3.1 The current investment strategy
The government is saving the revenues from petroleum activities in the Government Pension Fund Global (GPFG) on an ongoing basis. Such savings are fully integrated in the fiscal budget; see Box 3.1. Annual withdrawals from the Fund; the non-oil deficit, are determined in the fiscal budget. The deficit shall, over time, follow the expected real rate of return on the GPFG (the fiscal policy guidelines).
The Fund is a financial investor. The objective for the investments is to achieve the highest possible return, net of costs and measured in foreign currencies, given an acceptable level of risk. The investment strategy is expressed in the mandate laid down by the Ministry of Finance for the GPFG, whilst operational implementation of the mandate falls within the remit of Norges Bank; see section 3.1.7.
The strategy is derived from the purpose of the Fund and its distinctive characteristics, assumptions as to the functioning of financial markets, as well as the strengths of the asset manager. It has been developed over time on the basis of public domain knowledge, research, practical experience and thorough assessments. The strategy is summarised in Figure 3.1.
The benchmark indices defined by the Ministry of Finance are closely replicated in the management of the GPFG. More than 99 percent of the volatility in the return of the Fund can be explained by volatility in the benchmark index. Although the scope for deviations from the benchmark index is limited, Norges Bank has over time achieved excess return in its management of the Fund.
Transparency is important and a prerequisite for widespread confidence in the management of Norway’s national savings in the GPFG. Important decisions are endorsed by the Storting. Broad support for the key features of the management of the Fund facilitates consistent adherence to the long-term investment strategy, also during periods of financial market turbulence.
3.1.2 Broad diversification of the investments
A key premise underpinning the investment strategy for the GPFG is that risk can be reduced by broad diversification of investments. Risk is reduced when investments are diversified across asset classes, countries, sectors and individual companies. This makes the Fund less vulnerable to events that impinge on individual equities or individual markets. Such an approach makes it feasible to eliminate major parts of the risk that is specific to individual investments, also called unsystematic risk, and contributes to improving the ratio between expected return and risk in the Fund.
The principle of broad diversification of the investments is reflected in the Ministry’s choice of equity and fixed-income benchmarks in the mandate for the management of the GPFG. The benchmark indices comprise several thousand individual equities and bonds and are intended to reflect the investment opportunities in international financial markets; see Figure 3.2. The indices specify an allocation across countries, sectors, individual companies and bonds. They are composed in such a way as to enable investors to readily replicate them closely and at a low cost. The chosen index providers are leading internationally and have established their own criteria for which markets, companies and issuers to include in the benchmark indices.
Textbox 3.1 The fund structure and the fiscal policy framework
The ongoing inflow of capital to the GPFG predominantly represents a conversion of the petroleum wealth on the Norwegian continental shelf into financial wealth abroad. The oil and gas revenues accruing on an ongoing basis differ from other central government revenues in that these represent a conversion of wealth. Moreover, these revenues are highly volatile and will come to an end at some point in the future.
A key objective of the GPFG and the fiscal policy guidelines is to facilitate permanently high value creation and stable development in the mainland economy. To this end, the central government’s net cash flow from petroleum activities is transferred to the Fund in full. An amount is withdrawn from the Fund annually pursuant to a resolution passed by the Storting to cover the deficit in the remainder of the fiscal budget (the non-oil budget deficit). Since 2001, the following guidelines have applied to withdrawals from Fund (the fiscal policy guidelines):
The spending of fund revenues shall, over time, follow the expected real rate of return on the GPFG.
Considerable weight shall be attached to the smoothing of fluctuations in the economy to ensure good capacity utilisation and low unemployment.
The Fund and the fiscal policy guidelines serve to shelter the fiscal budget from short-term petroleum revenue fluctuations and provide fiscal policy room for manoeuvre, thus enabling economic setbacks to be countered. At the same time, petroleum revenue spending via the fiscal budget becomes an integral part of a comprehensive budget process. As long as the central government does not accumulate debt by funding expenditure through borrowing, the capital in the GPFG will reflect real financial savings on the part of central government. The fiscal policy framework facilitates preservation of the real value of the Fund for the benefit of future generations. Whilst the capital of the Fund can only be spent once, the real return may fund a permanently higher level of central government expenditure. The fiscal policy guidelines support the long time horizon of the Fund.
The equity benchmark is based on an index from FTSE Russell and includes all countries, with the exception of Norway, classified by the index provider as developed markets, advanced emerging markets or secondary emerging markets. The allocation of investments internally in each region is based on the size of the listed equity markets in the countries included in the index. The allocation between regions deviates somewhat from market weights in that a larger portion is invested in Europe and a smaller portion in the US and Canada. The chosen geographical allocation is outlined in the report on the Government Pension Fund submitted in the spring of 2012.
The fixed-income benchmark is based on indices provided by Bloomberg Barclays, and comprises sub-benchmarks for government bonds and corporate bonds. The Ministry has stipulated an allocation of 70 percent government bonds and 30 percent corporate bonds across the two sub-benchmarks. Norwegian fixed-income securities are omitted from the benchmark. Whilst the allocation of investments within the sub-benchmark for corporate bonds is based on market weights, the allocation within the sub-benchmark for government bonds is based on the relative size of the economies as measured by GDP. At the same time, certain adjustments have been made in order to, inter alia, ensure broad geographical diversification of the investments. See section 2.3 for further details on the benchmark index and fixed-income investments.
3.1.3 Reaping of risk premiums
Broad fluctuations in the market prices of equities, currencies, commodities and interest rates are generally referred to as market risk or systematic risk. According to financial theory, investors can expect to be compensated for accepting this type of risk. The expected excess return is termed a risk premium. Investors need to accept risk over time in order to achieve a satisfactory expected return. Higher risk implies a higher expected return, but also larger fluctuations in the value of the investments and a higher probability of long-term loss.
A key risk premium is the equity premium, i.e. the expected excess return from investing in equities rather than fixed-income securities. Correspondingly, those investing in fixed-income securities can expect a compensation; a so-called credit premium, depending on how high the risk is that the borrower will default on its obligations. The magnitude of these premiums is uncertain and may vary over time. The investment composition reflects investors’ trade-off between expected return and risk.
Investors differ in their time horizons for investments and in their capacity to absorb risk. The central government, as owner of the GPFG, aims to preserve the principal of the Fund over time, thus enabling future generations to benefit from the petroleum revenues as well. The probability of large and unexpected withdrawals from the Fund is held to be relatively low. Its long investment horizon makes the GPFG well placed to carry risk that requires a long time horizon. This is exploited in order to, inter alia, reap the expected excess return from investing in equities rather than fixed-income securities. The equity investments mean that the Fund is benefiting from global economic growth and value creation, and these are expected to make major contributions to the return on the Fund over time. Fixed-income securities are expected to generate a lower return than equities, but also lower risk. The role of fixed-income investments in the Fund is to reduce overall return variations, improve liquidity and reap risk premiums.
For the GPFG, the share invested in equities is the choice with the greatest impact on total return and risk in the Fund. Said share is indirectly determined by combining the equity and fixed-income benchmarks into an overall strategic benchmark index for the Fund. In 2017, the Storting endorsed an increase in the equity share of the strategic benchmark index for the GPFG from 62.5 percent to 70 percent. The phase-in is to be carried out over time in accordance with a plan established in consultation with Norges Bank. Once the plan has been implemented, fixed-income securities will represent 30 percent of the strategic benchmark index.
The market prices of equities and fixed-income securities fluctuate considerably, and will often develop differently over time. Given these constant price changes, maintaining a fixed allocation between equities and fixed-income securities is considered inexpedient, not least because this would entail unnecessary transaction costs for the Fund. An actual benchmark index has therefore been stipulated, in which the equity and fixed-income shares may deviate from their long-term weights, subject to a specified limit. Figure 3.3 shows how the strategic and actual benchmark indices for the GPFG were composed as at the end of 2017.
If the equity share in the actual benchmark index is materially higher or lower than the strategic allocation, this may result in different risk and expected return characteristics than those originally endorsed through the choice of equity share. The Ministry of Finance has therefore adopted rules on rebalancing of the equity share when the deviation exceeds a certain limit (four percentage points). Rebalancing also gives the investment strategy a certain counter-cyclical element, in that over time the Fund purchases the asset class which in relative terms has depreciated substantially in value and sells the asset class which has appreciated strongly in relative terms. Special rebalancing rules apply over the period when the equity share of the GPFG is being increased to 70 percent.
3.1.4 Limited scope for deviations from the benchmark index
The investment strategy for the GPFG is premised on financial markets largely being well-functioning. Competition between market participants is generally high, and new publicly available information is thus assumed to be rapidly reflected in securities prices. Hence, systematically outperforming the general market, i.e. the average investor, in well-functioning markets will be difficult. This suggests that investors should diversify their investments broadly and seek to minimise asset management costs.
Some investors may nonetheless have distinctive characteristics or advantages which allow them to achieve an excess return over time. Size is a distinctive characteristic of the GPFG, which may make the Fund suited for reaping economies of scale. Size may, at the same time, be a disadvantage, since some strategies are difficult to scale up and since it is more challenging to make large changes to the portfolio within a short period of time without incurring high transaction costs.
The mandate laid down by the Ministry of Finance for the GPFG allows Norges Bank to deviate somewhat from the benchmark index. The purpose of such deviations is to utilise the distinctive characteristics and advantages of the Fund to achieve excess return and cost-effective implementation of the strategy. Deviations from the benchmark index require market knowledge and proximity, and implementation has therefore been delegated to Norges Bank.
The scope for deviations from the benchmark index is specified in terms of expected tracking error in the mandate, and is stipulated at 1.25 percentage points. Expected tracking error expresses how much the return is expected to deviate from the benchmark index in a normal year.
The mandate also defines which assets can be included in the Fund (the investment universe) and stipulates other requirements intended to curtail the risk associated with deviations from the benchmark. Norges Bank may, inter alia, only invest outside Norway, only in tradable debt instruments and only in equities which are listed or planned listed on recognised market places. The Fund may only own up to 10 percent of the voting shares of any one company.1 There are, moreover, provisions intended to ensure considerable overlap between the benchmark index and the actual investments.
This strategy implies that the benchmark index largely reflects the investment opportunities open to the Fund. The benchmark specifies the desired allocation of the equity and fixed-income investments. This distinguishes the GPFG from some other large funds, for which the role of the benchmark index is to define overall risk limits, whilst the detailed investment composition is delegated to the manager. As far as the GPFG is concerned, the strategy implies that the return is predominantly determined by the benchmark index. More than 99 percent of the historical fluctuations in the return on the Fund can be explained by fluctuations in the return on the benchmark index.
The mandate allows for Norges Bank to invest a minor portion of the Fund in unlisted real estate. It is more difficult to measure return and manager risk in the unlisted market than in the listed market. There are no good benchmark indices, and the investments cannot be diversified broadly via small ownership stakes in a large number of properties in a simple and cost-effective manner. Achieved performance will depend on the manager’s strengths and specific investment choices. The unlisted real estate investments have therefore, based on an overall assessment, been made subject to the limit on expected tracking error, alongside other deviations from the benchmark index. The scale and scope of the real estate investments are determined by Norges Bank. As far as these investments are concerned, the benchmark index cannot be replicated closely and at a low cost.
The mandate for the GPFG imposes extensive reporting requirements on Norges Bank with regard to return, risk and cost, also for individual strategies used in its management of the Fund. The equity and fixed-income benchmarks are broadly composed and can, as a general rule, be closely replicated, and at a low cost. This makes them well suited to measuring achieved performance. The performance of the equity and fixed-income portfolios is measured against the respective benchmark indices. The performance of these portfolios may be affected by which equities and fixed-income securities are divested in order to fund the purchase of unlisted real estate. The contribution from such funding shall therefore be specified separately. The overall benchmark index is a performance measure for the investments of the GPFG as a whole.
3.1.5 Responsible investment
The GPFG shall be a responsible investor, within the overarching financial objective. The mandate laid down by the Ministry is based on the premise that good financial returns over time will depend on well-functioning markets and sustainable development. There is a broad political consensus that the Fund shall not be used as a foreign policy or climate policy tool.
The GPFG can, as a responsible and global investor, contribute to reducing externalities that may arise as the result of the production or consumption of one market participant affecting others, positively or negatively, without this being reflected in prices. One example is pollution in the event of inadequate regulation on the part of the authorities. For a large, long-term investor like the GPFG, with ownership stakes in thousands of companies globally, externalities from one company in the portfolio may reduce the return or earnings of other companies in the portfolio over time. It is thus in the self-interest of an investor like the GPFG to take such potential interaction effects into account.
3.1.6 Cost effectiveness
A number of circumstances facilitate low costs in the management of the GPFG. The investment strategy involves the Fund being predominantly invested in listed equities and fixed-income securities, whilst the scope for deviations from the benchmark index is limited. Moreover, the size of the Fund enables economies of scale to be achieved and internal expertise to be developed. Costs will generally increase in response to any increase in active management and unlisted investments, and the same applies to any increase in the portion of the management activities conducted externally. Asset management costs, measured as a portion of fund capital, will therefore be lower for a large fund than for a small fund.
The Ministry of Finance and the Storting have emphasised that the management of the GPFG shall be cost effective. The mandate laid down by the Ministry instructs Norges Bank to seek the highest possible return net of costs. The actual asset management costs of Norges Bank are covered up to a maximum limit stipulated annually by the Ministry of Finance. Such limit is specified as a portion of the assets under management. The Supervisory Council of Norges Bank adopts, within such limit, a budget for Norges Bank’s management of the GPFG, measured in Norwegian kroner, based on a proposal from the Executive Board of Norges Bank. Comparisons with other large funds show that the asset management costs of the GPFG are low, measured as a portion of assets under management.
However, the objective is high net returns, not low costs as such. In order to assess Norges Bank’s management of the GPFG, one needs to assess both the costs and the excess return achieved over time. Notional passive index management would somewhat reduce asset management costs, but also implies less scope for seeking excess return and meeting other requirements under the mandate. Such a comparison also needs to take into account that the return on the benchmark index cannot be achieved at zero cost as the result of, inter alia, the transaction costs associated with securities trading.
3.1.7 Clear governance structure
The Storting has, under the Government Pension Fund Act, made the Ministry of Finance responsible for the management of the GPFG, while Norges Bank is responsible for operational implementation. The Storting, the Ministry of Finance and Norges Bank have different roles in the management of the GPFG. A clear division of roles between the various governance levels, from the Storting down to the individual portfolio manager, clarifies responsibilities. Tasks and authorisations are delegated downwards in the system, whereas performance and risk are reported upwards; see Figure 3.4. Regulations and delegations necessarily become more detailed further down in the hierarchy. Each part of the system has its own supervisory unit which receives reports from, and supervises, its subordinate unit. The exception to this principle is that the Executive Board of Norges Bank is subject to the supervision of the Supervisory Council, a governing body appointed by the Storting, which also appoints Norges Bank’s auditor.
Textbox 3.2 International standards and principles
The mandates for the GPFG refer, in particular, to three international sets of standards and principles intended to address environmental, social and corporate governance considerations.
OECD Guidelines for Multinational Enterprises
The OECD Guidelines for Multinational Enterprises are voluntary recommendations intended to promote responsible conduct in all business sectors. The guidelines were launched in 1976, and most recently updated in 2011. They are not legally binding, and individual enterprises should independently assess how the guidelines can be implemented.
The guidelines aim for companies to contribute positively to economic, environmental and social conditions worldwide. They stipulate principles and internationally recognised standards for responsible business conduct. The guidelines encourage companies to avoid causing or contributing to negative social or environmental effects through their own operations, and to follow-up cases in which such effects do occur. Guidance is also provided on how companies should follow up on their business relations and supply chains. The guidelines also ask companies to conduct due diligence assessments to ensure that obligations are met. For certain selected sectors, the OECD has prepared specific and more practical guidance notes for such due diligence assessments.
Countries that have adopted the OECD guidelines are obliged to establish a national contact point for responsible business conduct. The contact points are mandated to spread knowledge about the guidelines and offer dialogue and mediation in individual cases. The Norwegian contact point is an independent specialist body subject to the administrative oversight of the Ministry of Foreign Affairs.
UN Global Compact
The UN Global Compact is currently the world’s largest corporate social responsibility initiative, with more than 12,000 participants in about 170 countries. The initiative is voluntary and focuses primarily on the commercial sector. Companies are encouraged to comply with 10 universal principles relating to human rights, labour rights, the environment and anti-corruption. In addition, participants shall report annually on their efforts to implement the principles in their operations. The results are published in the annual Global Corporate Sustainability Report.
The principles are based on the Universal Declaration of Human Rights, the ILO Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development, and the UN Declaration Against Corruption and Bribery in International Commercial Transactions. The principles are general in nature and state, inter alia, that businesses should respect fundamental human rights, should uphold the freedom of association and collective bargaining, and eliminate all forms of forced and compulsory labour, child labour and discrimination with respect to employment and occupation. Furthermore, businesses should support a precautionary approach to environmental challenges and promote the environment, development and environmentally friendly technologies. They should also combat all forms of corruption, including extortion and bribery.
G20/OECD Principles of Corporate Governance
The G20/OECD Principles of Corporate Governance discuss the distribution of roles and responsibilities between the owners, the board of directors and the senior executives of a company. The principles are designed to promote a common understanding of best practice in areas such as transparency and disclosure, equitable treatment of shareholders, and the responsibilities and liabilities of the board of directors.
The principles are based on the view that good governance over time promotes growth in company value, access to financing and well-functioning capital markets. Effective corporate governance and capital allocation will in turn promote welfare and general economic growth. The revised principles were launched in 2015 and were endorsed by the G20.
The governance structure must ensure that the investment strategy and risk profile of the Fund are supported by the owner, represented by the Government and the Storting. Major strategic choices in the management of the Fund are therefore endorsed by the said bodies prior to implementation. This is effected through, inter alia, the deliberation of the annual fund reports. Broad endorsement and appreciation of the risk profile of the Fund facilitates consistent adherence to the investment strategy, also during periods of financial market turbulence. Experience from the financial crisis in 2008–2009 shows that it can be more challenging to identify, communicate and obtain support for risk in active management than for risk implied by the benchmark index. This is reflected in the strategy for the Fund inasmuch as the risk taking is predominantly determined by the chosen benchmark index.
The governance structure must at the same time be sufficiently flexible, through the delegation of authority, to enable ongoing operational investment decisions to be made close to the markets in which the Fund is invested. It is neither desirable, nor feasible, for the operational management of the GPFG to be regulated and managed in detail by the Ministry of Finance. The mandate expresses the overarching investment strategy and limits. Norges Bank is required under the mandate to make investment decisions independently of the Ministry. Such independence also pertains to the exercise of the ownership rights implied by the investments. This division of responsibilities is broadly endorsed by the Storting.
In Norges Bank, responsibility for adopting the investment strategies and for other key choices lies with the Executive Board, whilst daily operations are delegated to the head of Norges Bank Investment Management (NBIM).
As a more general observation, the delegation of authority implies that the governance structure must also serve to reduce potential conflicts of interest that may arise because the person issuing an assignment (the principal) and the decision-maker (the agent) may generally have conflicting interests or different information (so-called principal-agent problems). Such conflicts of interest may arise at different levels, for example between the owners and the board of directors of an enterprise, or between the board of directors and the senior executives. In asset management there may be conflicts of interest between the capital owner and the asset manager. As far as the GPFG is concerned, the governance structure must, in addition to contributing to the maximum alignment of interests between the owner and the manager, also facilitate a high degree of transparency.
Textbox 3.3 Guidelines for Observation and Exclusion from the GPFG
The Ministry of Finance has adopted ethically motivated guidelines for the observation and exclusion of companies from the GPFG. The guidelines include exclusion criteria that are based on what the companies produce (products) or on their conduct. Companies may be placed under observation if there is doubt about whether the exclusion conditions are met. The Fund is also prohibited from investing in bonds issued by certain sovereign states.
The product criteria
The Fund shall not be invested in companies which themselves or through entities they control:
produce weapons that violate fundamental humanitarian principles through their normal use;
sell weapons or military materiel to sovereign states in whose government bonds the Fund is barred from investing (the government bond exemption); or
have a significant element of thermal coal in their operations.
The weapons criterion encompasses chemical weapons, biological weapons, anti-personnel mines, undetectable fragmentation weapons, incendiary weapons, blinding laser weapons, cluster munitions and nuclear arms.1 Moreover, the Fund shall not be invested in companies that develop or produce key components for these types of weapons.
The tobacco criterion is limited to the actual tobacco product, and does not include associated products such as filters and flavour additives or the sale of tobacco products. All companies that grow tobacco plants or process tobacco into end products, whether directly or through entities they control, shall be excluded. Tobacco is a product distinguished by its normal use entailing a risk of severe illness and death. This is reflected in strict regulations, both nationally and internationally. In 2009, when it was decided to exclude tobacco producers from the GPFG, an international tobacco control convention had been adopted.
The product-based coal criterion implies that observation or exclusion can be decided for mining companies and power producers which themselves or through entities they control derive 30 percent or more of their revenue from thermal coal or base 30 percent or more of their operations on thermal coal.
There is a broad political consensus that there should be a high threshold for excluding an entire sector from the Fund. In Recommendation 290 (2014–2015) to the Storting, the Standing Committee on Finance and Economic Affairs stated, in its deliberation of investments and policy initiatives targeting coal and petroleum companies, that it is not considering further product exclusions for other operations/sectors in this regard.
Observation or exclusion may be decided for companies where there is an unacceptable risk that the company contributes to or is responsible for:
serious or systematic human rights violations, such as murder, torture, deprivation of liberty, forced labour or the worst forms of child labour;
serious violations of the rights of individuals in situations of war or conflict;
severe environmental damage;
acts or omissions that on an aggregate company level lead to unacceptable greenhouse gas emissions;
gross corruption; or
other particularly serious violations of fundamental ethical norms.
1 See the Revised National Budget 2004.
3.2 The current framework for responsible investment
The Government Pension Fund is a financial investor. The objective is the highest possible return, given an acceptable level of risk. The Fund shall be a responsible investor, within the overarching financial objective. The Ministry of Finance has in the mandate for the GPFG adopted the premise that good long-term returns are held to depend on sustainable development and well-functioning markets. Such an interrelationship is assumed to be of particular importance to a large, diversified long-term fund like the GPFG, whose return will over time be determined by global value creation.
The Fund’s role as a responsible investor is reflected in guidelines and limits for Norges Bank’s responsible management of the GPFG. The mandates for the Fund refer to international principles and standards, such as the UN Global Compact, the G20/OECD Principles of Corporate Governance and the OECD Guidelines for Multinational Enterprises; see Box 3.2. Norges Bank applies these standards in its responsible investment practice. Norges Bank also participates in the further development of such international standards.
The Ministry of Finance and Norges Bank have joined the Principles for Responsible Investment (PRI). The initiative is focused on asset owners, asset managers and professional collaboration partners, and is supported by two UN partners: the Global Compact and the UN Environment Programme Finance Initiative (UNEP FI). The PRI encompasses six responsible investment principles, including respect for the environment, society and corporate governance.
Norges Bank makes investment decisions and exercises ownership rights independently of the Ministry, in line with established mandates and guidelines. It is neither desirable, nor feasible, for the operational management of the Fund to be regulated and managed in detail by the Ministry of Finance. Such a division of responsibilities is broadly endorsed by the Storting. Figure 3.5 shows the distribution of responsible investment roles and responsibilities in the Government Pension Fund.
The Ministry of Finance has adopted ethically motivated guidelines for the observation and exclusion of companies from the GPFG; see Box 3.3. Certain criteria in the guidelines are based on the products produced by companies, such as tobacco, weapons and coal. Other criteria are based on the conduct of companies, such as serious human rights violations and severe environmental damage. The Executive Board of Norges Bank makes decisions on the observation and exclusion of companies from the Fund, based on recommendations from the Council on Ethics. An exemption is made for the product-based coal criterion, for which Norges Bank can make decisions without a recommendation from the Council on Ethics.
The mandate from the Ministry of Finance implies that the GPFG cannot be invested in interest-bearing instruments issued by states that are subject to large-scale UN sanctions or other international initiatives of a particularly large scale and where Norway supports the initiatives. The Ministry of Finance decides which countries are encompassed by this provision. The list of excluded countries is reviewed on a regular basis, as international sanctions and initiatives are changed over time. North Korea and Syria are currently excluded from the investment universe under this provision.
Environmental, social and corporate governance issues form an integral part of the management of the GPFG. Key responsible investment tools include the promotion of principles and expectations based on internationally recognised standards. Furthermore, Norges Bank pursues dialogue with companies on relevant issues and matters, while also voting in general meetings of companies in which the funds are invested. Risk management is also a key responsible investment focus.
An exception has been made in respect of real estate companies.