Investment strategy

Introduction

The main purpose of Norges Bank’s foreign exchange reserves is to be available for interventions in the foreign exchange market in connection with the implementation of monetary policy or in the interests of financial stability. Guidelines for the management of the reserves are laid down by the Executive Board.

The foreign exchange reserves are currently divided into three portfolios: a buffer portfolio, a money market portfolio and a long-term portfolio.

The money market portfolio is managed by Norges Bank Monetary Policy (NBMP) and is to be used for minor interventions and to meet short-term liquidity needs relating to transactions with the International Monetary Fund (IMF).

The buffer portfolio is managed by Norges Bank Investment Management (NBIM) and is a means of limiting transaction costs to the government and Norges Bank when capital is transferred to the Government Pension Fund Global. Petoro AS, the government corporation set up to manage the State’s Direct Financial Interest in petroleum activities (SDFI), transfers most of its foreign currency income to the buffer portfolio. At the end of each month, an amount is transferred from the buffer portfolio to the Government Pension Fund Global as instructed by the Ministry of Finance. If the amount transferred from the SDFI is not sufficient, Norges Bank makes up the difference by purchasing foreign exchange in the market.

The following presents the investment strategy for the long-term portfolio, which is the largest of the three portfolios and is also managed by NBIM.

Investment strategy for the long-term portfolio

Norges Bank’s foreign exchange reserves are relatively large in relation to its needs. The Bank also has a relatively high risk-bearing capacity, which means that it can adopt a long investment horizon in its management of the reserves. One lesson from the financial crisis, however, is that the need for international liquidity in the performance of central banking activities can be greater than previously assumed. The portfolio is managed against this background on the basis of a long-term investment strategy with a relatively high level of liquidity.

High level of liquidity

An investment is considered highly liquid if it can be converted into cash in a predetermined currency free of charge within a given timeframe during periods of significant stress in financial markets.

The table below assesses various asset classes on the basis of three criteria: the difference between buying and selling prices in a stressed situation (spread), the likelihood of it being possible to trade at all in a stressed situation (market), and what can be expected to happen to the value of assets of this type in a period of stress in financial markets (value). This is then used to rate the liquidity quality of each asset class.

Government bonds are the asset class with the highest liquidity quality. The need for a high level of liquidity in the portfolio is met by having a sufficient proportion of the portfolio invested in this asset class.

Long-term orientation

The long-term orientation of the management of the portfolio is expressed primarily through the chosen allocation to equities. The choice of a 40 percent allocation to equities is based on the following assumptions:

• Equities have a higher expected return than bonds
  Provided that issuers of fixed-income securities are solvent, the owners of these securities will receive a predetermined cash flow from the issuers. Equities do not offer a fixed return. Lenders, employees and suppliers are entitled to have their claims met before shareholders receive anything. For equities to be an interesting investment, this higher risk to investors needs to be offset by a higher expected return than on fixed-income securities. This assumption is confirmed by historical returns in global capital markets over the past century.

•  Even a securities portfolio with the lowest possible expected volatility will include a certain proportion of equities
  Although equities can be expected to fluctuate in price more than fixed-income securities, this does not necessarily mean that the portfolio with the lowest expected variation in value will consist entirely of fixed-income securities. Calculations by Norges Bank show that the portfolio with the lowest volatility over a five-year horizon will contain about 10 percent equities, and can include up to about 20 percent with only a very small increase in volatility.

The portfolio’s 40 percent allocation to equities reflects the balance that the Executive Board has chosen to strike between expected (excess) return and risk. A 40 percent allocation to equities is higher than a minimum-risk portfolio would imply. The Executive Board has opted to increase the expected return by accepting a higher risk of weak or negative returns.

To ensure a fairly constant asset allocation over time, a rebalancing regime has been established where the allocation to equities is automatically reset if it deviates by more than 5 percentage points from the target allocation. This ensures a satisfactory trade-off between the need to limit the frequency of rebalancing (and so transaction costs) and the need to adhere to the long-term investment strategy.

Benchmark portfolio for the long-term portfolio

The benchmark portfolio for the long-term portfolio has a 60/40 split between government bonds and equities. The benchmark portfolios for the two asset classes are presented below.

Fixed-income securities

The benchmark portfolio for fixed-income securities includes government and government-guaranteed bonds in the Treasury category and Supranational and Sovereign subcategories of the Barclays Capital Global Aggregate Bond Index which are covered by the list of approved issuers in the relevant investment mandate for NBIM’s CEO.

The benchmark portfolio’s currency distribution balances the need for diversification of foreign exchange risk in the portfolio against the currencies in which future intervention needs might arise. A portfolio consisting of a limited number of currencies with a relatively large share of US dollars has been found to strike the best balance. The currency distribution is close to the composition of the IMF’s special drawing rights (SDR) at 45 percent US dollars, 35 percent euro, 10 percent pounds sterling and 10 percent Japanese yen. The strategic currency distribution and list of approved issuers will be assessed annually in connection with the review of the relevant investment mandate for NBIM’s CEO.

Equities

The benchmark portfolio for equities is a market-weighted, tax-adjusted FTSE All-Cap Developed index.

Emerging economies are not included in the benchmark portfolio, as their currencies will often not be convertible. Investing parts of the foreign exchange reserves in non-convertible currencies is considered pointless.

Management of the long-term portfolio

The long-term portfolio is managed by NBIM. The management objective is to maximise the long-term return while maintaining sufficient liquidity in the foreign exchange reserves.

The Executive Board’s limit for market risk in the management of the portfolio is based on a risk measure called expected tracking error. The portfolio is to be managed such that expected tracking error does not exceed 100 basis points under normal market conditions. To ensure sufficient liquidity in bond investments, the mandate also requires a high degree of overlap at issuer level between the actual bond portfolio and the benchmark portfolio.