The Government Pension Fund Global aims to get the highest return possible on its investments without taking too much risk. To do this, the fund must identify, measure and manage the risks it faces, using various models and analyses.
The fund’s market risk is primarily determined by the composition of its benchmark portfolio. The most important market risk factors are the fund’s share of equities, movements in stock prices, exchange rates and interest rates, as well as credit risk changes in fixed-income investments.
Expected tracking error
The Ministry of Finance has set limits for how much risk NBIM may take in its active management of the fund. The most important limit is expressed as expected tracking error (relative volatility) and puts a ceiling on how much the return on the fund may be expected to deviate from the return on the benchmark portfolio. The expected tracking error limit is 100 basis points, or 1 percentage point. This means that the difference between the fund’s return and the benchmark portfolio’s return is expected to exceed 1 percentage point in only one out of every three years.
Expected tracking error uses historical prices to predict future market volatility. The extremely volatile markets of 2008 showed that it is important to view risk from several angles, not only relying on traditional mathematical models based on historical pricing relationships. These mathematical models underestimated expected relative risk in 2008 by assuming normal markets and a reasonable continuity of relationships between risk factors. NBIM uses the following risk measurement methods as a supplement to traditional statistical risk models based on historical pricing:
One of the simplest measures of risk in the equity portfolio is the degree of overlap with the benchmark index. A 100 percent overlap means the equity portfolio is exactly the same as the benchmark index and has the same risk as the benchmark. The actual overlap at the end of 2009 was about 85 percent. This means that about 85 percent of the fund’s equity portfolio corresponded to the benchmark index, while the remainder deviated from the benchmark as a result of NBIM’s active management.
To assess the risk associated with investments that deviate from the benchmark index, NBIM looks at a number of factors. These include the concentration of the portfolio, meaning to what degree the portfolio consists of a few large or many small investments. A portfolio with a few large investments will be more concentrated than a portfolio with many small investments. NBIM measures the concentration of investments in individual companies, sectors and regions. The level of risk will often be higher in a concentrated portfolio than in a diversified portfolio. Even so, a manager may prefer to concentrate investments in a portfolio if the possibility of solid returns over time is higher than in a more diversified portfolio. NBIM seeks to balance concentration and diversification of investments.
Exposure to systematic factors such as small-cap companies, value companies and emerging markets normally entails higher returns, but also higher risk. It is therefore important to continuously measure the fund’s exposure to such factors. It is important to gain a static and dynamic overview to manage systematic exposure to one or more risk factors.
The ability to change the composition of the fund’s investments depends on its liquidity exposure. The size of the fund’s investments relative to overall market turnover decides how quickly such changes can be made. It is relatively straightforward to calculate the liquidity risk of the fund’s stock market investments. It is more challenging when it comes to fixed-income positions, where a high proportion of trading is over the counter.