Norges Bank’s target for active management is an average annual net value added of 25 basis points. Net value added is the difference between the fund’s actual results with active management and the results that could have been achieved with passive index management.
Norges Bank publishes regular data for gross excess return. This number is based on actual portfolio values and is a well-defined measure of return used widely in international funds’ reporting. The reporting of gross excess return enables comparisons between funds and for a fund over time. Since its inception, the fund has produced an average annual gross excess return of 25 basis points.<7P>
While gross excess return is a number that emerges from the fund’s accounting, the calculation of net value added is more of an approximation, as it compares actual results from active management with hypothetical results for a passively managed fund.
Passive index management is based on a benchmark, which is a theoretical index that follows set rules. Making actual investments identical to this index will result in a variety of costs. The most important of these costs are as follows:
- Transition and rebalancing costs will be incurred with passive management. The fund has had substantial inflows of capital in recent years due to high petroleum revenues. Phasing in new capital is resource-intensive. Costs are also incurred when the strategic weights in the fund’s benchmark portfolio are altered, for example due to new regional weights or a change in asset allocation. Liquidity costs, market impact and the costs associated with it sometimes not being possible to obtain some securities, mean that a passive strategy will generally produce a lower return than the benchmark index, which is not adjusted for these costs. The fund’s transition and rebalancing costs have varied considerably, but have averaged around 10 basis points per year to date. Should inflows into the fund and changes in the benchmark index decrease in the years ahead, these costs may also fall.
- Ongoing indexing costs. The composition of the benchmark portfolio is altered continuously by the market participants who own the market indices, in accordance with set rules. A passively managed fund will typically be adjusted mechanically to index changes, which entails costs for the fund. Norges Bank has previously estimated these costs at 4 basis points per year. This estimate is affected by the fund’s investment universe and market conditions. For example, factors such as the inclusion of emerging markets and a lack of liquidity in fixed income markets will push up these costs.
- Management costs. Management costs will be incurred whatever the strategy, and will be higher for active management. To date, the fund’s management costs have averaged 10 basis points per year, including performance-related fees to external managers. As a rough estimate, about half of these costs can be attributed to active management. In recent years, external management has consisted primarily of active mandates.
Unlike the theoretical index, a passive index fund will also be able to generate some income. The most important source of income is as follows:
- Income from securities lending. This is currently included in the gross excess return generated through active management of the fund. Since 1998, the fund has had average annual income from securities lending of 5 basis points. It is debatable how much securities lending income is compatible with a passive investment mandate, but it will be less than with active management. This income is not risk-free. As with other strategies that aim to create value for the fund, this activity depends on the skill and systems of the manager. Securities lending requires a sound knowledge of counterparties and the market, good technological solutions and a solid legal framework.
A rough estimate of the cost of passive index management can be
obtained by adding together the costs in 1-3 above and subtracting
the income in 4. On this basis, a passively managed index portfolio
will typically generate a negative net excess return, which can tentatively
be estimated at 10-15 basis points, depending on the assumptions
made for levels of securities lending income and future transaction
costs.
As stated above, net value added is defined as the difference between
the fund’s actual results with active management and the results that
could have been achieved with passive index management.
Since its inception, the fund has produced an average annual gross
excess return of 25 basis points. With management costs of 10 basis
points per year, this gives a net excess return after all costs of 15
basis points. However, this excess return from active management
cannot be compared with a theoretical benchmark index, only with
practically feasible passive index management. Passive management
of this kind will typically be able to produce a negative excess return
of at least 10 basis points. The net value added from active management
compared with such an alternative will therefore be in the region
of 25 basis points.
On this basis, the actual gross excess return of 25 basis points per
year is of the same order as the estimated net value added from
active management. Although these two numbers can vary over time,
previous calculations performed by Norges Bank have also found little
difference between them historically.
