In its letter to Norges Bank dated 27 June 2013, the Ministry of Finance announced a broad review of the Bank's management of the Government Pension Fund Global (GPFG). As part of this review, the ministry has asked the Bank to assess whether the current limits for the management of the fund are appropriately formulated and suited to the investment strategies used in its operational management.
The limits for our management of the fund are set out in the investment mandate from the ministry. In our letter to the ministry of 1 October 2010, we wrote that the mandate for the management of the fund contains a number of provisions that impose constraints on its management, and that there might be a need to adjust the mandate as we gained experience. Our assessment of whether the general rules are appropriately formulated is therefore an assessment of whether the sum of the provisions in the mandate give the Bank sufficient leeway to undertake the management assignment in a way that helps maximise the long-term return with moderate risk. Against this background, we have drafted a proposed new investment mandate, enclosed with this letter as Enclosure 1.
The proposed new investment mandate for Norges Bank's management of the GPFG is based on the principles underlying the current mandate:
- The fund's objective and risk profile reflect the decisions of the Storting and the Government.
- The mandate clearly defines roles and responsibilities between the ministry and the Bank.
- The mandate’s provisions are formulated in a way that ensures that the fund is managed with a view to an attractive long-term return while also taking account of the role of a responsible investor.
The fund is a financial investor and not an instrument of foreign policy.
- Responsibility for detailed provisions is delegated to the Bank.
- The Bank's reporting must contribute to the greatest possible transparency about the management of the fund.
The proposed new investment mandate does not entail any major changes to the fund's overall risk profile. We do, however, propose that the Bank is given greater leeway in the execution of its management assignment in the form of a somewhat higher risk limit and by delegating responsibility for detailed provisions to the Bank to a greater extent. These changes will support the fund's long investment horizon and make the mandate more robust in terms of the frequency of amendments. In addition to these major changes, we propose a number of simplifications and a new structure for the mandate. The proposal is formulated in a way that allows for further development of the investment strategy.
Risk measure for Norges Bank's management of the fund
One key provision of the mandate is the limit for expected relative volatility (tracking error). This limit is intended to regulate how much market risk the Bank can take in the execution of its management assignment.
In our opinion, there are now a number of reasons to review this provision. The decision to invest up to 5 percent of the fund in real estate is one change in the Bank's management assignment that warrants reassessment of the risk measure. Investments in unlisted markets are significantly more challenging to manage within a relatively narrow limit for relative volatility. If the share of private investments increases in the future, this will exacerbate these challenges. To date, the ministry has chosen to resolve this issue by excluding the fund's real estate investments from the calculation of relative volatility. From a general governance perspective, it may seem less than ideal for the ministry's overall risk limit to apply only to parts of the fund. In the proposed new mandate, the fund's benchmark index in section 2-1 (2) covers liquid equities and bonds, while real estate is excluded. The fund’s real estate investments are, however, included in the limit for relative volatility in the Bank’s proposal. In this case, the limit should be increased to take account of the calculations of relative volatility being somewhat less precise than before.
By making adjustments in the operational reference portfolios, we have established a more tailor-made starting point for our management of the fund. These adjustments currently draw on the limit for relative volatility. We have previously highlighted the ability to exploit time variation in risk premiums and pursue a countercyclical investment strategy as among the fund’s strengths. In recent years we have further developed the management of the fund with a view to harvesting systematic risk premiums, partly through adjustments in the operational reference portfolios. The limit for relative volatility can prove challenging when executing such an investment strategy. The fund was managed with a limit for relative volatility of 150 basis points from 1998 onwards until it was lowered to 100 basis points in the wake of the financial crisis. Experience from both before the crisis and subsequent years indicates that the limit can now be raised again.
If the main risk measure for the Bank's management of the fund is still to be based on a limit for relative volatility, we believe that it should be raised from the current 100 basis points. Norges Bank recommends a limit of 200 basis points. This would give the Bank the leeway to manage the fund in a way that exploits its defining characteristics and supports the overall objective for its management (cf. section 3-4 of the proposed new mandate).
One alternative to raising the limit for relative volatility would be to make it clear in the mandate that the provisions on fiscal strength, environment-related mandates and the Bank's adjustment of the portfolio after rebalancing are to be excluded from the calculation of relative volatility. The fund's real estate investments should then also continue to be excluded from the calculation of relative volatility, and real estate should continue to be included at book value in the benchmark index. Norges Bank does not recommend such a solution.
Finally, Norges Bank would like to point out that having relative volatility as the main measure of risk taking has a number of drawbacks. These drawbacks are well known. Expected relative volatility is calculated using statistical models based on a number of assumptions, and not all of these assumptions are equally realistic. The models often assume that historical market fluctuations and covariances calculated for a given historical period provide a good indication of future market developments. This may mean that risk is systematically overestimated in periods of high volatility and underestimated in periods of low volatility, which can, in turn, give the investment strategy a procyclical bias.
In the longer term, we believe that the ministry should therefore consider whether the Bank's management of the fund should be based on an absolute measure of risk rather than a relative measure. This measure would ensure that the management of the fund prioritises the fund's overall volatility over the risk of deviation from the benchmark index.
Detailed presentation of the Bank's proposed new mandate
The following presents the Bank's proposed new mandate in more detail. In our proposal, we have attached importance to the provisions in the mandate being general and mutually independent, yet robust and easy to communicate. Reference should also be made to the table in Appendix 2, where the proposal is compared with the current mandate.
Chapter 1 contains general provisions. We propose simplification and moving some provisions to other chapters of the mandate. The rules for inflows into the fund are set out in a new section 1-4. Inflows currently take the form of the Ministry of Finance setting a monthly transfer amount in kroner. The equivalent amount in foreign currency is obtained partly through direct transfers of foreign exchange from the State’s Direct Financial Interest in petroleum activities (SDFI) and partly through Norges Bank's purchases of foreign exchange in the market. We propose that the provision is amended to the Bank receiving inflows of new capital on a regular basis. In our opinion, this formulation would cover both the continuation of the current practice and any future change to more frequent transfers.
Chapter 2 presents the general investment strategy. We have used the current strategic allocation in our proposal, but would refer to the assessments in Norges Bank's letter of 6 July 2010 on the development of the investment strategy for the fund. By defining the strategic allocation as we have done in section 2-1 (1) of the proposed new mandate, the allocation between b) and c) can be amended as and when the ministry decides to allow real assets other than real estate in the strategic allocation.
Norges Bank proposes some simplifications in sections 2-1 (2) and (3) of the new mandate. These include removing the description of operational procedures between the Bank and the ministry, and moving the detailed description of the benchmark indices to an appendix to the mandate. We also propose that the fund's real estate investments are no longer part of the strategic benchmark index. We do not propose any material changes to content of the provision on returning the equity allocation in the benchmark index to 60 per cent.
The fund's investment universe is defined in a new section 2-2. Rather than specifying in detail which instruments the fund may invest in, we propose a more generic definition of the investment universe followed by a separate list of the types of investments that the fund is not currently permitted to make. The provision is formulated in a way that allows for future changes to the investment universe.
We propose simplifying the provision on instrument approval and due diligence in section 4-10 of the current mandate and transferring it to section 2-2 (4) of the new mandate. In our opinion, some of the provisions in the current mandate are already covered by the regulation on risk management and internal control at Norges Bank. We propose removing these provisions from the mandate in order to avoid ambiguity and make the mandate robust to future changes in the internal control regulation.
Chapter 3 presents more detailed provisions on the Bank's management assignment. We propose a reformulation of the objective for the management of the fund in section 3-1. The current mandate formulates objectives in two separate provisions, 1-2 (3) and 2-1 (1). This could cast doubt on whether the mandate is formulated in line with the principle of mutually independent rules. Norges Bank would also refer to our consultation response of 24 January 2014 to the recommendations of the Strategy Council. We therefore propose including in section 3-1 of the new mandate that a good long-term return is considered dependent on sustainable development. We also suggest some reformulations and simplifications. We propose moving the provision that the Bank is to make investment decisions independently of the ministry from section 1-1 (2) of the current mandate to section 3-1 of the new mandate.
We propose moving the provision concerning the strategy plan in the first sentence of section 1-6 (1) of the current mandate to section 3-2 in the new mandate, and consider the remaining provisions of the current section 1-6 to be redundant.
Norges Bank's work on responsible investment and active ownership is an important part of the management assignment. Section 3-3 (1) of the proposed new mandate has essentially the same content as the provisions of section 2-1 (2) and (3) of the current mandate with some reformulations and simplifications. Norges Bank does not consider it necessary to have separate provisions for different types of investments. The provisions on responsible management should, in principle, apply to the whole portfolio. The reference to active ownership in section 3-3 (2) of the new mandate is a continuation of the current mandate's sections 2-2 and 2-3 with some minor adjustments. Our proposals for changes to the provisions on responsible investment do not take account of any changes that may result from the ministry's consideration of the Strategy Council's recommendations in this area. The Bank assumes that we will be able to revisit this at a later stage.
Norges Bank believes that there is a need for some changes to the limits set by the ministry for the management of the fund. The limits set by the ministry should be few in number and mutually independent. Our proposed change to the limit for expected relative volatility is discussed above. We also recommend simplifying the description of the limit for exposure to equities. The allocation between other assets is covered by section 2-1 (1) of the new mandate.
Section 3-5 of the current mandate contains a number of provisions that Norges Bank proposes removing, as we consider the intentions of these provisions to be met by other provisions. These are:
- Qualitative requirements for systematic risk factors. We believe that this is covered by other general provisions on the management of the fund.
- Quantitative limit for investments in high-yield bonds. We believe that the requirement for the assessment of credit risk in the bond portfolio and the setting of appropriate limits should be the responsibility of Norges Bank, cf. section 3-5 (1) in our proposed new mandate. We would also refer to our general assessment of the limit for credit risk in our letter of 1 October 2010.
- Qualitative provisions for the real estate portfolio. These concern the rate at which these investments are phased in and no longer apply.
We suggest moving the requirement for guidelines on the reinvestment of cash collateral and securities that the Bank does not own (short selling) to section 4-1 (3) in the new mandate.
Section 3-6 of the current mandate contains requirements for limits that are to be set by Norges Bank. We propose simplification here, and replacing the requirement for diversifying the real estate portfolio with a more general requirement that the Bank must set limits for the fund's real estate investments, including requirements for diversification and relevant return objectives.
We propose replacing the detailed specification of the return objective for the real estate portfolio with a more general measure set by Norges Bank within the overall objective for the management of the fund in section 3-1 of the new mandate. Section 3-4 of the current mandate, cf. section 4-2 (2), states that the objective for the Bank's management of the real estate portfolio is a net return (i.e. gross return less all costs, including operational, transaction, management and tax costs) that at least corresponds to the return on the Investment Property Databank (IPD) Global Property Benchmark excluding Norway. Like other indices for private investments, the IPD index has a number of shortcomings. The composition of the index does not necessarily reflect investment opportunities, but will depend on which owners choose to report return data to the index supplier. The index is not replicable. It will not be possible for the individual investor to buy a small share of all of the properties included in the index. Our experience is also that the IPD index is ill-suited as an instrument in our public communication of the results of our management of the fund's real estate investments.
We also propose removing the requirement that the Bank sets limits for the minimum overlap between the equity and bond portfolios and their corresponding benchmark indices. In our opinion, the intentions behind the requirement for a minimum overlap are already adequately addressed by other requirements, such as those for liquidity risk, credit risk and ownership.
Chapter 4 of the new mandate, like chapter 4 of the existing mandate, contains provisions on operational and risk management. Norges Bank believes that there is scope for considerable simplification, while retaining the main principles of the existing mandate.
Our proposal for section 4-1 (1) has essentially the same content as the provisions of sections 4-1 and 4-2 in the current mandate. Since the internal control regulation for Norges Bank applies to the Bank's management of the fund regardless, there is no need to refer to the regulation in the mandate. Similarly, the current section 4-2 contains provisions that are covered by the accounting regulation for Norges Bank. Section 4-1 (2) of the proposed new mandate has essentially the same content as sections 4-3 to 4-6 and 4-9 of the current mandate. We propose moving the provision on limits and guidelines for the remuneration system from section 5-2 of the current mandate to section 4-1 (4) of the new mandate and simplifying the provision by removing those parts of it that are set out in the remuneration regulation.
Chapter 5 of the new mandate concerns the relationship between the ministry and the Bank. The provisions are simplified somewhat in the Bank's proposal.
Chapter 6 of the new mandate covers the Bank's official reporting on the management of the fund. The provisions are simplified somewhat in the Bank's proposal. Norges Bank attaches importance to its regular reporting contributing to the greatest possible openness and public insight into the management of the fund. The Bank has published annual and quarterly reports for the fund at press conferences since 1998, and reporting has been expanded considerably in recent years. This applies particularly to the more detailed notes to the financial reporting in line with new international standards. We have also continuously developed our website, www.nbim.no, which is now an important supplement to the printed reports.
Øystein Olsen Yngve Slyngstad