About 10 percent of the Government Pension Fund Global was managed externally at the
end of 2010. External mandates were mainly in specific industrial sectors or geographical
markets requiring levels of expertise and local knowledge that currently is not practical
for NBIM to develop in-house. Experience of this type of external management has been
positive to date.
Many of today’s specialised mandates are in individual emerging markets. NBIM’s experience is that managers who are based where a company is established and listed have a better understanding of, and better access to, information about the company. Local managers have greater opportunities to visit the company and meet its management. At the same time, the fund has an upper limit on ownership of a company of 10 percent and will always be a minority shareholder. This role is a particular challenge in emerging markets, which have a shorter history of well-functioning capital markets. NBIM has therefore identified local managers in these markets who we consider to be skilled investors with high ethical standards. Locally based managers are well placed to look after our interests and will help reduce the risk in our investments.
Among the equity mandates specialising in specific industrial sectors, healthcare is the most important area. Here, managers look for companies at the cutting edge of developments and many of the investments are in small companies in biotechnology or technical equipment. Our external healthcare managers are currently heavily invested in companies developing new medicines for cancer, which requires considerable expertise in medical research. Another area is new technology for renewable energy and water management. Although we are building internal expertise in this area, we also need the skills of external managers. We need to know what we are investing in and we need insight and expertise to find the right companies.
Fundamental requirements for external managers
NBIM has a number of requirements that a management External management of the fund About 10 percent of the Government Pension Fund Global was managed externally at the end of 2010. External mandates were mainly in specific industrial sectors or geographical markets requiring levels of expertise and local knowledge that currently is not practical for NBIM to develop in-house. Experience of this type of external management has been positive to date. company must meet to be awarded a mandate on behalf of the fund. These requirements are set out in our guidelines for external management.
Ethical and legal footing
The manager must be licensed to operate in a country with adequate regulation and supervision of the financial sector. The manager must have satisfactory ethical rules for its operations, good delegation of responsibilities between departments and an appropriate internal organisation.
All of those applying for a mandate must undergo extensive vetting by NBIM personnel. This includes multiple site visits to the company’s offices before and after signing the agreement, a review of large volumes of documentation and the retrieval of information from public sources. In addition, NBIM has hired a global accountancy firm to perform independent evaluations of managers’ background, reputation and integrity.
If we find that an external manager’s affairs are not in accordance with the mandate or NBIM’s expectations, action is taken. In serious cases the mandate will be terminated. NBIM’s standard external management agreement forms the basis for all agreements with external managers. In any situation where NBIM deems it necessary, the agreement can be terminated the same day and the entire portfolio transferred immediately to our internal management.
NBIM’s close monitoring of external managers requires them to be well organised with a good operational framework. External managers have to invest in Norges Bank’s
name. They are authorised only to make use of securities and bank accounts administered by Norges Bank’s own custodian. All trades must be registered and all holdings
are verified daily.
This monitoring gives NBIM a complete picture of all positions at all times. We can continuously analyse transactions and exposure to specific stocks, sectors and risk factors. The data are also used to analyse the factors behind returns and to check whether managers have remained within their allotted mandate and investment universe.
NBIM believes that an in-depth understanding of companies’ underlying operations is required to create real value through active investment decisions.NBIM applies a number of criteria when choosing external managers for specialised mandates. First and foremost, we look for organisations that specialise in the specific segments where we need managers. It is essential that the organisation has both analysts and portfolio managers whose main focus is on the strategy in question. It is through thorough and independent collection and analysis of information that managers can create an informational advantage.
Much of the information about a company can only be Chart 14-1 External equity mandates per strategy in 2010 understood by a manager based in the local market in which the company is established and listed. Local managers have greater opportunities to visit the company and meet its management, which can help build a deeper understanding of the company.
The process of choosing an external manager
Choosing a manager is a process that consists of information- gathering, analysis, meetings and assessments. The process normally takes six to eight months from the first meeting between NBIM and the manager to the decision to award a mandate.
Before NBIM embarks on this process, information about the relevant market is analysed. NBIM uses a number of independent sources, such as market participants, observers and databases, to identify relevant candidates for the mandate.
To be considered, a manager must complete a questionnaire with information on ownership structure, assets under management, investment process, personnel and portfolio composition. It is normally NBIM that initiates contact with the manager and invites it to apply. The initial investigations form the basis for deciding which managers NBIM meets. We usually meet 20 to 30 different managers in these initial phases. All of the meetings are held on the management company’s premises, as this provides information about local conditions and makes it possible to meet everyone who influences investment decisions portfolio managers, analysts, risk managers, employees in operational functions and executives.
A limited number of managers are then selected for a more detailed process where we ask for further information about their organisation and obtain detailed historical data on their portfolios and performance. Through repeated meetings with the manager, we aim to build a fuller picture of its portfolio managers’ and the organisation’s competence.
The final decision on the choice of manager is based on an expectation of its ability to create value over time. Key elements in this assessment are the depth of the manager’s knowledge of the companies in its portfolio, the information sources used and how its company analyses and opinions differ from those of its competitors. Analyses of the portfolio’s performance over time and discussions with the manager’s employees about individual companies are the most important factors in the final decision.
Experience with external management
NBIM’s experience with having external managers manage parts of the equity portfolio has been very positive. The excess return from external managers has made a stable, positive contribution to the fund’s overall excess return. Through to 2010, the total contribution from external equity management to the fund’s overall excess return was 22.4 billion kroner, while fees to these managers over the same period came to 6.9 billion kroner.
A detailed understanding of equity investments’ underlying operations is very important for the fund. It is therefore important to have external specialists in the geographical areas, market segments and industrial sectors where it is not currently practical for NBIM to build inhouse expertise.
The strategy adopted for external fixed-income management has differed from that for equity management. The negative excess return on external fixed-income mandates has been due primarily to exposure to market segments, while the positive excess return on equity mandates has been due to investments in selected companies. Experience with external fixed-income mandates has been much less positive than on the equity side and the fund’s external fixed-income management has now been largely phased out. External fixed-income management was discussed in detail in the 2008 and 2009 annual reports.
The fund scaled back its externally managed fixed-income mandates from 128 billion kroner in 2007 to 25 billion kroner in 2010. The remaining fixed-income mandates were retained and contributed a return of 5.8 billion kroner in 2010. In addition, the fund has retained a substantial proportion of the positions originally purchased by external managers. These contributed to the fund’s strong performance in 2009 and 2010.
|Table 14-1 Excess return and fees for external equity managers.
||Table 14-2 Excess return and fees for external fixed-income managers.|
Millions of kroner
Over the past two years, NBIM has introduced a new fee structure to further impress its long-term investment approach upon external managers. Fees to external managers consist primarily of two components: a base fee and a performance-based fee. All mandates awarded since the end of 2009 employ the new structure.
In principle, the base fee is intended to cover the costs associated with the specific mandate and is generally well below the market standard for the mandate.
To achieve its long-term goal for the management of the fund, NBIM makes extensive use of performance-based fees for external management. These fees are calculated on the basis of the difference between the return on the mandate on the one hand and the return on a comparable index plus a set percentage and the base fee on the other hand.
Under the new structure, managers will be paid only a certain percentage of the fees accrued during the first five years. The longer the mandate has been active, the higher the percentage paid out. This system of retaining parts of the fee helps align managers’ incentives with the fund’s objective, which is to achieve a long-term real return by taking moderate risk.
The new structure also means that the performancebased fee is linked to the whole history of the mandate. If a manager has a period with returns lower than the benchmark, it must earn back all of this underperformance before performance-based fees begin to accrue again. Even over many years, the total fees paid for a mandate will therefore not normally be higher than a fixed percentage of the excess return generated by that mandate. In some cases, the fees paid out in a single year have been substantial. The two highest annual fees ever paid to an external management company both came in 2009, at 530 million kroner and 170 million kroner, respectively. During the course of 2009, a ceiling was introduced for annual fees in all external management agreements. Any fee accrued above this ceiling may be paid out at a later date, but only if the mandate retains a positive excess return since inception.
In this way, the agreement furthers the mandate’s long-term incentives even after the return reaches the ceiling. Following these changes, fees in a single year will in future not hit the record levels of 2009.
Management agreements are entered into with the aim of keeping total fees as low as possible, given the objective of an excess return. How far NBIM is willing to stretch when negotiating fees depends on an assessment of the manager’s ability to generate excess return over time. As a large, recognised long-term investor, NBIM normally has a strong hand when negotiating with external managers. Competition for many managers’ capacity is fierce, however, and not all managers are willing to accept NBIM’s terms.
As a large proportion of external management fees depend on excess return generated, total management costs will normally be higher in years of good performance. Specialised management mandates will also require more resources and somewhat higher fees. In recent years, NBIM has increased the proportion of specialised mandates and has also reported good results. Costs for external active equity management are nevertheless low compared with the market for equivalent mandates.