Terms of reference for an expert group appointed to review the fixed-income investment framework for the Government Pension Fund Global

1 Background
The capital of the Government Pension Fund Global (GPFG) has its origin in accumulated central government petroleum revenues from the extraction of oil and gas on the Norwegian continental shelf. The market value of the Fund’s investments was NOK 7,952 billion at the end of September 2017.

The governance structure for the Fund is based on a clear division of roles and responsibilities. Overarching management responsibility lies with the Ministry of Finance, whilst operational management execution is performed by Norges Bank (the central bank). Fundamental strategic choices have been endorsed by the Storting (parliament). Norges Bank manages the GPFG on the basis of a mandate laid down by the Ministry of Finance. The mandate expresses the key features of the investment strategy for the Fund, and includes, inter alia, provisions on benchmark indices, risk taking limits, reporting requirements and responsible management.

The GPFG is primarily invested in listed equities and fixed-income instruments. The Fund is also invested in unlisted real estate within limits stipulated in the mandate. The investment objective is to achieve the highest possible return at a level of risk that is acceptable to the Fund owners. The investment strategy for the Fund has been developed gradually on the basis of assessments of expected risk and return, as well as the purpose and distinctive characteristics of the Fund and the comparative advantages of the asset manager, along with the fundamental investment beliefs of the Ministry.

The investment strategy for the GPFG is premised on the following key principles:

→	Overall risk in the Fund can be reduced by diversifying the investments across a large number of securities.
→	The equity and fixed-income benchmarks are based on broad, global sub-indices and segments from recognized index providers with additional bespoke filters such as ethical screening. The indices shall be investable and shall as a main rule lend themselves to being replicated closely and at low cost.
→	Risk taking shall be clearly communicated and broadly endorsed. There is a high degree of transparency concerning the basis for the investment strategy and a moderate degree of active management.

Over time, the risk level in the GPFG has increased and the Fund’s benchmark and investment universe have been expanded by, inter alia, increasing the equity share and permitting investments in additional countries, currencies, asset classes and financial instruments. In 2017, the Storting endorsed an increase in the equity share of the strategic benchmark index to 70 percent, with the phase-in being implemented over time. Fixed-income instruments will make up the remaining 30 percent of the index. In conjunction with the decision to increase the equity portion in the Fund, a review of the fixed-income benchmark index was announced in the white paper to parliament on the management of the Fund in the spring of 2017. As part of the ongoing review, advice and assessments have been obtained from Norges Bank. In order to broaden the decision-making basis further, the Ministry has decided to appoint an expert group to assess the topics outlined in section 3.  

2 The current fixed-income benchmark
The purpose of the Fund’s fixed-income investments is:

→	to reduce the volatility of overall Fund returns,
→	contribute liquidity, and
→	provide exposure to fixed-income risk factors, such as interest rate risk and credit risk.

The current fixed-income benchmark index was adopted in 2012 on the basis of a strategic equity share of 60 percent, and reflects the said purposes. The benchmark is based on index products provided by Bloomberg L.P., and comprises a government bond portion (70 percent) and a corporate bond portion (30 percent). The apportionment between the two parts of the benchmark is fixed, with full monthly rebalancing back to the chosen weights. The fixed-income benchmark is exclusively comprised of investment-grade securities. Bonds from Norwegian issuers and bonds denominated in Norwegian kroner are not included in the benchmark index.

The composition of the government bond portion of the fixed-income benchmark is based on the securities included in the underlying indices at any given time, and consists of nominal government bonds, inflation-linked government bonds and bonds issued by supranationals. The country distribution within the government bond portion is calculated on the basis of the size of the economy of each country, as measured by gross domestic product (GDP) in US dollars. The country weights are rebalanced back to the original weights monthly. Within each country, sub-segments and individual bonds are weighted by market weights. Certain country weights in the government bond portion are supplemented by adjustment factors motivated by investability considerations (to avoid excessive ownership shares in countries with high GDP relative to the size of their government bond market)¹⁾. Investability is of particular concern, given the considerable size of the Fund. In addition, the management mandate requires Norges Bank to take account of differences in fiscal strength between countries in the composition of the government bond investments. The latter mandate provision implies that the asset manager cannot necessarily closely replicate the benchmark index. The corporate bond portion comprises corporate bonds and covered bonds issued in seven approved currencies²⁾. See Section 3-2 of the Ministry’s mandate for the management of the GPFG for a detailed description of the fixed-income benchmark.

The Ministry has in its management mandate defined an investment universe for fixed-income instruments which is broader than the benchmark index. The Bank shall seek to keep any deviations from the benchmark index in the composition of the actual portfolio within the mandated limit for expected tracking error of 1.25 percentage point. In addition, the Bank is required to have limits for the minimum overlap between the actual fixed-income portfolio and the fixed-income benchmark, separate limits for tail risk, as well as credit risk limits for individual investments and at the portfolio level. In order to ensure that Norges Bank is not forced to immediately divest bonds that are omitted from the benchmark index as the result of their credit rating being downgraded below investment grade, it is permitted to hold up to 5 percent of the fixed-income portfolio in high-yield bonds.

3 The assignment
The expert group shall by [1 October 2018] submit a report containing analyses and assessments. The report will form part of the basis for the Ministry’s assessments of a suitable fixed-income investment framework for the GPFG, including the fixed-income benchmark. The expert group shall in its analyses and assessments attach weight to the characteristics of the overall strategic benchmark index comprising equities and fixed-income instruments (70 percent and 30 percent, respectively). The group shall base its analyses and assessments on the Ministry’s key investment strategy principles.

In a letter 1 September 2017 Norges Bank proposed several changes to the benchmark index, including a significant reduction in the number of currencies in the fixed-income benchmark, and to limit the composition of the index to nominal government bonds only. The bank further recommended to leave the investment universe unchanged. In light of Norges Bank’s advice the Ministry requests the expert group to analyse and assess the following aspects:

a) Choice of currencies and index weighting principle
The group is requested to analyse how various country and currency compositions in the fixed-income benchmark may  contribute to meeting the principle of broad diversification. The analysis shall be conducted on the basis of various weighting principles, including market weights (with or without adjustment factors) and GDP weights. Advantages and disadvantages of the various weighting principles shall be discussed. The significance of emerging markets for diversification shall be addressed. The group shall also assess whether the long investment horizon of the Fund suggests that the index rules should pay special heed to capturing any changes in the fiscal strength of government bond issuers over time.

b) Choice of segments
The group is requested to assess whether other segments than nominal government bonds from developed economies should be included in the benchmark index, including corporate bonds, covered bonds, bonds issued by supranationals and nominal government bonds from emerging economies issues in local currency. The group is requested to assess the expected credit premium in this context, and how one should ensure exposure to such premium.

c) Choice of duration and sensitivity to interest rate changes
The group is requested to assess the expected term premium, and how one should ensure exposure to such premium. The group is also requested to assess whether there is reason to assume segmentation in the bond market and the significance thereof for the index rules.

d) Inflation-linked government bonds
The group is requested to assess whether inflation-linked government bonds should be included in the fixed-income benchmark.

e) Risk premiums which should not be harvested through the benchmark index
If the group is of the view that there are bond market risk premiums to which the GPFG should be exposed, in addition to term and credit premiums, but which are not suited for inclusion in the benchmark index, an assessment is requested as to how the Ministry should stipulate risk limits in the mandate for any exposure to such premiums.

4 Relevant background information 

• Report of 29 March 2011 from Stephen Schaefer and Jörg Behrens: NMOF Fixed Income Review – Final Report
• Letter of 9 June 2017 from the Ministry of Finance to Norges Bank on the fixed-income benchmark for the GPFG
• Letter of 1 September 2017 from Norges Bank to the Ministry of Finance on the fixed-income investments in the GPFG
• Letter of 26 October 2017 from the Ministry of Finance to Norges Bank on the fixed-income investment framework for the GPFG
• Letter of 14 December 2017 from Norges Bank to the Ministry of Finance on the fixed-income investment framework for the GPFG
• Mandate for the management of the GPFG
• Meld. St. 17 (2011–2012) Report to the Storting on Management of the Government Pension Fund in 2011, chapter 2.2
• Meld. St. 23 (2015–2016) Report to the Storting on Management of the Government Pension Fund in 2015, chapter 8

 

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1) An adjustment factor of 0.25 is applied to the country weights for Chile, Hong Kong and Russia.