Introduction
Norges Bank manages the foreign exchange reserves on its own behalf. The foreign exchange reserves consist of a money market portfolio and an investment portfolio. In addition, a buffer portfolio has been established for the accumulation and transfer of foreign exchange to build up the Government Petroleum Fund. The investment portfolio constitutes the bulk of the foreign exchange reserves, and is managed with a long-term horizon. The management of the other portfolios is based on short-term objectives.
The management strategy for the investment portfolio has two main components. It consists partly of the long-term strategy, which is reflected in the benchmark portfolio, and partly of active management, which results in departure from the benchmark portfolio. The owner of the capital, i.e. Norges Bank's Executive Board, defines the long-term strategy and the benchmark portfolio. The manager, i.e. Norges Bank Investment Management (NBIM) is responsible for implementing this strategy and for active management.
In the management regime defined by the Executive Board, the total return on the reserves will largely be determined by the strategic decisions concerning the composition of the benchmark portfolio. The risk taken in active management is small in relation to the total risk in the benchmark. Experience shows that almost all fluctuations in the return on the reserves move in tandem with fluctuations in the return on the benchmark. This is in line with what one finds in most other funds.
The subportfolios
The money market portfolio is managed by Norges Bank Monetary Policy (NBMP), and shall cover minor interventions, short-term liquidity requirements associated with transactions with the International Monetary Fund (IMF) and the Government Petroleum Insurance Fund.
The buffer portfolio is managed by Norges Bank Investment Management (NBIM), and is a means of limiting the total transaction costs to the government and Norges Bank associated with the transfer of capital to the Petroleum Fund. The state-owned company established to manage the State Direct Financial Interest, Petoro AS, transfers most of its foreign exchange income to the buffer portfolio. If this is not sufficient, the remaining foreign exchange requirements are met through Norges Bank purchasing foreign exchange in the market. At the end of each month, an amount is transferred from this portfolio to the Petroleum Fund, according to instructions from the Ministry of Finance.
In the following, the focus is on the investment strategy for the investment portfolio, which is the largest subportfolio in the foreign exchange reserves and the only one with a long-term investment horizon.
The investment strategy for the investment portfolio
Introduction
The foreign exchange reserves have one fundamental purpose: they shall be available for interventions in the foreign exchange market in connection with the implementation of monetary policy or in the interest of promoting financial stability. An inflation target has been defined for Norwegian monetary policy, the key instrument of which is the setting of the interest rate on banks' deposits in the central bank. In addition, Norges Bank can intervene in the foreign exchange market at short notice, but will not normally use interventions with the aim of influencing the krone exchange rate.
Emergency preparedness in connection with financial stability is linked to Norges Bank's possibility of providing foreign exchange liquidity in the event of a liquidity crisis in the Norwegian banking system. The reserves will only be used for this purpose in exceptional cases, and the probability of their being used is therefore small.
This means that the investment portfolio can have a long-term investment horizon.
The portfolio will generate income for Norges Bank. Since some of the offsets to the foreign exchange reserves on Norges Bank's balance sheet are not interest-bearing, the investments have an expected profit, but with considerable fluctuations over time. This accounting profit/loss risk has not influenced the investment strategy for the foreign exchange reserves, but has been important in the establishment of the rules and regulations for allocating Norges Bank's profit.
The expected return on and risk associated with the investment portfolio are determined largely by the share of equities, by regional weightings in the equity and fixed income portfolios, and by which markets and instruments are included in the benchmark indices. All these variables in the overall investment strategy are fixed with the objective of maximising the expected return, with a subsidiary condition of limited risk to the return in the long term.
When the return and risk associated with alternative investment strategies are to be measured, it is necessary to specify a currency basket as a measuring unit. It is not appropriate to measure in NOK, since the purpose of the portfolio is to maintain or maximise long-term preparedness for intervention. It seems reasonable that the return and risk associated with the foreign exchange reserves should be measured in terms of a broadly diversified currency basket, since this will contribute to maintaining satisfactory preparedness for intervention. The importance of the various currencies as transaction currencies in both international trading and financial investments forms the starting point for this distribution.
Equity portion
The choice of an equity portion of 40 per cent in the investment portfolio is based on the following assumptions:
- Equities have a higher expected return than fixed income instruments.
As long as the issuers of interest-bearing securities are solvent, the owners of the securities will receive a steady cash-flow from the borrowers. Equities do not have any fixed return. Borrowers, employees and suppliers all have the right to have their claims covered before shareholders receive anything. In order for equities to be an interesting investment option, this higher risk for the investors must be counterbalanced by a higher expected return than on fixed income securities. This assumption is confirmed by the historical return in the global capital market over the last hundred years.
- Even a securities portfolio with the lowest possible expected risk will contain a certain share of equities.
Even though equities must be expected to show much larger price fluctuations than fixed income securities, this does not necessarily mean that the portfolio with the lowest expected volatility only contains fixed income securities. Calculations carried out in Norges Bank show that a portfolio with the lowest volatility over 5-year horizons contains around 10 per cent equities, but with very little increase in volatility up to an equity share of about 20 per cent.
- The choice of a 40 per cent equity share is the result of the Executive Board's discretionary weighing of expected (excess) return against risk.
An equity share of 40 per cent is thus somewhat higher than a minimum-risk portfolio would imply. The Executive Board has chosen to increase the expected return while accepting some increase in the risk of a weak or negative return.
Regional weightings
In the benchmark portfolio for fixed income instruments, the regional weightings are Europe 60 per cent, Americas 35 per cent and Asia 5 per cent. For equities, the regional weightings are Asia/ Oceania 15 per cent , Europe 50 per cent and Americas/Asia 35 per cent, with the distribution between the Americas and Asia based on relative market value weightings.
The choice of regional weightings is based on the idea that preparedness for intervention is closely related to the international purchasing power of the portfolio. Global GDP weightings are probably the best point of departure for assessing the total supply of goods and services Norway will be facing in the future. A broad diversification of the portfolio, as implied by GDP weights, makes it less vulnerable to one-off regional falls in value relating, for example, to war, environmental disasters, regional "bubbles" in capital markets etc.
European currencies no longer hold any special position as an anchor for monetary policy. For Norway, purchasing power and preparedness for intervention in relation to European currencies are nevertheless more important than the GDP weightings imply, since these markets will probably provide a substantial portion of actual future imports of the goods and services that Norway will be demanding in the future. It is therefore desirable to have a certain excess weighting of European markets and enterprises.
The relationship between market exposure and underlying economic exposure is weaker for equities than for the fixed income portfolio. Enterprises will have extensive activity also in markets where they are not listed on the stock exchange. Regional weightings for equities are therefore closer to market value weightings.
Markets and instruments
The benchmark index for both equities and fixed income instruments is broadly diversified across markets. The benchmark consists of fixed income instruments from a larger number of public and private issuers with high credit ratings. The desire to utilise long-term diversification gains points to a broad portfolio composition of this nature. In the interests of long-term preparedness for intervention, the share of government bonds is higher than market value weightings alone would imply.
The equity portfolio is distributed among enterprises in various sectors in all developed markets. In addition, there is a small share in emerging equity markets. This is assumed to result in a somewhat higher expected return on the reserves without increasing the risk appreciably.
Rebalancing regime
The benchmark portfolio consists of specific securities. Because of ongoing market developments, the relative shares in the benchmark will drift away from the proportions laid down by the Executive Board in its investment strategy. It might appear that the benchmark, and hence the actual portfolio, should be constantly restored to the specified weightings in order to maintain the risk profile defined by the Executive Board. However, over time this would involve substantial transaction costs. The objective of limiting transaction costs and the use of operational resources suggests infrequent rebalancing and hence greater tolerance for deviations between benchmark portfolio weightings and the weightings in the established investment strategy.
The rebalancing regime has been laid down by the Governor as authorised by the Executive Board. The equity portion and regional weightings in each asset class (equities and fixed income instruments) in the benchmark is allowed to drift up to a maximum deviation from the established weightings. If the limits are reached, however, the benchmark and hence also the actual portfolio will be restored to the initial weightings.
The benchmark portfolio with the precise weightings decided on by the Executive Board is called the strategic benchmark. But it is the actual benchmark, with slightly deviating weightings, which is determinative for the operational management. In the management reports, it is therefore the return and risk in relation to the actual benchmark that is reported.
Relative risk / Expected tracking error
The benchmark portfolio is used as a tool for managing risk. Limits are set for how much the expected return on actual investments may differ from the expected return on the benchmark portfolio.
The Executive Board's limit for market risk in the management of the investment portfolio is based on the risk measure expected tracking error. This measure is defined as the expected value of the standard deviation of the difference between the annual returns on the actual portfolio and the benchmark. When deviations from the benchmark are controlled by setting an upper limit to expected tracking error, it is highly probable that the actual return will lie within a band around the return on the benchmark. The lower the limit for tracking error, the narrower the band will be.
The Executive Board has set the risk limit at an expected tracking error of 1.5 percentage points. This simply means that in two out of three years the Petroleum Fund will have a return that does not deviate from the return on the benchmark portfolio by more than plus/minus 1.5 percentage points, assuming that Norges Bank Investment Management makes full use of this margin. In practice, however, the use of relative risk has remained well below this limit.
