2 Folketrygdfondet's active management of the Government Pension Fund Norway

Letter of 1 December 2010 from Folketrygdfondet to the Ministry of Finance

Dear Sirs,

We refer to the letter of 20 august 2010 from the Ministry of Finance, in which the Ministry requests Folketrygdfondet to submit analyses and assessments in relation to the active management of the Government Pension Fund Norway (the GPFN). In the said letter, the Ministry also requests Folketrygdfondet to prepare a business plan for the active management activities based on the general advice and assessments of Folketrygdfondet.

Against this background, Folketrygdfondet has carried out an assessment of the active management activities and prepared a plan for the management of the GPFN. The main aspects are presented in this letter, with more detailed discussion being provided in enclosures.

Folketrygdfondet is of the understanding that the duties relating to the management of the GPFN may be separated into four parts:

• Achieve the market exposure desired by the principal, as expressed through the defined benchmark portfolio

• Achieve the highest possible return over time, given the benchmark portfolio and the risk limit adopted by the Ministry of Finance

• Safeguard financial interests through the exercise of ownership and creditor rights

• Strategic advice to the Ministry of Finance relating to the GPFN

Folketrygdfondet is a responsible asset manager that creates, through size and ability to adopt a long-term perspective, added value in the management of public assets. Folketrygdfondet has established management strategies that are tailored to the general management mandate and the objective of generating added value relative to the stipulated benchmark portfolios. The management strategies encompass both the effort to obtain the market exposure desired by the principal and the effort to achieve the best possible excess return within stipulated risk limits. However, the practical implementation will often be an integrated process, because active choices need to be made in order to retain and maintain market exposure.

The Norwegian equity and fixed-income markets are small in an international context. The Oslo Stock Exchange, for example, represents no more than 0.4 per cent of the global equity markets. Folketrygdfondet is a large player in the Norwegian stock market, holding about 4.4 per cent of the value of all companies on the Stock Exchange as per year-end 2009. The Benchmark index of the Oslo Stock Exchange excludes shareholdings that are not freely transferable. The Norwegian stock portfolio of the GPFN represents 9.3 per cent of the Benchmark index. Folketrygdfondet is also a large player in the Norwegian fixed-income market, and the Norwegian fixed-income portfolio of the GPFN represented about 5.9 per cent of the value of the benchmark portfolio for Norwegian fixed-income instruments as per year-end 2009.

The management of a large portfolio in a small market raises many practical issues. The size of the GPFN implies, in combination with low liquidity in individual equities and fixed-income instruments, that it is in many cases difficult to maintain the traditional distinction between active and passive management. Based on assessments of these issues, Folketrygdfondet does not recommend passive management of the GPFN. Folketrygdfondet believes that the special characteristics of the Norwegian stock and bond markets, as well as the size of the GPFN and its long investment horizon, mean that a return-oriented and responsible investment approach requires active management.

Folketrygdfondet benefits from its ability to operate with a stable framework and a regulatory basis that enables it to invest countercyclically. The predictability provided by the framework contributes to distinguishing the active management of the GPFN from that of many other actively managed portfolios, inasmuch as it is possible to maintain a long investment horizon without being forced to perform unwanted dispositions. In addition, the size of the GPFN contributes to enabling Folketrygdfondet to conduct cost-effective active management.

The active investment decisions of Folketrygdfondet are based on quantitative and qualitative evaluations of individual companies, sectors, securities, market developments and macroeconomic conditions. In order to facilitate the implementation of active management strategies, Folketrygdfondet has attached weight to the development of an asset management organisation with high expertise, clear responsibilities, well-defined investment strategies, defined decision-making processes, good portfolio follow-up and responsible corporate governance. An important element of the organisational set-up is the integration of risk control and return follow-up in the asset management activities. The active management activities are premised on investment processes intended to ensure continuity and predictability in the ongoing portfolio follow-up.

Although Folketrygdfondet is a large player in the Norwegian market and a smaller player in the Nordic market, asset management activities in both Norway and the Nordic region are primarily based on the same management strategy and process. An important reason for this is that Folketrygdfondet has experienced positive interactions and knowledge transfer effects from managing both Norwegian and Nordic equity and fixed-income portfolios. The expanded access to information achieved by the asset managers through operating in a more international investment universe is deemed to have a positive effect on their asset management work, hereunder by making it easier to pick up on market changes at an earlier stage. Such knowledge is further expanded by making decisions about individual investments through active management in the Nordic region, which also contributes to Folketrygdfondet becoming a better asset manager in the Norwegian market. In addition, this is deemed to be important for purposes of being able to attract, develop and retain the appropriate expertise at Folketrygdfondet.

The Norwegian stock and credit markets are, from an investment perspective, highly concentrated. However, although Nordic investments only represent 15 per cent of the overall portfolio, investments in this market are often more liquid, and consequently offer more flexibility and scope for increased diversification when portfolio adaptations are to be implemented.

The Ministry of Finance has requested Folketrygdfondet to comment on what role exposure to systematic risk factors may play in the active management of the GPFN. Folketrygdfondet is of the view that benchmark indices based on known systematic risk factors are not well suited for a large investor in the Norwegian market. As far as the Norwegian stock market is concerned, we register that various systematic factors, like for example company size and liquidity, may contribute to explaining market developments, but we are unable to conclude that these are particularly suited for purposes of evaluating asset management or as a basis for making decisions about future investments. The reason for this is, inter alia, that there is limited scope for trading such factors on a scale of relevance to the GPFN, given its size in the Norwegian stock market. As far as the fixed-income portfolio is concerned, the systematic factors term premium and credit are made use of in the asset management activities. However, we are unable to see, given the lack of available data, how these factors may be expressed in an appropriate manner in the benchmark portfolio.

Folketrygdfondet is committed to the active exercise of ownership rights and the follow-up of bonds for purposes of safeguarding the financial interests of the GPFN and contributing to long-term value creation. It is our experience that good ownership and creditor follow-up requires expertise and knowledge of the companies. It is therefore an important principle for Folketrygdfondet that the exercise of ownership and creditor rights must form an integrated part of the investment activities. Folketrygdfondet shall be a credible player and achieve results in the exercise of its ownership rights. We must therefore have the necessary knowledge and expertise to assess the issues owners need to address. The expertise used for such purposes has been accumulated by Folketrygdfondet over many years, by continuously monitoring developments on the part of the companies and by maintaining a dialogue with the companies and with relevant market players. We are of the view that ownership follow-up improves when the managers responsible for ownership follow-up are also responsible for making active investment decisions in relation to deviations from the benchmark portfolio.

A passive mandate may result in the corporate governance inputs of Folketrygdfondet making less of an impact. This is, inter alia, because Folketrygdfondet would in such case not be able to divest, or underweight, its holdings in a company that fails to pay sufficient heed to the feedback and views of its shareholders. Folketrygdfondet is therefore of the view that active management of the portfolio has more of an impact on corporate governance than does passive management.

Since 1998, the annual average excess return on the GPFN has been 0.45 percentage points. In 2006, the asset composition of the GPFN was changed by way of the redemption of part of the investments of the State and the repayment of the capital to the State. If the historical return on the portfolio and the benchmark portfolio is adjusted for this fact and the current benchmark portfolios are used, the estimated average annual excess return is 0.36 percentage points. Folketrygdfondet aims for active management to generate an annual excess return of 0.40 percentage points before management costs over time.

Yours faithfully,

Folketrygdfondet

Erik Keiserud, Chairman of the Executive Board

Olaug Svarva, Managing Director

Enclosures