2 Glossary of terms

Active management

Active management involves the asset manager composing, on the basis of own analyses and assessments, a portfolio that deviates from the benchmark index established by the asset owner. The purpose of such deviations is to outperform the benchmark index. The Ministry of Finance has defined qualitative and quantitative limits for the GPFG and the GPFN, which regulate their deviations from the benchmark index. See Differential return, Index management, Actual benchmark index, Strategic benchmark index and Tracking error.

Actual benchmark index

The composition of the actual benchmark index is based on the strategic benchmark index. See Strategic benchmark index.

The mandates permit Folketrygdfondet and Norges Bank to manage the assets with some deviations from the actual benchmark index (active management). The actual benchmark index forms the basis for managing risk in the context of active management, and serves as the benchmark index against which the asset manager's performance is measured. See Active management and Actual portfolio.

Actual portfolio

The term actual portfolio designates investments included in the Fund. The actual portfolio will normally deviate somewhat from the benchmark index as the result of active management. See Active management, Actual benchmark index and Strategic benchmark index.

Arithmetic return

Average arithmetic return is the mean value of all numbers in a time series of returns. It is calculated by adding up the return achieved in different time periods and dividing the sum by the number of periods. If the return in year 1 is 100 percent and the return in year 2 is -50, average arithmetic return equals 25 percent (= (100 + (-50)) /2). See Geometric return.

Asset allocation

Asset allocation means the distribution of the assets under management across different asset classes. We distinguish between strategic asset allocation and tactical asset allocation. Strategic asset allocation expresses the owner’s underlying risk preferences and return expectations, and is expressed through the benchmark index as far as the Government Pension Fund is concerned. Within the limits of the investment mandate, the asset managers may engage in tactical asset allocation. This entails actively choosing to deviate from the strategic asset allocation on the basis of assessments as to whether one asset class is over- or underpriced relative to another. See Asset classes.

Asset classes

The benchmark index for the GPFG encompasses three asset classes; stocks, bonds and real estate. The GPFN includes two asset classes; stocks and bonds. See Bond.

Bond

A bond is a marketable loan with a maturity of more than one year. Bonds are redeemed by the issuer (lender) upon maturity, and the issuer pays interest (so-called coupon) to the bondholders over the period from issuance until maturity. Most bonds are based on a fixed nominal interest rate, i.e. the coupon is a specified predetermined amount, but bonds are available with different features, hereunder with floating interest rate, zero coupon or with a redemption structure.

Capital Asset Pricing Model

The Capital Asset Pricing Model is an equilibrium model for the pricing of securities (or a portfolio of securities) with an uncertain future return. The model features a linear relationship between the expected return, in excess of a risk-free rate of interest, and the sensitivity of the security (or the portfolio) return to the return on portfolio of all securities in the market.

Correlation

Correlation refers to the degree and direction of the linear interdependence between two variables. Perfectly positive correlation means that the variables always move perfectly in tandem. Zero correlation means that there is no linear interdependence. Perfect negative correlation means that the variables always move in exact opposition to each other. The risk associated with a portfolio can be reduced by diversifying the investments across several assets, unless there is perfect positive correlation between the returns on the various investments. See Diversification.

Counterparty risk

Counterparty risk is the risk that a bank or other contracting party is unable to fulfil its obligations, such as for example paying the value of a derivatives contract upon settlement.

Credit risk

Credit risk is the risk of a borrower being unable to fulfil its legal obligations, like for example the payment of accrued interest or the repayment of principal.

Currency basket

The GPFG is exclusively invested in foreign securities, and thus only in securities that are traded in currencies other than Norwegian kroner. Hence, the return on the GPFG measured in Norwegian kroner will not only vary with market developments in the global financial markets, but will also vary with changes in the exchange rate between Norwegian kroner and the currencies in which the Fund is invested. However, the international purchasing power of the Fund is unaffected by developments in the Norwegian kroner exchange rate. In order to measure return independently of Norwegian kroner exchange rate developments, the return on the Fund is also measured in foreign currency. This is done on the basis of the currency basket for the Fund, which weights together the currencies included in the benchmark index.

Differential return

Differential return is the difference in return between the actual portfolio and the benchmark index. A positive differential return is referred to as positive excess return, whilst negative differential return is referred to as negative excess return. See Actual portfolio, Actual benchmark index and Strategic benchmark index.

Diversification

The risk associated with a portfolio may normally be reduced by including more assets in the portfolio. This is referred to as diversification, or the spreading of risk. This is the main reason for spreading the benchmark index of the Government Pension Fund across different asset classes and a broad range of countries, sectors and companies. Diversification can improve the ratio between expected return and risk until a certain point, where the portfolio is said to be efficient or optimally diversified. See Actual benchmark index and Strategic benchmark index.

Duration

Duration measures how long time it takes, on average, for the cash flows (coupons and principal) from a bond to be repaid. The value of a bond is sensitive to interest rate changes, and such sensitivity increases with the duration. See Bond.

Emerging markets

The term emerging markets denotes the financial markets in countries that are not yet considered developed economies. There is no unambiguous set of criteria that defines whether a market is emerging. The Ministry uses the classifications of the index provider FTSE. FTSE's classification of emerging markets is based on, inter alia, gross national product per capita and the characteristics of the market, such as size, liquidity and regulation.

Exchange rate risk

Investments may feature a different distribution across countries and currencies than the goods and services they are intended to finance. Changes in international exchange rates will therefore influence the amount of goods and services that can be purchased. This is referred to as (real) exchange rate risk. International purchasing power parity plays a key role when it comes to measuring such exchange rate risk. See International purchasing power parity.

Expected return

Expected return is a statistical measure of the mean value in a set of all the possible return outcomes and is equal to the average return on an investment over a period of time if it is repeated many times. If an investment alternative has a 50 percent probability of a 20-percent appreciation, a 25 percent probability of a 10-percent appreciation and a 25 percent probability of a 20-percent depreciation, the expected return is 7.5 percent: (20 x 0.5) + (10 x 0.25) + (-20 x 0.25) = 7.5. See Return.

Externality

Externalities are production or consumption costs or benefits that do not accrue to a producer or consumer. An example of a negative externality may be costs relating to greenhouse gas emissions. Externalities lead to market failure, and a different use of resources than the economically optimal solution. Government-based solutions to externality problems include, inter alia, direct and indirect taxes, quotas and subsidies.

Financial investor

The term financial investor denotes an investor with a primarily financial objective for its securities investments. A financial investor will often prefer to be a small owner in many companies, rather than a large owner in a few companies, in order to diversify risk. See Strategic investor.

Fundamental analysis

Fundamental analysis primarily aims to analyse the factors that influence the cash flow of an asset. A key feature of a fundamental analysis of individual stocks will be assessments relating to the income, costs and investments of the company. Fundamental analysis is used for, inter alia, the valuation of companies. Active management strategies in the stock market will often involve the investor purchasing stocks that are deemed to have a low valuation in the stock market relative to the fundamental value of the company. The investor therefore expects the fundamental value of the company over time to be reflected in its stock price. See Active management.

Geometric return

Geometric return (or time-weighted return) indicates the average growth rate of an investment. The geometric return is always lower than the arithmetic return for the same period (see the example under arithmetic return). This is because of the compound interest effect. If a year of negative return is followed by a year of positive return, the amount invested will not have been recouped. The more pronounced the variation in the annual return, the greater the difference between the arithmetic and the geometric return. In quarterly and annual reports, return over time is most commonly reported as geometric average. See Arithmetic return.

Index

An index comprises a set of securities defined on the basis of certain selection criteria and weighting methods. Securities indices are provided by securities exchanges, consultancy firms, newspapers and investment banks. They may, for example, be based on countries, regions, market value weights or sectors. When an index is used as a return measure in respect of a specific securities portfolio, it is referred to as a benchmark index. See Index management, Actual benchmark index and Strategic benchmark index.

Index management

Index management (passive management) means that the management of the assets is organised to ensure that the return on the actual portfolio reflects the return on the benchmark index. If the composition of the actual portfolio is identical to the composition of the benchmark index, the return on the actual portfolio will be equal to the return on the benchmark index, before the deduction of management costs. If the benchmark index includes most of the securities traded in the market, index management will achieve a return that reflects the return on the market as a whole. See Index, Actual benchmark index and Strategic benchmark index.

Inflation

Inflation is an increase in the general price level in the economy.

Inflation risk

Inflation risk is the risk of a change in purchasing power as the result of unexpected changes in inflation.

Institutional investor

Institutional investors are organisations set up for the purpose of engaging in investment activities, typically on behalf of clients. Institutional investors will typically manage large portfolios, divided into several asset classes and geographical markets. Examples of institutional investors are pension funds, insurance companies, money market funds and sovereign wealth funds. Banks and hedge funds may also be classified as institutional investors.

International purchasing power parity

According to the theory of international purchasing power parity, a broad range of goods should cost the same when converted into a common currency, irrespective of which country the goods are manufactured in and which currency the goods are originally priced in. There has over time evolved a consensus among many researchers that international purchasing power parity applies in the long run. Purchasing power plays a key role in the measurement of foreign exchange risk. If the cost of goods is the same irrespective of location, it does not matter from where one purchases such goods. Consequently there is no foreign exchange risk. See Exchange rate risk.

Investability

By investability is meant the extent to which an investment idea or rule can be implemented in the operational asset management.

Liquidity premium

Liquidity premium is an expected compensation for investing in securities that are not readily tradable. The compensation is paid to enable the execution of a desired trade. In practice, tradability is difficult to define precisely and the liquidity premium is difficult to measure. See Risk premium.

Liquidity risk premium

Historical data show that the liquidity of risky securities is covariant over time. A liquidity risk premium compensates an investor for holding some securities that are more sensitive to market turbulence and a decline in overall market liquidity than others.

Market efficiency

In simplified terms, the efficient market hypothesis implies that the price of a security, such as a share or bond, at all times reflects all the available information on the fundamental value of the asset. If this hypothesis is correct, it will be impossible for a manager to consistently “beat the market”. Active management would thus play only a minor role in terms of adding value. See Active management and Fundamental analysis.

Market risk

Market risk is the risk that the value of a securities portfolio will change as the result of broad price fluctuations in the markets for stocks, currencies, commodities or credit. It is normally assumed that an investor must accept higher market risk in order to achieve a higher expected return. See Expected return.

Market value weights

A portfolio or index is market value weighted when investments in each individual asset are included with a weight corresponding to such asset's proportion of the overall value of the market.

Negative excess return

See Differential return.

Nominal return

Achieved return measured in nominal prices, i.e. without inflation adjustment. See Inflation and Real return.

Operational risk

Operational risk may be defined as the risk of economic losses or loss of reputation as the result of deficiencies in internal processes, human error, systems error or other losses caused by external circumstances that are not a consequence of the market risk associated with the portfolio. There is no expected return linked to operational risk.

However, in managing operational risk, one must balance the need to keep the probability of such losses low against the costs incurred as a result of increased control, monitoring, etc.

Passive management

See Index management.

Positive excess return

See Differential return.

Principal-agent problem

Principal-agent problems refer to situations in which there is not a complete alignment of interests between the person issuing an assignment (the principal) and the person charged with performing such assignment (the agent). In situations of asymmetric information, e.g. where the efforts of the agent cannot be fully observed by the principal, the agent may conduct himself in ways, and make decisions, that are not in the best interest of the principal. Principal-agent problems are well known from political and economic literature and theory. In the asset markets, principal-agent problems may arise both between the asset owner and the asset manager and between the asset manager and the senior executives of the companies in which investments are made.

Private equity

Private equity denotes assets that are not listed on regulated market places.

Probability distribution

A probability distribution describes the relative frequency of various values that an uncertain (stochastic) variable may assume. The best known probability distribution is the normal distribution, which is symmetric around the mean value (the expected value). Distributions that are not symmetric are often referred to as skewed. Distributions in which extreme outcomes (large or small) carry a higher probability than under the normal distribution are referred to as distributions with “fat” or “heavy” tails.

Real return

Real return is the achieved nominal return adjusted for inflation. It may also be referred to as the return measured in constant prices or in terms of purchasing power. See Inflation and Nominal return.

Rebalancing

The Ministry has adopted a strategic benchmark index for the Fund with a fixed allocation across asset classes. Since returns develop differently in respect of each asset class, the portfolio will over time move away from the strategic allocation. The Fund therefore has in place rules on rebalancing of the portfolio.

The rules imply that the Fund has an actual benchmark index that is permitted to deviate from the strategic allocation. In the case of deviations exceeding preset limits, the necessary assets are purchased and sold to bring the actual benchmark index into conformity with the strategic benchmark index. See Actual benchmark index and Strategic benchmark index.

Relative return

See Differential return.

Return

Historical return is calculated as the change in the market value of the Fund from one specific date to another, and is often referred to as absolute return. See Arithmetic return and Geometric return, Differential return and Expected return.

Risk

Risk is a measure that provides some indication as to the probability of an event occurring and the consequences thereof (for example in the form of losses or gains). There are various aspects to risk. One important aspect is the distinction between risks that can be quantified and risks that are difficult to quantify. An example of the former is the market risk associated with investments in the securities market. An example of the latter is the operational risk inherent in a portfolio. Standard deviation is one way of quantifying risk. See Market risk, Operational risk, Credit risk, Systematic risk and Standard deviation.

Risk factors

Risk factors are factors that may influence investment returns. Such a risk factor is referred to as systematic risk if it influences the return on a broad range of investments, and hence cannot be eliminated through diversification. This implies that investors may require an expected return in excess of the risk-free interest rate to accept exposure to the systematic risk factor. This is labelled a risk premium. Known systematic risk factors in the stock market are market risk, value, size, momentum, liquidity and volatility. Important systematic risk factors in the bond market are term, credit, inflation and liquidity risk, with appurtenant risk premiums. See Diversification.

Risk-free interest rate

The risk-free interest rate is the return on a risk-free security over a specific investment horizon. It is often considered a hypothetical investment, without any exposure to risk factors that may influence returns (such as market risk, credit risk, liquidity risk, currency risk, etc.) In practice, the interest rate on short-term government securities with the highest credit rating is considered to be risk free. See Risk factors.

Risk premium

See Risk factors.

Standard deviation

Standard deviation is a statistical measure of the risk in a portfolio. It indicates how much the value of a variable (here the portfolio return) can be expected to fluctuate around its mean. The standard deviation of a constant value will be 0. The higher the standard deviation, the larger the fluctuations (volatility) or risk relative to the average return. Linking the standard deviation to a probability distribution sheds light on the probability of a portfolio decreasing in value by more than x percent or increasing in value by more than y percent during a given period.

If normally distributed, the probability of returns deviating from the average return by less than one standard deviation is 68 percent. In 95 percent of the cases, the return will deviate by less than two standard deviations. Empirical studies of returns in the securities markets indicate that very low and very high returns occur more frequently than would be expected if the rates of return were normally distributed. This phenomenon is called “fat tails”. See Probability distribution and Risk.

Strategic benchmark index

The basic investment strategy of the Government Pension Fund is expressed through strategic benchmark indices for each of the GPFN and the GPFG. These benchmark indices specify a fixed allocation of fund assets across asset classes and provide a detailed description of how fund assets will be invested if the asset manager does not make use of the scope for active management. See Asset allocation.

Strategic investor

The term strategic investor applies to an investor that, unlike a financial investor, actively seeks to exploit ownership for purposes beyond the purely financial, for example to effect a certain change in conduct. For a strategic investor it is important to achieve influence over the company, typically through a large ownership stake and a seat on the board of such company. See Financial investor.

Systematic risk

Systematic risk is the part of the risk in a security or a securities portfolio that cannot be diversified away by holding more securities.

Systematic risk reflects the inherent uncertainty of the economy. Investors cannot diversify away from recessions, credit crunches, illiquidity and market collapse, etc. According to financial theory, systematic risk will be compensated in the form of higher expected returns.

Systematic risk is commonly measured by so-called beta values. A beta value of 1 represents the average systematic risk in the market. Hence, a representative benchmark index, such as for example the benchmark index of the GPFN, will have a beta close to 1. A portfolio with a beta in excess of 1 will on average have more return volatility, but higher expected return, than a portfolio with a beta of 1. The opposite will be the case for a portfolio with a beta of less than 1. See Risk factors.

Tracking Error

The asset owner will normally define limits as to how much risk the asset manager may take. A common method is to define a benchmark index, together with limits as to how much the actual portfolio may deviate from the benchmark index. The Ministry of Finance has defined limits, applicable to Norges Bank and Folketrygdfondet, in the form of a target for the expected tracking error, which is the expected standard deviation of the return difference between the actual portfolio and the benchmark index. The limit applicable to Norges Bank is a 1 percentage point expected tracking error, whilst the limit applicable to Folketrygdfondet is 3 percentage points. Over time, and under certain statistical assumptions, this means that if the entire limit is utilised, the actual return will in two out of three years deviate from the return on the benchmark index for the GPFG by less than 1 percentage point, and deviate from the return on the benchmark index for the GPFN by less than 3 percentage points. See Active management, Actual portfolio, Actual benchmark index and Strategic benchmark index.

Volatility

Return variations as measured by standard deviation. Volatility may also refer to a systematic risk factor in the stock market. See Standard deviation and Risk factors.