Prudent and long-term asset management

– Despite financial turmoil in the second half of 2007, this was a satisfactory year for the Government Pension Fund, says Finance Minister Kristin Halvorsen.

High petroleum revenues and moderate financial returns helped the fund grow to NOK 2 136 billion. As part of a regular review of the investment strategy, the Minister of Finance reveals plans to include real estate as a separate asset class for the Pension Fund – Global and to expand the benchmark portfolio to include more emerging markets. While there are also plans to increase the limit on ownership stakes from 5 pct to 10 pct, this does not alter the Fund’s role as a financial investor. At the same time, the Minister is emphasizing the ethical obligations of the Fund, says Finance Minister Kristin Halvorsen.

Moderate financial returns
In the annual white paper report to Parliament on the management of the Government Pension Fund, which is composed of the Pension Fund – Global (previously known as the Petroleum Fund) and the Pension Fund – Norway, Norwegian Minister of Finance Kristin Halvorsen noted that high petroleum revenues and moderate financial returns contributed to another significant increase in the Fund to NOK 2 136 bn (around USD 395 bn).

The Pension Fund – Global, which is managed by Norges Bank (the Central Bank), registered a 4.3 pct return (measured in local currency) in 2007 and stood at NOK 2 019 bn (around USD 375 bn) at the end of the year. Since 1998, the average annual nominal return has totalled 6.0 pct. Of this, the manager’s excess return last year relative to the benchmark amounted to –0.2 pct, the first year of negative excess returns, while the average the past 10 years is a respectable 0.4 pct.

The Pension Fund – Norway, which is managed by Folketrygdfondet, enjoyed a robust 9.8 pct return last year (measured in NOK), while the average return since 1998 is 7.7 pct. The manager’s excess return in 2006 was a record 2.5 pct, while the 10-year average is 0.4 pct.

Review of investment strategy leads to inclusion of real estate
The Government intends to include real estate as a separate asset class in the Pension Fund – Global. Based on the recommendations of Norges Bank and the Strategy Council, as well as its own analyses, the Ministry envisages that up to 5 pct of the capital of the Fund may be invested in real estate, which would be offset by a reduced allocation to fixed income investments. “– Investing a portion of the Fund in real estate is expected to improve risk diversification and enhance returns,” says Finance Minister Kristin Halvorsen. While real estate investments may commence in 2008, creating a diversified and significant real estate portfolio will take many years, taking into account the desire to minimize transaction costs and market impact.

More emerging markets included in the equity benchmark
The Ministry is planning to expand the Pension Fund – Global’s benchmark portfolio for equities by including all the advanced and secondary emerging stock markets, as defined by FTSE. This implies that the current benchmark will be expanded to include also the stock markets in the following countries: Argentina, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Morocco, Pakistan, Peru, Poland, the Philippines, Russia, Thailand and Turkey. (Other advanced emerging countries like Brazil, Mexico, South Africa, South Korea and Taiwan are already in the equity benchmark.) Emerging markets will then represent a total of 10 pct of the benchmark portfolio for equities, up from 5 pct today.

– Including more emerging markets in the benchmark is expected to improve risk diversification, and the benchmark portfolio will better reflect developments in global stock markets,” says Finance Minister Kristin Halvorsen. The change to the benchmark will be phased in over time.

Increased limit on ownership stakes
The Ministry intends to raise the Pension Fund – Global’s limit on ownership stakes in individual companies from 5 pct to 10 pct. The Ministry has balanced the desire to underscore the Fund’s role as a financial (and not a strategic) investor against the potential costs of imposing too low a limit. Taking into account the continued strong growth in the assets of the Fund, the previously decided changes to the investment guidelines (i.e. the increase in the equity portion from 40 pct to 60 pct, and the expansion of the benchmark portfolio to include listed small-cap equities), as well as Norges Bank’s efforts to generate excess returns relative to the benchmark portfolio, the Ministry plans to increase the limit on ownership stakes from the current 5 pct of the voting shares of listed companies to 10 pct. Finance Minister Halvorsen emphasizes that this does not affect the role of the Fund as a financial investor. On average, the Fund owns considerably less than 1 pct. of each company in the portfolio. This will not change significantly as a consequence of the planned increase in the limit on ownership stakes.

Investments in Burma
In the spring of 2007 the Government decided, against the background of the measures adopted by the EU and other countries against Burma (Myanmar), to amend the guidelines of the Pension Fund – Global in such a way as to explicitly bar Norges Bank from investing the Fund’s capital in bonds issued by the state of Burma. This decision supplemented the arrangement for the exclusion of equities and bonds issued by specific companies. In November 2007, Norway joined expanded international measures affecting certain types of investments in Burma. These include a prohibition against the funding of listed Burmese state-owned enterprises and enterprises that are engaged in the extraction of timber, metals, minerals and gemstones. The prohibitions affect in excess of 1 200 Burmese enterprises. The Fund neither has nor shall have holdings in any of these companies.

Furthermore, the Government has now chosen to implement a prohibition on investing in companies selling arms or weapons technology to a country whose sovereign bonds are excluded from the investment universe. This means that the Fund shall not invest in companies selling arms to the Burmese regime. A preliminary review suggests that there are currently no such companies in the Fund’s portfolio.

Evaluation of the ethical guidelines
Norway is privileged to have a large petroleum wealth, and there is broad political support to transform this wealth into financial assets in an ethically responsible way. The Government wishes to ensure a continued strong ethical foundation for the Pension Fund – Global by evaluating the ethical guidelines. The objective of the evaluation is to ensure that the guidelines have worked as intended, to ensure broad political support for the further development of the guidelines, as well as to strengthen the ethical profile of the Fund.

Many aspects of the present system work well. A number of elements and principles should be preserved; a high degree of openness and reporting, a high quality of the decision-making process leading up to the resolutions passed, a focus on certain particular areas of the corporate governance effort, as well as the safeguarding of credibility and seriousness in all efforts pursued.

The Ministry intends to circulate a discussion paper on the ethical guidelines this spring as part of a broad public consultation process. The evaluation of, and any proposals for adjustments to, the ethical guidelines, will be submitted to the Storting in the spring of 2009.

Risk-based monitoring and due diligence project
After Norges Bank received more degrees of freedom in its active management effort from 2006, the Ministry’s requirements have primarily been based on overarching principles to the effect that Norges Bank should adhere to ”best market practise” and ”internationally recognised standards”. The Ministry has introduced risk-based monitoring of Norges Bank’s asset management, and the first due diligence project was implemented over the period 2006-2007 as an international team from Ernst &Young reviewed the risk management and control procedures of Norges Bank. The report from Ernst & Young, which is now being made public, describes how risk management is organised on the part of leading financial institutions internationally, what are the main areas involved, as well as the principles for best practise within each of the main areas. The report goes on to make recommendations, focusing on areas offering a potential for improvement. Norges Bank agrees with the vast majority of the recommendations from Ernst & Young, and agrees that the frame of reference adopted by Ernst & Young forms a good basis for the further operationalisation of the provisions included in the framework.

The Ministry is of the view that the strong growth in the assets of the Fund, the increased complexity of the management of the Fund, and the concern for good management control over central bank duties make it necessary to evolve the management and control structure of the Bank. The Ministry is considering proposing this autumn amendments to the Central Bank Act relating to accounting and audit arrangements.

APPENDIX: Background information on the Pension Fund
The Government Pension Fund was established with effect from 1 January 2006, encompassing the former Government Petroleum Fund and National Insurance Scheme Fund. The purpose of the Government Pension Fund is to facilitate government savings to fund the pension expenditure of the National Insurance Scheme, and to strengthen long-term considerations in the allocation of government petroleum revenues. To ensure that the petroleum revenues are contributing to the stable development of the Norwegian economy, the revenues shall be phased into the economy gradually, whilst the savings capital shall be invested outside Norway. The Government Pension Fund – Global contributes, by investing a significant part of the petroleum revenues abroad, to a capital outflow that offsets the impact of large and varying foreign exchange inflows from the petroleum sector on the Norwegian krone exchange rate.

The savings of the Pension Fund take the form of general fund accumulation. The Fund is fully integrated with the Fiscal Budget, in order to facilitate growth in the fund being a reflection of the State’s actual accumulation of financial assets. The Government Pension Fund does not have its own Executive Board or administrative staff.

Under the Pension Fund Act, the Ministry of Finance has been charged with managing the Fund. The Ministry determines the general investment strategy of the Pension Fund, as well as its ethical and corporate governance principles, and follows up on its operational management. The Government Pension Fund adopts a long investment horizon. Our management responsibility includes responsibility for ensuring that the Fund is managed with a view to maximizing return, given a moderate level of risk. This enables future generations to draw the maximum possible benefit from our savings capital as well. At the same time, we share responsibility, as investors, for the conduct of the companies in which the Fund invests. The Government is therefore concerned that ownership interests in the companies in which the Fund invests is exercised with a view to promoting good and responsible conduct, showing respect for human rights and the environment.

The Pension Fund is invested in securities issued by many different states and by companies in many different countries. Consequently, the risks facing the Fund are well diversified. The expected return and risk of the Pension Fund is in large part determined by the Ministry’s guidelines on how funds shall be invested. Norges Bank and Folketrygdfondet have been charged with the operational management of the Government Pension Fund – Global and the Government Pension Fund – Norway, respectively, within the guidelines laid down by the Ministry.

The management of the Government Pension Fund is subject to a high degree of openness. The Storting is apprised of the investment framework and the Ministry’s follow-up of the Pension Fund on a regular basis. Operational management performance is also reported by Norges Bank and the Folketrygdfondet on a regular basis. This is emphasised by the Ministry for purposes of strengthening the credibility of, and confidence in, the Fund and the fund structure.
 
The Government Pension Fund is one of the largest funds in the world, and its assets are growing rapidly. The Fund is large relative to the size of the Norwegian economy, and the return on the Fund will make considerable contributions to the funding of State expenditure in coming years. Focus on the management of the Fund has increased in line with the growth in its size. This underscores the importance of ensuring that the investment strategy of the Fund, as well as its ethical and corporate governance guidelines, have the firm backing of the Storting, and that the Ministry reports thoroughly on its follow-up of operational management.

The present Report primarily addresses matters relating to the management of the capital of the Government Pension Fund. More general issues relating to the management of the petroleum revenues, the position of the Fund within overall economic policy, as well as how much of the oil revenues should be spent and how much saved for the future, are discussed in the National Budget documents.

The report is available on the internet at www.government.no/gpf.