The investment universe

The market for Norwegian securities is a small part of the international capital market. Norwegian shares that are included in the FTSE All-World stock index represent 0.38 per cent of this index. The share of Norwegian issuers on the Barclays Capital Global Aggregate bond index is 0.30 per cent.

At the end of 2009, the market value of listed shares on the Oslo Børs and Oslo Axess markets was NOK 1,446 billion, while the value of the main Oslo Børs index (OSEBX) was NOK 682 billion. The main index is the benchmark for the GPFN"s Norwegian equity portfolio. When calculating share indices for use as a benchmark for actual portfolios, it is common to only include the part of the stock market that is subject to free trade (free float), while it is common to include all stocks for share indices that are intended to represent the development of the market. The great difference between the market value of all listed companies and the value of the main index are one of the characteristics of the Norwegian stock market. The reason is that an unusually large share of the Norwegian stock market, measured in both value and number of companies is not subject to free trade, compared with other markets. 49 out of a total of 53 companies on the OSEBX have limitations on free float, representing 46.4 per cent of the value. In comparison, only 52 of the 537 U.S. companies included in the FTSE All-World share index have limitations on free float; the free float adjustment here only represents 3.4 per cent of the value. For the United Kingdom, the figures are 19 out of 101 companies, and 5.3 per cent of the value.

At the end of the year, the GPFN"s Norwegian equity portfolio was about 9.3 per cent of the benchmark for Norwegian shares, while the GPFN"s Nordic equity portfolio was 0.28 per cent of the benchmark for Nordic shares. The corresponding share for the GPFG (as of 30.09.2009) was 1.75 per cent in Europe, 0.68 per cent in Asia and Oceania, and 0.66 per cent in America. The GPFN"s benchmark for Norwegian shares now includes 53 companies and 139 companies in the benchmark for Nordic shares, while about 7,300 companies are part of the GPFG"s benchmark.

The same differences also apply to the fixed-income portfolios. At the end of 2009, the GPFN"s Norwegian fixed-income portfolio was about 5.9 per cent of the value of the benchmark for Norwegian bonds. There were 61 bonds in the benchmark for Norwegian bonds issued by a total of 13 different issuers at the end of 2009. The benchmark for Nordic bonds covers 277 bonds. By way of comparison, there were about 10,600 bonds in the GPFG"s benchmark.

Oslo Børs is characterised by having a very skewed corporate structure, as shown by the five largest companies in the OSEBX making up 55.8 per cent of the composition of the index. This share is somewhat higher for listed Norwegian shares overall (Oslo Børs and Oslo Axess): 57.6 per cent. Internationally, the corporate structure is far more diversified. In the United Kingdom the five largest companies represent 27.3 per cent, while the figure is 24.5 per cent in Germany.

There is also a narrow industry structure on the Oslo Børs, where the energy sector makes up 44.5 per cent of the index, and the materials sector 12.3 per cent. There is a high (and fluctuating) share of foreign investors on the Oslo Børs. The liquidity is generally weak among the smaller companies on the Oslo Børs. At the end of 2009, a total of 180 companies were listed on the Oslo Børs, and a further 30 companies were listed on the Oslo Axess.

The fact that the energy sector and other cyclical enterprises make up a large share of the companies on the stock exchange and that the corporate structure is very concentrated serves to make the Norwegian stock market one of the more volatile stock markets in the world. This company and industry concentration can be well diversified through participation in the international markets. This is not possible for investors who have limited access to international markets, and the element of unsystematic (company-specific) risk for a Norwegian equity portfolio is therefore great. This last factor also applies to indices that represent developments on the Oslo Børs.

Active management of the GPFN

The task of Folketrygdfondet is to achieve the highest possible return over time, relative to the benchmark and the risk limits set by the Ministry of Finance. It is a goal of Folketrygdfondet to achieve a return that is better than the return on the benchmark. An attempt is made to achieve this through an active management strategy. An active management strategy is understood to mean a conscious investment choice that contributes to a different portfolio composition than the benchmark. Folketrygdfondet attempts to make such active investment choices based on company and security selection and by exploiting changes in systematic risk factors.

We believe that the characteristics of the Norwegian stock market (like company size, liquidity and volatility), and the size of the GPFN and the long investment horizon mean that return-oriented and responsible investment activities require ­active management. Over 42 years of fixed-­income management and 19 years of active stock management, Folketrygdfondet has acquired value in excess of the benchmark return. During the past 11 years (until the last accounts submitted on 30.06.2009), we have achieved an annual excess return of 0.47 percentage points for the entire GPFN, and an annual excess return for Norwegian shares of 1.85 percentage points. The excess return is also positive when including the second half of 2009.

In its management of the GPFN, Folketrygdfondet has placed emphasis on active investment decisions based on quantitative and qualitative assessments of individual companies, sectors, market development and macroeconomic issues. Folketrygdfondet benefits from being able to operate with a stable framework and regulatory conditions that make it possible to make countercyclical investments in periods characterised by strong optimism or pessimism. This has contributed to the active management of the GPFN differentiating itself from many other active managers, in that it is possible to maintain a long-term investment horizon without being forced to make unwanted disposals. A management organisation with great competence, clear lines of responsibility, well-defined investment strategies, good decision-making processes, good portfolio follow-up and responsible exercise of active ownership is required to execute such a strategy.

Folketrygdfondet has found it appropriate to apply the same active investment strategies to its management of the Nordic securities portfolio where this has been natural. In addition, the active management of the Nordic portfolio has provided useful experiences and feedback for the management of the Norwegian portfolio.

As a long-term financial investor and owner on the Oslo Børs, it is important to us that the market works well and is monitored adequately. Passive management requires correct pricing of the companies on the stock exchange. Passive managers are often called freeloaders in this context, benefitting from the behaviour of different active managers. We see it as a natural job for a large investor to have an opinion on the pricing of the securities on the stock exchange. Such participation requires active management. The presence of active managers will further contribute to a market that functions better.

The Ministry of Finance has defined a frame for active management, measured through an expected relative volatility of 3 percentage points for the fund. We would like to point out that it is important that such a risk frame is related to the long-term investment horizon Folketrygdfondet is operating with. This is important, among others, to prevent Folketrygdfondet in critical market conditions from making disposals that appear undesirable in a long-term perspective.

We have noted that the Mercer report on active management points out that it is common to evaluate large funds with liquid equity and fixed-income portfolios over a three-year period, but that illiquid asset classes are usually evaluated over longer periods of time. We would like to point out that less liquidity in the Norwegian market than is the case internationally draws in the direction of a longer evaluation horizon than three years.

Ownership

As an investor with a large ownership stake (independent of whether the management is passive or active) in Norwegian companies, Folketrygdfondet has a particular ownership responsibility in the companies in which we have invested, to both secure our financial assets and to contribute to a well-functioning financial market. This is reinforced by about half of the shareholders of Norwegian companies not attending annual meetings. Folketrygdfondet has set ownership principles and ethical guidelines for the investment activity, and a guiding principle over the years has been that active ownership is an integrated part of investment activity. Our experience is precisely that good ownership follow-up requires an understanding and knowledge of, among others, the companies" operations, value creation strategies, framework conditions, and corporate governance. This is necessary in order to act with credibility and expect to achieve results in the exercise of ownership. The competence used in such a context is built up in the management organisation over a period of many years, achieved by constantly following the companies" development, and by being engaged in a dialogue with the companies and relevant market actors. Mercer"s report «Active management and active ownership» lists a number of issues that have been mentioned as advantages for owner follow-up with active management. It is our view that owner follow-up is better when those who perform the owner follow-up are also responsible for making active investment decisions regarding deviations from the benchmark.

The management costs

The costs associated with management of the GPFN are low; an estimated 7.6 basic points in 2008. A comparison from the Canadian analysis firm CEM Benchmarking shows that similar funds have costs of 16.3 basic points. The costs can be divided in four: security selection, transaction execution, checks and owner follow-up. The low trade speed of the portfolio, resulting from the active and long-term management style of Folketrygdfondet, means that the costs associated with transaction execution are low, and less than if the portfolio had been passively managed like an index fund, where there are constant transactions, as a result of changes to the index. For checks and owner follow-up, we presume that the costs will be approximately the same size through passive management as with the present active management. For the first point, security selection, the issues that arise as a result of a lack of liquidity will mean that management of the GPFN must be based on active decisions, independent of whether the management will be passive or active. This means that there will be little difference between active and passive management of the GPFN, from a pure cost perspective, also on this point. On whole, this means that the costs for the GPFN will mainly be the same, regardless of whether the management is active or passive.

Challenges associated with passive management

The GPFN"s portfolio makes up such a large share of the benchmark that there are several issues of importance to the choice of management strategy. It is our view that the opportunity to perform passive management, i.e. seek to maintain an index-adjacent portfolio in the Norwegian market is limited and will encounter a number of practical issues. In the following, we will point to several examples illustrating this.

We have analysed a number of these purely practical issues, taking the GPFN"s Norwegian equity portfolio and the benchmark as our starting point. The corporate structure in the OSEBX is reviewed every six months. We have looked at situations where we have made an assumption that the portfolio had the same composition as the index before the index changes. We have presumed that with passive management, the GPFN has dealt with index changes by attempting to execute these changes to the portfolio as quickly as possible, and by the GPFN in the time after the index change representing 10 per cent (the GPFN"s share) of normal trade in the share until the index growth is achieved. With such an assumption, several of the index changes during the past few years will create problems in that normal trade in the company is very limited. Our analysis is based on the index composition at the end of 2006, and we have studied the effect of six index revisions until December 2009. Our analysis indicates that this issue alone requires a level of expected relative volatility as a frame of about 1.0 percentage points for the Norwegian stock portfolio with passive management. For some of the companies that have entered and exited the OSEBX several times, we see that the liquidity is barely limited by normal trade indicating that it can take up to 1.5 years to buy or sell an index block for a portfolio of the size of the GPFN, even if all trade is taken as the basis. If we are responsible for 10 per cent of normal trade, this means that it can take up to 15 years to buy or sell the index weight in such companies.

Low liquidity in many of the companies on the Oslo Børs means that rebalancing to bring the share of stocks back to the defined starting point of 60 per cent will in isolation also be especially demanding with passive management, by it not being possible to increase or reduce the weight of all of the companies at an equal speed. A rebalancing of the GPFN"s portfolio to the level executed in 2008/2009, after the strong fall in shares that followed the financial crisis, will require an even greater risk frame when using passive management. We have presumed that the two issues mentioned will require a frame of a total of 1.5 percentage points of expected relative volatility for the Norwegian equity portfolio if this portfolio is passively managed.

A passive management strategy will mean practical challenges in the management of the bond portfolio too. The GPFN uses the same supplier of benchmark indices for the interest portfolios as the GPFG. In its report, Norges Bank commented that changes to the composition of the benchmark are made at the end of each month. New bond loans in the market are issued on an ongoing basis and are included in the benchmark at earliest at the end of the month in question. As a result of low liquidity in the bond market, it is demanding to sell an existing portfolio in order to include new loans that we see enter the index. A passive approach to this issue entails significant transaction costs, and a lapse of the opportunity to reap possible rewards when they are issued. We also see that several loans that are included in the index are directly placed with international actors (for example a British pension fund). As it is not possible to fully invest directly in the loans that are part of the benchmark, the portfolio will consist of other securities and other issuers than the benchmark. This entails a high need for diversification, which in itself indicates active management of the portfolio.

Finally we would like to point out that a special aspect of the passive management of the GPFN, which is a large actor in the market, is other investors" opportunity to exploit the knowledge of passive strategies. If a large share of a market is passively managed, other actors will be able to use this to make adaptations at the same time during index changes, and before passive investors.

The size of the GPFN in the Norwegian equity and fixed-income market makes it difficult to execute a passive management strategy. We believe that the challenges are so great that we do not recommend a passive strategy.

Further details on systematic factors

The report from the three professors (Andrew Ang, William N. Goetzmann and Stephen M. Schafer) concludes that the GPFN"s return is mainly a combination of passive management and exposure to known systematic factors, like liquidity and volatility. They recommend that the manager, NBIM, construct indices for applicable factors and that the client, the Ministry of Finance, set the exposure in the benchmark to the different factors.

For the Norwegian stock market, empirical studies show that factors that explain the return on shares do not fully concur with the factors that are observed in the major markets around the world. For the Norwegian stock market, company size and liquidity provide the best explanation, together with general developments in the market, in that small companies appear to make a positive contribution to the return, compared with big companies; and less liquid companies also making a positive contribution, compared with large companies. To the extent that factors in the Norwegian markets deviate from the factors in the global market and/or are unstable in size and composition, the challenges increase in composing investable benchmarks that exploit these risk premiums.

The fact that the factors company size and liquidity appear to help explain the return on shares in Oslo can be used as an argument for making adaptations to the benchmark for Norwegian shares. The OSEBX stock index uses precisely these two criteria, liquidity and size, as requirements for inclusion in the index. This means that the OSEBX has less exposure to companies with low liquidity and to small companies than that represented by the whole market.

In internal analyses we have looked at the qualities of alternative compositions of the benchmark for Norwegian shares, with a view to market weight the two factors small companies and low liquidity. These analyses indicate that the practical issues related to a lack of liquidity as a result of the size of the GPFN"s portfolio are reinforced by expanding the benchmark to include more companies. In isolation this means a need for a somewhat higher limit for expected relative volatility. If also executed in the portfolio, an increase in the number of companies will entail higher costs associated with owner follow-up and checks. We will investigate the effects associated with size and liquidity in the Norwegian stock market further and may return to the Ministry with a recommendation to make changes to the composition of the benchmark. We also want to perform a similar investigation of the benchmark for Norwegian bonds.

However, we see general challenges associated with executing the kind of model recommended in the professors" report by weighting certain factors differently from the market weight, and we would like to point out that the benchmark should ideally be maintained by the client, not the manager. It is important to avoid benchmarks being constructed in such a way that the distribution of roles and responsibilities between the Ministry of Finance as client and Folketrygdfondet as asset manager is unclear. We therefore advise against the manager maintaining and constructing factor indices, as suggested in the professors" report. We also want to point out that we identify special challenges associated with management of the Norwegian markets if the Ministry of Finance is to point out the relevant factors to weight differently than indicated by the market weights, to the extent that such factors depend on how economic policy is directed.

The current legislation entails rebalancing one factor: the share of stocks. A factor-adjusted benchmark entails rebalancing as a result of several factors, and may therefore entail more frequent rebalancing. This will be especially demanding and costly in less liquid markets, like the Norwegian stock and bond markets.

Summary

In this letter, Folketrygdfondet has reviewed the three items of feedback regarding the GPFG, considering the extent to which they are relevant to the present active management of the GPFN, and we have commented on the differences between the GPFN and the GPFG, among others regarding characteristics, the investment universe, ownership stakes and the characteristics of the marketplace.

It is our view that the characteristics of the Norwegian stock market, and the size of the GPFN and the long investment horizon mean that return-oriented and responsible investment activities require active management. There does not appear to be any alternative to the Fund through active management seeking to exploit the opportunities for achieving an excess return. Even practically, passive management would require active investment decisions that make it challenging to even achieve a return on the same level as the benchmark indices. Active management is further reinforced by Folketrygdfondet over long time having added value beyond the benchmark"s return through an active investment choice with relatively low management costs. It is also our assessment that several of the issues that were brought up in the three items of feedback to the Ministry of Finance support the strategy chosen.

However, a management organisation with extensive competence, clear lines of responsibility, well-defined investment strategies, good decision-making processes, good portfolio follow-up and responsible exercise of ownership is required to execute this strategy. It is also our view that owner follow-up is significantly reinforced when those who perform the owner follow-up also have in-depth knowledge of the companies and are responsible for making active investment decisions.

We advise against a passive management strategy, as it is would be neither in the GPFN"s interest nor contribute positively to the way the market functions. Neither do we see it as relevant to adjust the benchmark for systematic factors in a financial market that is not very liquid.

On this basis, the conclusions of this letter can be summarised as follows:

A volatile Norwegian capital market with little liquidity creates other challenges for a large actor than in a far more liquid global market. Among others, this applies to consideration of the market"s way of functioning.

Active investment decisions are required to achieve an index-adjacent portfolio, even with passive management. This also requires good competence and entails a level of cost that is approximately equal for passive and active management.

As a large shareholder in Norwegian companies, the ownership role is considered to be better met through active management of the portfolio.

Factor-based benchmark indices are considered unsuitable for a large investor in the Norwegian market. Based on few observable factors, establishing an appropriate benchmark, based on known systematic factors is not considered very realistic.

We believe that active management of the GPFN also in the future will be the best way of creating added value. Folketrygdfondet"s investment philosophy will contribute best to securing the Fund"s financial assets in the long term and in a functioning financial market through responsible investment activities and good follow-up of ownership.

Yours sincerely,

Folketrygdfondet

Erik Keiserud Olaug Svarva

Chairman of the Board Managing Director