassing the Government Pension Fund – Global and the Government Pension Fund – Norway. Under the Government Pension Fund Act, the Ministry of Finance has been charged with managing the Fund. The Ministry determines the guidelines for the management of the two parts of the Fund, and follows up on their operational management. The operational management of the Government Pension Fund – Global and the Government Pension Fund – Norway has been delegated to Norges Bank and Folketrygdfondet, respectively, on the basis of guidelines laid down by the Ministry of Finance.

Concern for the stable development of the Norwegian economy suggests that the petroleum revenues should be phased into the economy gradually, by investing a significant part of the ongoing petroleum revenues in the Government Pension Fund – Global. This capital is invested abroad, thus contributing to a capital outflow that offsets the impact on the Norwegian krone exchange rate that would otherwise have resulted from large and variable foreign exchange inflows from the petroleum sector.

The Government aims for the Government Pension Fund to be the best managed fund in the world. This implies that one shall seek to adopt best practice within international asset management in all aspects of fund management. Our management responsibility includes responsibility for ensuring that the Fund is managed with a view to maximizing return, given a moderate level of risk. At the same time, the management responsibility implies that we, as investors, share an element of responsibility for the conduct of the companies in which the Fund invests. The investment strategy of the Fund is described in more detail in Box 5.1.

The Ministry emphasises a high degree of openness for purposes of strengthening the confidence in the Government Pension Fund and the fund structure. Operational management performance is reported by Norges Bank and Folketrygdfondet on a regular basis. The Ministry provides an account of the management of the Fund in an annual report to the Storting during the spring session, cf. Report No. 16 (2007-2008) to the Storting On the Management of the Government Pension Fund in 2007.

The present report starts out, in Sub-chapter 5.2, with an updated discussion of the performance of the Government Pension Fund. Sub-chapter 5.3 discusses several matters that are under deliberation in relation to the management of the Fund. Sub-chapter 5.4 discusses the status for the implementation of previous changes to the management of the Fund.

 

Box 5.1 Investment strategy for the Government Pension Fund

There is a broad political consensus that the Pension Fund should be managed with a view to achieving the maximum possible return within a moderate level of risk. The Ministry of Finance has formulated a long-term investment strategy ensuring that the capital is invested in a broad-based portfolio comprising securities from many countries. The long investment horizon of the Fund means that the portions invested in various asset classes and geographical regions can be determined on the basis of assessments of expected long-term returns and risks.

Priority is accorded to achieving broad political agreement as to the investment strategy of the Fund, and a high degree of openness as far as the management of its capital is concerned. This strengthens the credibility of, and confidence in, the Fund.

The investment strategy of the Government Pension Fund is defined by the general investment limits and the benchmark portfolios of the Government Pension Fund – Global and the Government Pension Fund – Norway, respectively. The benchmark portfolios of the Government Pension Fund comprise equity and bond indices from different countries, cf. Chart 5.1. The developments in these indices reflect, in large part, market developments in the relevant countries. The Fund's benchmark portfolio for equities comprises more than 7,000 equities across 47 countries, whilst the benchmark portfolio for bonds comprises about 10,000 bonds from about 1600 issuers in 21 countries.

Chart 5.1 Strategic benchmark portfolio of the Government Pension Fund

Chart 5.1 Strategic benchmark portfolio of the Government Pension Fund 

1The Ministry of Finance has defined the benchmark portfolio. It has been decided to increase the equity portion of the Government Pension Fund – Global to 60 pct., and the portion is now being increased to this level. The Ministry has continued to pursue plans for the investment of up to 5 pct. of the capital of the Fund in real estate, following the Storting's deliberation of Report No. 16 (2007-2008) to the Storting. These investments will result in a corresponding reduction in the portion invested in fixed income.

Source:Ministry of Finance.

 

As shown in Chart 5.1, the Government Pension Fund – Global holds all its investments abroad. It is the return in international currency that is relevant for measuring developments in the Fund’s international purchasing power. The Government Pension Fund – Norway is primarily invested domestically, and its return is measured in Norwegian kroner. Norges Bank and Folketrygdfondet both seek to achieve a higher return than dictated by the respective benchmark portfolios, within the defined risk limits. The Ministry of Finance has defined an investment universe for the Government Pension Fund that is wider in scope than the benchmark portfolios. By making investments in securities that fall outside the scope of the benchmark portfolio, and by investing other portions of the Fund in certain securities than would be dictated by the benchmark portfolio, Norges Bank and Folketrygdfondet are exploiting their permitted leverage in terms of deviations from the benchmark portfolio, for purposes of achieving excess return.

 

5.2 Management performance

5.2.1 Introduction

As per the end of June 2008, the market value of the Government Pension Fund was NOK 2,104 billion, as compared to NOK 2,136 billion as per yearend. There was an inflow of new funds in the amount of NOK 179 billion during the first half of the year, while weak returns in financial markets contributed to a reduction in the Fund’s market value.

The Government Pension Fund – Global accounted for 95 pct. of the overall value of the Government Pension Fund as per the end of the first half of the year, whilst the Government Pension Fund – Norway accounted for 5 pct.

Sub-chapters 5.2.2 and 5.2.3 provide an account of returns on the Fund, with the main emphasis being on developments during the first half of 2008. The financial market turbulence over the last year, which originated in parts of the US residential mortgage sector and rapidly spread to other parts of the financial markets, has strongly influenced returns on the Fund. A number of financial institutions in the US and Europe have suffered large losses over the last year, several institutions have found that their business model was no longer viable. Many have had to raise new capital in order to stay in business. The authorities in the US, as well as in other countries, have taken substantial measures to ease the problems, and further measures have been announced. See section 2.6.1 for a supplementary discussion of international financial market developments. The bonds issued by the two dominant mortgage finance institutions in the US, Fannie Mae and Freddie Mac that were rescued by US authorities recently, account for a high share of the US bond market. The benchmark portfolio for the Fund has, as discussed in Box 5.2, included a lower proportion of these bonds that would have been dictated by their market share as such.

There is considerable uncertainty as to the repercussions of the financial market turbulence over the last year. More uncertainty and lower economic growth expectations have already resulted in low earnings expectations for businesses. This development has, in combination with increased risk premiums, resulted in declining global stock markets. At the same time, uncertainty and scaled-back growth expectations have contributed to increasing the value of the government bonds held by the Fund. On the other hand, the return on the bond portfolio of the Fund has been reduced as the result of increasing interest differentials between fixed-income securities issued by governments and private issuers, as well as higher uncertainty as to future inflation prospects.

Periods of market turbulence, as have been witnessed over the last year, will influence the return on the Government Pension Fund. Acceptance of such fluctuations in the return on the Fund will increase the expected long-term return, by way of a compensation for assuming risk.

 

Box 5.2. The Government Pension Fund – Global's benchmark portfolio for bonds

Fannie Mae and Freddie Mac are so-called government-sponsored enterprises (GSEs)[1]. The purpose of the enterprises is to improve private households' access to residential mortgages. Instead of granting favourable mortgages in respect of homes (as does the Norwegian State Housing Bank), the enterprises stimulate the lending market by purchasing portfolios of such mortgages from the lending institutions. The original lenders immediately resell more than 40 pct. of their paid-out residential mortgages to Fannie Mae and Freddie Mac, instead of funding the lending themselves.

The federal credit institutions retain part of the acquired mortgage portfolios on their own balance sheets. These are financed through the issuance of senior unsecured bonds. Portfolios that are not retained on their own balance sheets are transferred to isolated trusts, and refinanced through the issuance of mortgage-backed bonds; so-called securitised mortgages.

Fannie Mae and Freddie Mac are directly involved in the refinancing of half of all outstanding residential mortgages in the US. As per 30 June 2008, the sum total of these institutions' debt and guarantee liabilities had grown to about USD 6,000 billion, and they account for a large share of the US bond market and the benchmark index for the Government Pension Fund – Global's investments in US bonds.

In order to ensure the diversification of risk and prevent individual issuers from carrying a dominant weight in the benchmark portfolio, the mortgage-backed bonds of these institutions have been given a lower weight in the Fund's benchmark portfolio than would otherwise have been the case. It was announced, in the National Budget 2006, that one was working on amendments to this underweighting rule, and that one would examine, in particular, whether the underweighting rule should also apply to the senior unsecured bonds of these institutions.

In January 2007, the Ministry adopted, on the basis of, inter alia, input from Norges Bank, a new rule under which the sub-sector “Agencies” and the main sector “securitised bonds” in the USD-part of the benchmark portfolio for fixed-income instruments were both scaled back to 50 pct. of market value.[2]

The Ministry will also in future consider underweighting individual issuers if the market value of their outstanding bonds represents a significant portion of the adopted index.

 

5.2.2 Performance in the management of the Government Pension Fund – Global

Norges Bank manages the Government Pension Fund – Global on behalf of the Ministry of Finance. The market value of the Fund was NOK 1,992 billion as per the end of the first half of 2008. The equity portfolio accounted for NOK 1,031 billion of this, which corresponds to 52 pct. of the aggregate portfolio value. The market value of the fixed-income portfolio was NOK 961 billion (48 pct.). The inflow of new capital during the first six months of the year was NOK 179 billion.

The value of the Government Pension Fund - Global is in this report estimated to grow to NOK 2,300 billion as per yearend 2008. This estimate is based on the fund capital as per the beginning of September and an annual real return of 4 pct. for the remainder of the year. The net transfer from the Treasury to the Pension Fund – Global during 2008 is estimated at NOK 411 billion.

The return on the Government Pension Fund – Global during the first six months of 2008 is estimated to be -7.4 pct. as measured in foreign currency, when the returns in individual currencies are weighted together in proportion with the benchmark portfolio of the Fund. The return during the first six months of the year was -9.8 pct. when measured in Norwegian kroner. The discrepancy between the two return figures reflects the appreciation of Norwegian kroner relative to the currency basket of the Fund over the period. The appreciation of the Norwegian kroner exchange rate contributes to reducing the value of the Fund as measured in Norwegian kroner, but it is the return in international currency that is relevant for purposes of measuring developments in the international purchasing power of the Fund. The nominal returns on the sub-portfolios of the Government Pension Fund – Global since the beginning of 1998 are illustrated in Chart 5.2.

 Chart 5.2Nominal developments in the value of the sub-portfolios of the Government Pension Fund – Global, as measured in international currency. Index as per yearend 1997 = 100

Chart 5.2Nominal developments in the value of the sub-portfolios of the Government Pension Fund – Global, as measured in international currency. Index as per yearend 1997 = 100

Source:Norges Bank

The average annual real return, i.e. the return after deduction of management costs and adjusted for inflation, is estimated at 2.8 pct. as measured in foreign currency for the period from 1 January 1998 until the end of the 2nd quarter of 2008. An analysis of variations in the Fund’s real return is presented in Box 5.3.

The return on the Pension Fund – Global depends in large part on market developments in the securities that form part of the benchmark portfolio defined by the Ministry of Finance. The Ministry of Finance has defined a limit on the expected volatility in the discrepancy between the return on the actual portfolio and the benchmark portfolio. This limit is set at an expected tracking error (standard deviation of excess returns) of 1.5 percentage points. During the first half of 2008, the return on the Pension Fund – Global was 0.57 percentage points lower than the return on the benchmark portfolio. From the beginning of 1998 and until the end of the first half of 2008, the average annual excess return has been 0.32 percentage points. The average annual excess returns for various periods are shown in Table 5.1.

The negative excess return over the last year, until the end of the 2nd quarter of 2008, is -1.1 percentage points. The losses in active management have not exceeded what must be expected from time to time, in view of the overall risk limit for the active management of Norges Bank. Nevertheless, this negative excess return is high relative to the reported risk, which has for a long period of time been well below the upper limit. Reference is made to Report No. 16 (2007-2008) to the Storting for more detailed analyses of the performance of the Fund.

The risk associated with the Government Pension Fund – Global over the last 12 months until the end of the 2nd quarter of 2008, as measured by the standard deviation of returns in international currency, was 7.7 pct. This is markedly higher than the average annualised level over the last five years (4.8 pct.), which must, inter alia, be attributed to high volatility in international stock markets and the increase in the equity portion. The realised tracking error over the last year was 0.95 pct., which is a marked increase relative to the level over the last five years (0.54 pct.).

During the first half of 2008, Norges Bank's management costs, exclusive of performance-related fees and calculated as an annual rate, were 0.07 pct. of the average market value of the Pension Fund. Management costs, inclusive of performance-related fees, were 0.10 pct. of the average market value of the Fund.

The Ministry of Finance uses the consultancy firm Mercer Investment Consulting to verify the performance computations of Norges Bank and to evaluate performance. The annual reports from Mercer are available at the Ministry of Finance website (www.government.no/gpf).

The Pension Fund - Global

Last year

Last 3 years

Last 5 years

Last 10 years

Since 1.1.1998

Nominal return

-6.93

3.34

6.04

4.61

4.95

Inflation

3.98

2.97

2.63

2.08

2.02

Management costs

0.09

0.10

0.10

0.09

0.09

Net real return

-10.58

0.36

3.23

2.39

2.78

Excess return

-1.10

-0.02

0.20

0.29

0.32

Table 5.1Annualised key figures for the Government Pension Fund – Global. 1998 – 2nd quarter 2008. Percent

Source:Norges Bank

5.2.3 Performance in the management of the Government Pension Fund – Norway

Folketrygdfondet manages the Government Pension Fund – Norway on behalf of the Ministry of Finance. The market value of the Government Pension Fund – Norway was NOK 113.1 billion as per 30 June 2008, which is NOK 4.3 billion less than at the beginning of the year. The value of the shareholdings as per the end of the first half of 2008 was NOK 67.3 billion, of which NOK 58.5 billion was invested in the Norwegian stock market and NOK 8.9 billion in equities listed in Denmark, Finland and Sweden (Nordic equities). The market value of the fixed-income holdings was NOK 48.2 billion. NOK 41.2 billion of this amount was invested in Norwegian fixed-income securities and NOK 7.0 billion in Nordic securities outside the Norwegian market.

The return on the Government Pension Fund – Norway during the first half of the year was -3.6 pct. This is significantly less than during the first half of 2007. Folketrygdfondet achieved an excess return of 0.42 percentage point during the first half of 2008. This means that the active management of Folketrygdfondet has increased the return on the Fund by 0.42 percentage points relative to the return on the benchmark portfolio established by the Ministry. The return on the Norwegian equity portfolio was -4.7 pct. over the first half of 2008. The return on the Norwegian equity benchmark was -5.6 pct. over the same period. The Nordic equity holdings delivered a return of -17.2 pct. during the first half of the year, whilst the return on the benchmark portfolio was -18.4 pct. The return on the Norwegian and Nordic fixed-income investments was 0.5 pct. and 0.2 pct., respectively, over the same period. The overall 0.42 percentage point excess return on the Fund was primarily generated from the active management of the Norwegian equity portfolio as such, but there was also a positive contribution from the active management of the Nordic equity portfolio.

The risk associated with the Government Pension Fund – Norway over the last year, as measured by the standard deviation of returns, was 14.6 pct. This is markedly higher than the average level over the last five years (7.7 pct.), and reflects, inter alia, high volatility in the Norwegian stock market and the increase in the equity portion from December 2006, when the sight deposit arrangement was terminated. The actual tracking error was 1.9 pct. over the first half of 2008, which represents an increase relative to the level over the last five years (1.4 pct.), but is nevertheless well within the limit defined by the Ministry (3.0 pct.).

The costs incurred in the management of the Government Pension Fund – Norway during the first half of 2008 amounted to a total of NOK 36 million, corresponding to about 0.03 pct. of assets under management as per the end of the first half of the year.

 

Box 5.3 Variations in the return on the Government Pension Fund - Global

It is expected that the average return on the Fund's equity investments will be higher over time than that on investments in fixed-income securities, because the risk associated with equities is higher. This higher risk is reflected in more pronounced fluctuations in the return on the Fund. Consequently, the choice of equity portion for the Fund is in large part a choice as to what fluctuations can be accepted in the return on the Fund, and how that risk should be traded off against a higher expected return.

The Government Pension Fund makes long-term investments. The Government Pension Fund is large, and will be in operation for a long period of time. The capital is not, unlike that of other pension funds, earmarked for specific liabilities, and the Fund's capital is fully equity-funded. The Fund is not facing a significant risk that its owner needs to make large withdrawals over a short period of time. Consequently, there is a low risk that negative returns in themselves will result in the Fund being forced to dispose of assets. The Government Pension Fund – Global is well placed, against this background, to carry risk.

The real return on the benchmark portfolio of the Fund was very low over the last twelve-month period, as a result of the considerable turbulence that has characterised the financial markets since the second half of 2007. According to Norges Bank's report for the 2nd quarter of 2008, the real return on the benchmark portfolio of the Government Pension Fund – Global was about -9.4 percent over the period July 2007 – June 2008. This is the weakest twelve-month period in the history of the Fund, when measured in international currency. On the other hand, the real return over the preceding twelve months, during the period July 2006 – June 2007, was about 8.5 pct. These fluctuations illustrate that one should not attach too much weight to performance during a single period, as performance needs to be measured over a longer period of time. The average annual net real return on the Funds portfolio since 1998, which by the end of 2006 was 4 pct, fell to 2.8 pct. as per the end of the first half of 2008.

In Report No. 16 (2007-2008) to the Storting, the risk associated with the return on the investments of the Government Pension Fund was described in three ways. A simulation model was used to describe potential future developments in the Fund. Historical returns in the equity and bond markets were used to describe return fluctuations over the last hundred years, and historical returns during previous financial market crises were used to illustrate what would have been the return on the Fund during those periods.

Estimates were presented for normal fluctuations in the Fund by way of these various approaches, hereunder in the form of statistical measures for the uncertainty associated with expected and historical average returns. It follows from these analyses that the negative real return observed for the period July 2007 – June 2008 is an occurrence that must be expected every now and then, given the current equity portion, although such returns will only be experienced on relatively rare occasions. However, it is uncertain exactly how rare such an occurrence is, because it is difficult to model events that only take place occasionally, and because we have, even with data for more than 100 years, few observed events of this magnitude.

It can be estimated, based on simulations with the same assumptions as were outlined in Report No. 16 (2007-2008) to the Storting, that as poor performance as was registered for the period July 2007 – June 2008 must be expected to occur about five times in a century. However, computations made on the basis of historical returns indicate that as low returns as this may arise more frequently. The historical real return on a portfolio corresponding to that held by the Fund over the last year would have been less than -9.4 percent in 11 of the years since 1900.

The phase-in of the higher equity portion of 60 pct. must be expected to increase the volatility in annual returns. At the same time, the expected long-term real return will increase. The estimates for risk (volatility) and real return in the long run from the model-based computations in Report No. 16 (2007-2008) to the Storting are 9.2 pct. and 4.2 pct., respectively. It has been calculated that the probability of a real return over a 15-year period of less than 4 pct. is about 47 pct., whilst the probability of a real return of less than nil over a 15-year period has been calculated at about 4 pct. It has, correspondingly, been calculated that there is a 68-pct. probability that the real return as measured over 15-year periods will fall within the interval 1.8 – 6.8 pct., whilst the probability that it will fall within the interval -0.4 – 9.3 pct. has been estimated at 95 pct.

 

5.3 Current issues

5.3.1 Public hearing on amendments to the accounting and auditing clauses of the Central Bank Act

The need for certain amendments to the Central Bank Act is discussed in Report No. 16 (2007-2008) to the Storting and in Report No. 19 (2007-2008) to the Storting, the Credit Report 2007. The following is stated in Sub-chapter 5.4 of the Credit Report 2007:

”The Ministry of Finance announced, in Report No. 16 (2007-2008) to the Storting, that it aims to conduct a public hearing on amendments to the accounting and auditing clauses of the Central Bank Act, such as to enable the further strengthening of the control and supervision arrangements. The following is stated in Sub-chapter 5.7 in that regard:

”The Ministry of Finance is of the view that the strong growth in the assets of the Fund, the increased complexity of the management of the Government Pension Fund – Global and the concern for good management control over central bank duties make it necessary to continue evolving the management and control structure of the Bank.

The establishment of a designated internal audit department and the cooperation with the auditing firm Deloitte concerning the external auditing of the Bank’s management of the Government Pension Fund – Global, have contributed to strengthening the control and supervision arrangements of the Bank. These measures have been implemented within the framework of today’s Central Bank Act. The Ministry of Finance deems it appropriate to contemplate amendments to the accounting and auditing clauses of the Central Bank Act such as to enable the further strengthening of the control and supervision arrangements. One aims to conduct a public hearing in respect of the following proposed amendments to the Central Bank Act:

  • Replace the arrangement for a designated central bank audit department by an arrangement whereby the Supervisory Council appoints an external auditor for Norges Bank.
  • Establish legal authority for regulations on what accounting principles Norges Bank should observe.
  • Lay down rules on the scope of the audit and the contents of the auditors’ report or establish legal authority for regulations thereon (at present, the Supervisory Council stipulates an audit code for the Bank).

 

One should in this context consider whether the auditors should, in addition to performing a financial audit of the accounts, be given a so-called certification assignment within certain areas, for example in relation to the assessment of systems for internal control.””

The Ministry of Finance's consultation paper was distributed to the bodies included in the public hearing on 23 May 2008. The Ministry had received 12 consultative statements as per the expiry of the deadline for submitting statements, on 29 August 2008. One aims to submit a Proposition to the Odelsting in this matter during the spring of 2009.

 

5.3.2 Evaluation of the ethical guidelines for the Government Pension Fund – Global

The Government announced, in Report No. 24 (2006-2007) to the Storting on the management of the Government Pension Fund in 2006, that it would evaluate the ethical guidelines for the Government Pension Fund – Global. This process was commenced at the beginning of this year, and will continue until the end of 2008. The findings from the evaluation will be presented to the Storting in the report on the management of the Government Pension Fund in the spring of 2009.

The main objective of the evaluation is to assess whether the guidelines have worked as intended, to maintain broad-based political support for the guidelines, as well as to gather any feedback that may contribute to strengthening the profile of the Fund as a socially responsible investor.

In January 2008, the Ministry of Finance organised, in cooperation with Norges Bank and the Council on Ethics for the Government Pension Fund – Global, a large international conference in Oslo under the headline ”Investing for the Future”, as part of the evaluation process. The conference was attended by representatives from academic circles, financial institutions, NGOs, corporations and investors, who discussed the challenges associated with the integration of social and environmental concerns into investment decisions.

The Ministry has commissioned two external reports for use in the evaluation. One of these reports was prepared by Professor Simon Chesterman and The Albright Group, and concerns the work carried out by Norges Bank and the Council on Ethics pursuant to the guidelines. The second report was prepared by Professor Thore Johnsen and Professor Ole Gjølberg. This report addresses the use of positive selection as an investment strategy.

On 18 June 2008, a consultation paper was distributed to a comprehensive range of bodies included in the public hearing, domestically and abroad. The Ministry of Finance held an information meeting for the bodies included in the public hearing, during which the memorandum was presented. The deadline for submitting consultative statements expired on 15 September 2008, and about 50 bodies included in the public hearing have submitted statements.

Amongst the issues addressed in the public hearing is whether there is a need for making changes or adjustments to the current policy measures; exercise of ownership rights and exclusion of companies from the investment universe of the Fund. Furthermore, it has been asked whether one should make changes to the interaction between the policy measures, which are currently administered by Norges Bank and the Council on Ethics for the Government Pension Fund – Global, respectively. The Ministry also raises, in line with the announcement made in Report No. 16 (2007-2008) to the Storting, the issue of whether a minor part of the Fund should be earmarked for special investment purposes, for example within environmental technology or in developing countries.

 

5.3.3 The debate concerning Sovereign Wealth Funds

So-called Sovereign Wealth Funds can be characterised as government-held investment funds, often established by reference to some macroeconomic purpose, that make investments in foreign financial assets in pursuit of a financial objective. Sovereign funds have typically been created in countries characterised by current account surpluses. Many funds have been established on the basis of large foreign exchange revenues from the extraction of natural resources, whilst others may reflect the accumulation of foreign securities on the part of the State as the result of exchange rate policy and budget surpluses. The definition of Sovereign Wealth Funds will normally not extend to government-held corporations, government pension funds with earmarked pension liabilities, government-held banks or government foreign exchange reserves.

The international debate concerning Sovereign Wealth Funds has over the last year evolved from being characterised by widespread scepticism to a gradually more balanced perspective, which is partly due to a recognition that such funds have contributed to shoring up the stability of the international financial markets by contributing capital to financial institutions. There has been expressed concern that such sovereign funds may pursue political, rather than financial, motives in their investments (under reference to strategic ownership stakes within, inter alia, infrastructure and energy supply). In addition, reference has been made to the risk of financial market instability due to the funds’ size and limited openness.

References to Norway, hereunder the Government Pension Fund – Global, have generally been positive. This probably reflects the fact the management process emphasises a high degree of openness, the Fund’s role as a financial investor holding non-strategic ownership stakes, an unequivocal objective focused on maximizing financial returns, a transparent and predictable set of ethical guide­lines based on universal values, and clear lines of responsibility between political authorities and operative management.

In May 2008, there was established an international working group with participation from most of the countries having Sovereign Wealth Funds, in order to address the expressed concerns. The purpose of the working group was to prepare a set of voluntary guidelines for the management of such funds, in order to build confidence and ease pressure for the introduction of protectionist measures. Norway has participated actively in the preparation of the voluntary guidelines, referred to as the Generally Accepted Principles and Practices (”GAPP”), and the IMF has acted as facilitator by making its secretariat available for the process. Efforts within the international working group supplement the OECD's initiative on guidelines for countries that receive investments from Sovereign Wealth Funds.

The objective has been to prepare a GAPP document that embeds sound principles and politically commits the funds to transparency in key areas. The GAPP, including supplementary comments, address institutional frameworks, governance principles and investment activities for Sovereign Wealth Funds. The working group adopted the following main principles for purposes of preparing the GAPP:

  • contribute to stability in the international financial system and the free movement of capital and investments
  • comply with relevant regulatory frameworks on supervision and transparency in the countries in which one invests
  • invest on the basis of economic and financial considerations
  • have a transparent and robust governance system with clear lines of command, risk management and control.

The international working group has reached agreement on a set of draft principles. The plan is for the GAPP document to be made public in connection with the Annual Meeting of the IMF on 11 October 2008. The Ministry is of the view that the GAPP make an important contribution to enhancing knowledge of Sovereign Wealth Funds and their investment activities. It is laudable that more than 20 countries with different perspectives have reached agreement on such a document. The GAPP can contribute, by building confidence, to the continuation of a stable and open international investment climate, as well as well-functioning financial markets.

 

5.4 Implementation of previous changes to the management of the Government Pension Fund – Global

5.4.1 Real estate investments

In Report No. 16 (2007-2008) to the Storting, the Ministry proposed that up to 5 pct. of the capital of the Government Pension Fund – Global be invested in real estate, and that the real estate investments be offset by a corresponding reduction in the portion of bonds.

In Recommendation No. 283 (2007-2008) to the Storting, the Standing Committee on Finance and Economic Affairs unanimously backed the plan for investing part of the Fund in a designated real estate portfolio.

The Ministry has, following the deliberations of the Storting, continued its efforts to prepare guidelines for the real estate investments. The main part of the investments is expected to be effected through unlisted instruments. This presents challenges in relation to, inter alia, the measurement and evaluation of return and risk, and there is consequently a need for establishing designated return requirements, risk limits and reporting requirements that will address the Ministry's governance requirements related to the real estate investments.

The Ministry will in this effort be drawing on input from external experts. The underlying premise will be that management shall be in line with best practise for similar portfolios internationally. The Ministry has, following competitive tendering, awarded the company Partners Group the assignment to prepare a report setting out proposals as to how the guidelines for real estate investments should be formulated.

The Ministry is still operating on the assumption that it will take many years for the real estate portfolio to account for as much as 5 pct. of the Fund. The Ministry will revert with an update on this effort in the annual report on the Government Pension Fund next spring.

 

5.4.2 The change in the equity portion of the Fund to 60 pct.

In Report No. 24 (2006-2007) to the Storting, there was a discussion of both the short- and long-term effects on expected return and risk from increasing the equity portion. The analyses were based on comprehensive historical data and on simulations of future returns and risks premised on given expectations as to the future equity premium and risk in the stock and bonds markets. The simulations assumed an equity premium that was significantly lower than the historically observed premium. The Ministry concluded that an increase in the equity portion of the benchmark portfolio for the Government Pension Fund – Global from 40 to 60 pct. represents an attractive trade-off between expected return and risk in the long run for the investments of the Fund.

In Recommendation No. 228 (2006-2007) to the Storting, the majority of the members of the Standing Committee on Finance and Economic Affairs, comprising all members with the exception of those from the Progress Party, took note of this, and supported the increase in the equity portion to 60 pct.

As far as the implementation of this change is concerned, the Ministry wrote, in Report No. 24 (2006-2007) to the Storting, that the assessment of the consequences of an increase in the equity portion were primarily focused on how it might influence the return on, and risk associated with, the portfolio in the long run. It was noted, at the same time, that there was considerable uncertainty as to market developments in the short run, and that one must therefore be prepared for the possibility that the timing of the increase in the equity portion may in retrospect be perceived as more or less favourable. This risk is reduced somewhat by spreading the expansion of the equity investments over time, in line with expected growth in the Fund.

One aims, in consultation with Norges Bank, for a gradual adaptation to the new benchmark portfolio. A particular emphasis has been placed on transaction costs and expected returns when assessing how best to implement the phase-in of the increased equity portion. These concerns are described in more detail in Report No. 16 (2007-2008) to the Storting.

The Fund's equity portion was 52 pct. as per the end of the second quarter of 2008, and the Fund's equity portfolio was for the first time larger than its fixed-income portfolio. The phase-in of the increased equity portion has thus far taken place gradually over time, and by way of inflow of new capital to the Fund. The expansion of the equity portfolio from 52 to 60 pct. will be implemented based on the same principles.

 

5.4.3 Emerging markets in the equity benchmark

The equity portfolio of the Government Pension Fund – Global is broadly diversified across both regions and countries. One thereby attains a favourable trade-off between return and risk on the part of the Fund. However, the exposure of the benchmark portfolio to emerging stock markets has been limited to a relatively small number of countries (Brazil, Mexico, South Korea, Taiwan and South Africa). Report No. 16 (2007 – 2008) to the Storting presented a new assessment as to what emerging stock markets should be included in the Fund's benchmark portfolio, and what principles should underpin the selection of these markets. The Ministry planned to broaden the benchmark portboly by including all foreign markets classified as either developed, advanced emerging markets or secondary emerging markets by the index provider FTSE.

In Recommendation No. 283 (2007-2008) to the Storting, the Standing Committee on Finance and Economic Affairs unanimously supported the planned expansion of the benchmark portfolio for the Fund through the inclusion of new emerging markets. The Ministry decided, following the Storting's deliberation of the Recommendation, to change the benchmark portfolio.

The Ministry has planned, in consultation with Norges Bank, a gradual phase-in of the new markets in the actual portfolio and the benchmark portfolio. This will contribute to curtailing the transaction costs associated with the acquisition of equities in markets where liquidity is inferior to that of the developed markets in which the Fund is already invested. One will, at the same time, achieve the desired exposure to the new markets within a reasonable time horizon. Upon completion of the phase-in, investments in emerging stock markets will in aggregate represent about 10 pct. of the equity benchmark, double the previous share, and the number of emerging stock markets in the benchmark portfolio will have increased from five to 23.

 

5.4.4 Listed small-cap companies in the equity benchmark

The equity benchmark portfolio of the Government Pension Fund – Global has from 1998 and until the summer of 2007 comprised large- and medium-cap listed companies. Norges Bank has, at the same time, been permitted to invest in small-cap listed companies throughout this period. The Bank has made use of this investment opportunity. The number of companies in the actual portfolio has therefore been much higher than the number of companies in the equity benchmark. By small-cap companies are understood companies that are included in the FTSE index and that have a relatively low market value.

The Ministry proposed, in Report No. 24 (2006-2007) to the Storting, the inclusion of small-cap companies in the benchmark portfolio for the Fund. The Ministry pointed out that the objective of the investments of the Government Pension Fund - Global is to achieve the highest possible return at a moderate level of risk. It was noted that the risk is diversified by investing in several asset classes, and in various segments and countries within each asset class. The original equity benchmark comprising large-cap and medium-cap companies encompassed about 85 pct. of the overall value of the stock markets in the world index of the index provider FTSE. This portion would increase to about 95 pct. if small-cap companies were included. This would make the equity benchmark more representative of the investable part of the stock market. When taken together with the inclusion of emerging markets, as discussed in section 5.4.3, virtually full coverage is achieved. This means that the risk associated with the Fund is further diversified, and it is reasonable to assume that the trade-off between return and risk will improve.

It is argued, both in financial theory and within the asset management industry, that the expected return on small-cap companies includes a risk premium associated with a specific risk factor pertaining to small-cap companies. Such a risk premium will result in a further improvement in the trade-off between return and risk. However, transaction costs associated with the management of a portfolio comprising small-cap equities will be somewhat higher than for a portfolio comprising medium-cap and large-cap companies. Both the Strategy Council and Norges Bank recommended the inclusion of small-cap listed companies in the equity benchmark.

In the Report No. 24 (2006-2007) to the Storting, the Ministry wrote:

”The Ministry proposes, against this background, the expansion of the benchmark portfolio of the Government Pension Fund – Global to include the small-cap company segment of the FTSE index. Adaptation to the new benchmark portfolio will be implemented over a period of time.”

In Recommendation No. 228 (2006-2007) to the Storting, the Standing Committee on Finance and Economic Affairs unanimously supported the planned expansion of the benchmark portfolio for the Fund to include small-cap companies. The Ministry decided, following the Storting's deliberation of the Recommendation, to change the benchmark portfolio.

The Ministry of Finance decided, in consultation with Norges Bank, to implement a gradual expansion of the equity benchmark to include the listed small-cap company segment, cf. the discussion in Report No. 16 (2006-2007) to the Storting.

The transition to a new benchmark portfolio was implemented during the period from October 2007 until the end of the first quarter of 2008. As per the end of the phase-in period, the Bank had invested about NOK 120 billion, distributed across more than 4,500 companies. The small-cap companies account for about 12 pct. of the market value of the new benchmark index, which comprises more that 7,000 companies. Norges Bank estimates the overall transaction costs associated with the phase-in of small-cap companies in the portfolio at NOK 1.1 billion or 0.95 pct. of the transaction value. The management report for the Government Pension Fund – Global for the 2nd quarter, as prepared by Norges Bank, contains a more detailed discussion of the adaptation to a new equity benchmark.

 

5.4.5 Prohibition on investments in companies that sell weapons and military materiel to Burma

The Government proposed, in Report No. 16 (2007-2008) to the Storting, that the Government Pension Fund - Global shall refrain from investing in companies that sell weapons and weapons technology to regimes that are included in the list of those countries whose government bonds the Fund is prevented from investing in. This means that the Fund shall refrain from investing in companies that sell weapons to Burma.

The measure aimed at the sale of weapons to Burma is now laid down in the ethical guidelines for the Government Pension Fund – Global, and is regarded as a negative screening criterion alongside the existing criterion for the negative screening of weapons that through their normal use violate fundamental humanitarian principles. However, there are certain differences between the reasoning behind these to measures.

The reasoning behind the new measure is primarily to prevent contributing to human rights violations as the result of the Burmese regime's systematic repression of its own population. The regime's exercise of military power is therefore a key consideration in formulating the measure. The Ministry is of the view that this suggests that both weapons and military materiel should fall within the scope of the measure. Such a formulation of the new measure is also well aligned with, for example, US and UK prohibitions on the export of weapons and military materiel to Burma.

The existing negative screening criterion under the ethical guidelines addresses a certain type of weapons that is assumed to have particularly extensive/serious humanitarian consequences irrespective of where it is used. The new criterion will focus on where weapons are used. At present, the measure addresses Burma and the Burmese regime. Furthermore, the first criterion is concerned with production, whilst the second one is concerned with sale. These differences suggest that the criteria should be formulated somewhat differently.

In line with this, Clause 4.4 of the ethical guidelines is now formulated as follows:

”The Council shall issue recommendations on negative screening of companies that:

  • produce weapons that through their normal use violate fundamental humanitarian principles; or
  • sell weapons or military materiel to states mentioned in Clause 3.2 of the supplementary guidelines for the management of the Fund.

The Council shall issue recommendations on the exclusion of companies from the investment universe because of acts or omissions that constitute an unacceptable risk of the Fund contributing to:

  • serious or systematic human rights violations, such as murder, torture, deprivation of liberty, forced labour, the worst forms of child labour and other forms of child exploitation
  • serious violations of individuals’ rights in situations of war or conflict
  • severe environmental damages
  • gross corruption
  • other particularly serious violations of fundamental ethical norms.

The Council shall raise issues under this provision on its own initiative or at the request of the Ministry of Finance.”



[1] Government-sponsored enterprises (GSE) are enterprises established by the US Congress for specific purposes that are deemed to be important for economic and/or social reasons.

[2] Cf. the Ministry's letters of 6 May 2005 and 2 November 2006 to Norges Bank, as well as Norges Bank's replies of 24 August 2005 and 18 December 2006, which have been posted on the Ministry of Finance website.

 

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Last updated: 18.07.2013
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Contact information

Asset Management Department

Telephone: +47 22 24 41 63
Fax: +47 22 24 95 91

Address

The Ministry of Finance
Asset Management Department
P.O. Box 8008 Dep
0030 Oslo
Norway