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Management mandate for the Government Pension Fund Global – supplementary limits

Submission 6 April 2011

Norges Bank’s letter to the Ministry of Finance of 3 December 2010

The management mandate for the Government Pension Fund Global enters into force on 1 January 2011. Section 3-7 of the mandate requires the Bank to issue supplementary limits in a number of areas. These limits are to be presented to the Ministry by 1 December 2010(1)  for planned implementation from 1 January 2011.

On 24 November 2010 the Executive Board approved a new investment mandate for the CEO of Norges Bank Investment Management (NBIM) for the management of the Government Pension Fund Global, for entry into force on 1 January 2011 (see enclosure). This mandate contains the limits requested by the Ministry. Some of the limits are a continuation of those issued previously by the Board, while some are new. We have also made a number of minor changes to the limits issued previously.

The Executive Board’s investment mandate, the limits therein and the changes made are presented in more detail below. The mandate for NBIM’s CEO reflects the provisions of chapters 2, 3 and 4 of the mandate from the Ministry of Finance and the objectives formulated in chapter 1 of the mandate. The following looks particularly at the limits which have been established by the Executive Board against the background of section 3-7 (5) of the mandate and which must be submitted to the Ministry before entering into force under section 9-2 (1) of the mandate.

Regulatory framework and governance model

On the basis of the Ministry’s mandate and previous rules, the Executive Board and NBIM have issued supplementary rules and guidelines for the management of the Government Pension Fund Global. The Executive Board’s supplementary rules and requirements for the management of the fund are found in four key documents governing NBIM’s activities:

  • Principles for risk management
  • Investment mandate
  • Job description for NBIM’s CEO
  • Strategic plan for NBIM  

The Ministry of Finance’s requirements for the management of the fund are addressed in these four documents. It is natural for some of these requirements to be included directly in these key documents, while others have been met by the Executive Board itself setting limits. In some cases the Executive Board has delegated the setting of detailed limits and rules to NBIM’s CEO. The enclosed diagram illustrates the governance model for NBIM’s activities. We would also refer to our presentation of the governance model in our letter of 21 October 2009 in connection with the Ministry’s public consultation on new rules for the management of the fund.

The Executive Board’s investment mandate

The Executive Board has issued a mandate for the management of the Government Pension Fund Global spanning a broad set of risk indicators. The rules will therefore capture more aspects of investment risk in the management of the fund and provide a basis for a broader risk picture. In some cases, limits of this kind may partially overlap or be complementary. There are few objective or exact methods for selecting or setting risk limits. Normally they will be based on an assessment of risk tolerance for different types of investment and investment strategy. Historical usage of limits may also provide an insight into what is an appropriate level of risk.

The Executive Board has considered these factors in setting the limits in the mandate for NBIM’s CEO. Usage of the Board’s limits is reported regularly. The limits set by the Board should be viewed as thresholds which the fund should not normally cross, and which trigger signals to risk management when the portfolio approaches or exceeds them. An assessment will then be made of how quickly the fund is to be brought back within the limit.

Management of the equity and bond portfolio

Chapter 3 of the mandate from the Ministry of Finance deals with the management of the equity and bond portfolio. These provisions are reflected in sections 1 to 4 of the Executive Board’s investment mandate, where section 3 reiterates the provisions concerning the strategic benchmark index and section 4 defines the investment universe.

Section 5 of the Board’s investment mandate sets out investment restrictions for the equity and bond portfolio. The quantitative investment restrictions issued by the Ministry in its mandate for the management of the fund have been reiterated in the Board’s investment mandate. In addition, section 3-7 (5) requires the Bank to set supplementary risk limits for the management of the fund, as the Bank has done previously. The following risk limits have therefore been set by Norges Bank’s Executive Board with reference to section 3-7 (5):

  •  A limit for the minimum overlap between the portfolio and the actual benchmark index (section 3-7 (5) a)) of 60 percent at issuer level has been set for both the equity portfolio and the fixed-income portfolio (section 5.5 of the Board’s mandate). This is a straightforward and robust limit for deviations between the portfolio and the benchmark index which is not based on model assumptions. The required overlap on the fixed-income side has been raised from 40 percent as result of the management of this part of the portfolio being restructured in recent years. The limit has been set on the basis of the Executive Board’s wish for a reasonable degree of overlap between the portfolio and the benchmark index in terms of individual securities. At the same time, it signals that the benchmark index’s composition is not to be taken purely as a shopping list. So far this year, there has been more than 70 percent overlap on both the equity and bond sides of the portfolio.
  • Section 5.2 of the investment mandate sets a limit for credit risk at portfolio level, while section 5.3 sets a corresponding limit at individual issuer level, in line with the requirements of section 3-7 (5) b) of the mandate. At individual issuer level, the limit for high-yield bonds has been set at 1 percent of the value of the bond portfolio. Thelimit at individual issuer level has been set with a view to reducing the risk of having to sell off securities from large individual issuers which drop out of the benchmark index due to a downgrade. The Board has previously had an equivalent transaction-based limit for purchases of high-yield bonds, but this has been reformulated as a holding-based limit because a limit of this kind is easier to operationalise.
  • The requirement for a limit to be set for liquidity risk (section 3-7 (5) c)) has been met with the Executive Board’s requirement in section  5.6 for a minimum holding of liquid instruments equivalent to 10 percent of the value of the fund. There is also a definition of liquid instruments in the form of a specific list of low-risk bonds. The Bank has performed simulations to arrive at an expected liquidity requirement. The limit has been set on the basis of the expected liquidity requirement given today’s rebalancing rules. Liquidity will be required in periods of increased market turbulence, and especially in periods with sharply falling equity markets. In these circumstances it is important to have sufficient liquidity in the bond portfolio to be able to perform rebalancing (buy equities and sell bonds) in a cost-effective manner.
  • Limits for counterparty exposure (section 3-7 (5) d)) have been laid down in a separate section 9 of the Executive Board’s mandate. This investment risk differs from other types of investment risk in that it does not in itself have an expected positive return. The Board has set a minimum credit rating of A- for counterparties in all transactions that expose the Bank to counterparty risk. For unsecured counterparty exposure, the minimum rating is AA-. These requirements are a continuation of rules that have been unchanged for a number of years. The Bank has also set a limit for maximum aggregate counterparty exposure, and requirements for the provision of collateral and systems for netting. The 0.75 percent limit for maximum aggregate counterparty exposure needs to be seen in the light of the chosen confidence interval (95 percent) and measurement method (potential future exposure), and the extent of investment strategies that expose Norges Bank to counterparty risk.
  • The requirement for limits on leverage (section 3-7 (5) e)), including limits for gross exposure to different asset classes, is now met by provisions setting a limit of 5 percent leverage of the fund and permitting leverage only with a view to efficient management of the fund (section 5.7 of the mandate). The limit for leverage has been brought down from 7.5 percent. We now make less use than before of investment strategies that require leverage. Section 5.4 of the Board’s mandate establishes an interval for net exposure to equities of 55-65 percent. This means that the net value of the equity portfolio, including the market value of derivatives and cash, must lie within this interval. Intervals have also been set for gross exposure to equities, bonds and real estate respectively:
      Equities 50-70 percent 
      Bonds 30-50 percent 
      Real estate 0-7.5 percent
    These intervals have been established against the background of the Board’s separate restrictions on leverage and short-selling. The concept of gross exposure includes derivatives at their full exposure value (both positive and negative market exposure) and excludes cash holdings (both positive and negative).
  •  Section 5.8 of the Board’s investment mandate allows cash collateral received to be reinvested only in cash-equivalents. Thus the fund is not permitted to reinvest cash collateral received with a view to increasing the fund’s economic exposure to riskyassets. This provision formalises existing practice. The reinvestment programmes established in the past have been phased out over the past three years. 
  • The Executive Board has established a number of limits in addition to those set in the light of the Ministry’s mandate. Some of the previous limits for maximum deviation from the benchmark portfolio have been removed; in the new mandate these are captured in practice by the rules on minimum overlap, intervals for net/gross asset class exposure, maximum leverage and minimum liquidity in the bond portfolio.  

Management of the real estate portfolio

Section 6 of the Executive Board’s mandate is new but reflects the provisions of chapter 4 of the mandate from the Ministry of Finance on the investment universe and strategic benchmark for the real estate portfolio. Section 7 of the Board’s mandate continues the previously established risk limits for the management of the real estate portfolio (see section 4-6 (2)).

Yours faithfully

Svein Gjedrem Yngve Slyngstad

(1)Deadline moved back to 3 December 2010, cf the Ministry’s e-mail of 1 December 2010.