1 Glossary of terms used in the report

Active management

Active management entails that the manager on the basis of analyses and assessments composes an investment portfolio that differs from the benchmark established by the owner of the assets. The purpose of deviating from the benchmark is to achieve an excess return compared with the return on the benchmark.

The Ministry of Finance has defined qualitative and quantitative limits for the GPFG and the GPFN that regulate permissible deviation from the benchmark. See also index management , excess return and relative volatility .

Actual benchmark

The composition of the actual benchmark is based on the strategic benchmark . Variations in developments in the value of the equities between countries and variations in developments in share prices and bond quotations will entail that the equity portion and the geographical distribution of the actual benchmark will deviate from the strategic weights over time. For this reason, a so-called rebalancing regime has been established for the GPFG that entails that in certain circumstances attempts are made to bring the weights in the actual benchmark back into line with the weights in the strategic benchmark. See rebalancing and strategic benchmark .

In principle, the Ministry expects the managers at Folketrygdfondet and Norges Bank to deliver returns equal to the return on the benchmark. Nevertheless, active management is allowed within certain defined limits by means of which the managers strive to achieve a higher rate of return than that of the benchmark by compiling an actual portfolio that deviates from the benchmark. These limits are relatively moderate, meaning that the benchmark largely determines the rate of return and risk of the Fund. In active management, the benchmark will form the foundation for risk management and will be the starting point for calculating the manager’s contribution to the result.

Actual portfolio

Through active management , managers can compile a portfolio of securities that deviates from the benchmark . This portfolio constitutes the actual portfolio of the fund.

Arithmetic return

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

Asset allocation

Asset allocation means the distribution of the assets under management among 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; in the Government Pension Fund it is expressed through the benchmark . Insofar as it is permitted in the investment mandate, managers can employ tactical asset allocation. This entails actively choosing to deviate from the strategic weights on the basis of assessments of the degree to which one asset class is overpriced or underpriced relative to another.

Asset classes

Asset classes are different types or classes of financial assets, such as shares, bonds and property. The benchmark for the GPFG has three asset classes: equities, bonds and real estate (under establishment). The GPFN has two asset classes: equities and bonds.

Correlation

Correlation indicates the degree and the direction of the linear dependence between two variables. If the correlation equals 1, there is a perfect degree of positive covariance between the two variables and they always change in tact with one another. If there is zero correlation, there is no covariance, whereas correlation of -1 entails that there is a perfect degree of negative covariance between the two variables.

Only in the case of perfect positive correlation will the risk associated with a portfolio be equal to the weighted sum of the risk in the individual securities. The risk reduction achieved by spreading investments across different assets in this way is known as a diversification benefit, see diversification .

Covariance

See correlation .

Credit risk

Credit risk is the risk of incurring a loss as a result of default on the part of the issuer of a security or the counterparty in a securities transaction, for example due to bankruptcy.

Credit risk and market risk are partially overlapping concepts.

Currency basket

The GPGF is placed entirely in foreign securities and thus only in securities that are traded in currencies other than Norwegian kroner. The return on the GPFG measured in Norwegian kroner will thus not only vary according to market developments in the international securities markets, it will also vary according to changes in the exchange rate between the Norwegian krone and the currencies the Fund is invested in. However, the Fund’s international purchasing power is not affected by changes in the krone exchange rate. In order to measure the return independently of developments in exchange rates, the return on the Fund too is measured in foreign currency. This is done on the basis of the currency basket of the Fund, entailing weighting of the return in the individual currencies in accordance with the distribution into different currencies in the benchmark for the Fund.

Diversification

The ratio between the expected return and risk for a portfolio can normally be improved by spreading the investments over a larger number of assets in the portfolio. This is called diversification . This is why the benchmark for the Government Pension Fund is spread across a broad range of asset classes, geographical regions, countries, sectors and companies.

Spreading the investments over a larger number of assets will only improve the return–risk ratio if the returns on the various assets do not co-vary perfectly. However, the ratio can only be improved to a certain point, at which the portfolio is said to be efficient or optimally diversified.

Excess return

Excess return is the contribution to the return on the invested funds that is attributable to active management and is measured as the difference between the return on the actual portfolio and the return on the benchmark. Excess return is sometimes also called relative return. Excess return can be positive or negative.

Expected return

Expected return is a statistical measure of the mean value in a set of all the possible outcomes and is equal to the average return on an investment over a period of time if it is repeated many times. For example, if an investment alternative has a 50 per cent probability of 20 per cent appreciation, a 25 per cent probability of 10 per cent appreciation and a 25 per cent probability of 20 per cent depreciation, the expected return is 10 per cent: (20 x 0.5) + (10 x 0.25) + (-20 x 0.25) = 10. Expected return can be calculated using series of historical return data or be based on forward-looking model simulations.

Normally it is only possible to achieve a higher expected return by taking higher risks. However, diversification allows the expected return to be maintained while reducing the risk. Some investors’ risk preferences are such that they are not willing to take a higher risk without compensation in the form of a higher expected return. This is called risk aversion.

Geometric return

Average geometric return – or time-weighted return – indicates the average growth rate of an investment. If the return in year 1 is 100 per cent and the return in year 1 is -50 per cent, average geometric return is -1 plus the square root of (1+1) x (1-0.5) = 0. Geometric average is thus always lower than the arithmetic average; cf. the example above. This is because of the compound interest effect. If a year with weak returns (for example -10 per cent) is followed by a year with correspondingly strong returns, the amount invested will not have been regained.

The larger the variation in the annual return, the greater the difference between arithmetic and geometric average.

In its quarterly and annual reports, Norges Bank reports the real return on the GPFG as a geometric average.

Index

An index contains a given number of securities, which are selected on the basis of criteria defined by the index provider, and indicates the average return for the securities in the index. A variety of institutions compile securities indices, such as stock exchanges, consultancies, newspapers and investment banks. They can be based on countries, regions, market weights or sectors. Most equity indices are based on market weight where each individual security is weighted according to its relative market value (capitalisation), whereas most bond indices are based on market weights where each individual security is weighted according to the relative value of the nominal outstanding volume.

If it is possible to invest a securities portfolio in accordance with the composition of the index, the index is said to be investable. This will typically be the case for very liquid securities, such as listed equities. By contrast, an index of price developments in unlisted real estate would not be investable.

An index can be used to measure the return on a specific securities portfolio. It can also be used to measure the manager’s skill in the active management. See index management and benchmark.

Index management

Index management , also called passive management, means that the management of the assets is organised to ensure that the actual portfolio reflects the composition of the benchmark as far as is possible. If the composition of the actual portfolio is identical to the composition of the benchmark, the return on the actual portfolio will be equal to the return on the benchmark. If the indices that make up the benchmark include most of the securities traded on the market, index management will achieve the same return as the market as a whole, before deductions for costs linked to index management. The return achieved by broad exposure to general market developments is often called the beta return. See index and benchmark .

Market efficiency

Market efficiency entails that the price of a financial asset, 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.

An efficient portfolio is marked by the expected return being at its highest possible rate given a specific level of risk. In principle there are an infinite number of efficient portfolios, which together constitute what is called an efficient front. See diversification .

Market risk

Market risk is the risk that the value of a securities portfolio will change as the result of fluctuations in equity prices, exchange rates, commodity prices and interest rates. It is normally assumed that an investor must accept higher market risk in order to achieve a higher expected return.

Negative excess return

See excess return .

Nominal return

Return achieved without correction for changes in monetary value. See real return .

Operational risk

Operational risk is the risk of financial loss or loss of reputation as a result of breakdown of internal processes, human error, systems failure, or other losses caused by external factors that are not a consequence of the market risk of the portfolio. There is no expected return associated with operational risk. However, in managing operational risk, one must balance the objective of keeping the probability of such losses low against the costs incurred as a result of increased control, monitoring, etc.

Passive management

See index management .

Rate of return

The market value of the Government Pension Fund is the sum of the market value of all the equity and interest-bearing instruments that the fund is invested in at a given point in time. Historical rate of return is calculated as the change in the market value of the fund from one point in time to another, and is often called the absolute return. See arithmetic return and geometric return ; see also excess return and expected return .

Real return

Real return is the achieved nominal return adjusted for inflation. It therefore indicates the return in constant prices. See nominal return .

Relative return

See excess return .

Relative volatility (tracking error)

The owners of the assets will normally define limits for how large a risk the manager can take in his active management. A common method is to compile a benchmark and set quantitative limits for how far the actual portfolio can deviate from the benchmark. The Ministry of Finance has defined limits for Norges Bank and Folketrygdfondet in the form of a limit on expected relative volatility . This is the expected standard deviation of the difference in the return between the actual portfolio and the benchmark. The limit for Norges Bank is 1.5 percentage points expected relative volatility, the limit for Folketrygdfondet is 3 percentage points. Over time – and somewhat simplified – this means that if the entire limit is used, the actual return will deviate from the return on the benchmark for the GPFG by less than 1.5 percentage points in two out of the three years and by less than 3 percentage points for the GPFN.

Risk

Risk is a measure that indicates the probability of an incident occurring and the consequences it will entail (for example, losses or gains). There are various dimensions of risk. One important aspect is the distinction between risks that can be quantified and risks that are harder 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 premium

Many market players do not wish to take a larger risk than necessary – they are risk averse. This means that for a given return they will choose the investment alternative that entails the least risk. Market players will expect a higher return for investing in higher risk securities. This is called the risk premium.

For example, a higher average return is expected on equity investments than on investments in fixed-income securities, because equities entail a higher risk. There are a number of recognised, systematic risk factors, such as company size, liquidity, momentum, etc.

Sharpe ratio

Developed by Nobel laureate William Sharpe, the Sharpe ratio is used to measure risk-adjusted performance. It is defined as the ratio between expected real return minus the risk-free real interest rate and expected volatility. The Sharpe ratio thus measures the trade-off between expected real return minus risk-free interest and volatility. If two securities are compared to the same risk-free interest rate, the security with the greatest Sharp ratio will yield the best trade-off between return and risk.

Standard deviation

Standard deviation is a commonly used measure of the risk associated with a portfolio. It indicates how much the value of a variable – the return – can be expected to fluctuate. The standard deviation of a constant value will be 0. The higher the standard deviation, the larger the fluctuations (volatility) or risk compared with the average return. Linking the standard deviation to a probability distribution illustrates the probability of a portfolio decreasing in value by x per cent or increasing in value by y per cent during a given period.

With a normally distributed return in the securities markets, 68 per cent of the cases will be below one standard deviation of the average rate of return. In 95 per cent of the cases, the return will be below two standard deviations. Nevertheless, empirical studies of the rate of return on 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» since this distribution pattern entails more weight in the tails of the curve than in the bell-shaped normal distribution curve. See risk .

Strategic benchmark

The Ministry’s basic investment strategy for the Government Pension Fund is expressed in the strategic benchmarksfor the GPFN and the GPFG. These benchmarks define strategic asset allocation, which entails a particular distribution of the Fund capital among different types of assets and different geographical regions.

The strategic benchmark currently consists of 60 per cent shares and 40 per cent bonds. A real estate portfolio representing 5 per cent of the Fund is gradually being built up, which will entail a corresponding reduction in the bond portion. The benchmark is also divided into three geographical regions, with Europe weighted heaviest.

The benchmark includes several thousand companies and bond loans, selected on the basis of the criteria the index providers use for inclusion of securities in the benchmark. The Ministry has chosen FTSE as provider of the benchmark for equities, which consists of equities included in the FTSE Global Equity Index Series All Cap. The index consists of a given number of national indices weighted according to market value. The Ministry has chosen Barclays Capital as provider of the benchmark for bonds, which consists of the bonds included in the Barclays Global Aggregate and Barclays Global Real indices. The index consists of a fixed number of sub-indices based on currencies and sectors with weights based on nominal outstanding amount. See actual benchmark .

Systematic risk

Systematic risk is that part of the risk that is linked to developments in broad, well-diversified securities portfolios. The opposite of systematic risk is unsystematic or security-specific risk, which is risk that can be diluted by investing in a large number of securities. Because it can be avoided through diversification, exposure to unsystematic risk does not increase the expected return .

Systematic risk reflects the uncertainty inherent in the economy and will always exist. Investors cannot diversify away from economic downturns, credit crunches, inadequate liquidity and market collapses, etc. However, investors can refrain from investing (or only invest a smaller portion) in securities such as equities, for example, which fall relatively more in value in bad times. Higher systematic risk is compensated for in the form of a higher expected return .

Systematic risk is measured in beta . A beta value of 1 represents the average systematic risk in the market. A representative market index, such as, for example, the benchmark for the GPFG, will thus have a beta very close to 1. A portfolio with a beta over 1 will generally have a more variable return, but higher expected risk than a portfolio with a beta of 1. The inverse is true for a portfolio with a beta below 1. See risk premium .

Volatility

Variation in return. Measured as the standard deviation .