3 - Fund reporting

3.1 Government Pension Fund – Global

3.1.1 Mandate

The Government Pension Fund – Global is a continuation of the Government Petroleum Fund, which was established by the Storting in 1990. The first capital transfer of NOK 2 billion was made in 1996. The name was changed as from 1 January 2006. At the same time, the Ministry of Finance revised the guidelines for the management of the Fund. The most important changes were that the maximum ownership stake in companies was raised to 5 per cent (previously 3 per cent), the requirement of a minimum credit rating for corporate bonds was removed (previously a minimum of BBB investment grade), and investments may now be made in commodity-based contracts and in funds.

In the Revised National Budget for 2006, the Ministry of Finance published its decision to change the regional weights for the Fund's investments. The composition of the benchmark portfolio for equities was changed to 15 per cent in Asia and Oceania, 50 per cent in Europe and 35 per cent in the Americas and Africa. The composition of the fixed income benchmark portfolio was changed to 5 per cent Asia and Oceania, 60 per cent Europe and 35 per cent the Americas and Africa. The change was phased in gradually and was completed in the third quarter of 2006.

In November 2004, the Ministry of Finance approved ethical guidelines for the Fund's investments. These guidelines require that ethical issues be addressed through three mechanisms: corporate governance to promote long-term financial returns, negative screening and exclusion of companies to avoid complicity in unacceptable violations of fundamental ethical norms. Norges Bank is responsible for corporate governance, in accordance with the guidelines issued by the Ministry of Finance. Norges Bank's Executive Board has approved principles of corporate governance. Section 4.1 contains an account of corporate governance activities in 2006. The government has appointed an Advisory Council on Ethics to advise the Ministry of Finance on negative screening and exclusion of companies. The Ministry makes the final decision on the exclusion of companies and instructs Norges Bank accordingly. Section 4.2 provides an overview of the companies that were excluded from the investment universe at end-2006.

The Ministry of Finance has delegated the operational management of the Government Pension Fund – Global to Norges Bank, with a mandate set out in a regulation and written guidelines issued by the Ministry. A management agreement, which further regulates the relationship between the Ministry of Finance as delegating authority and Norges Bank as operational manager, has also been drawn up. According to the regulation, Norges Bank shall seek to achieve the highest possible return within the limits set out in the regulation. The Bank's strategy for achieving an excess return has been presented in earlier annual reports (for further details, see the 1999 and 2003 reports). Norges Bank reports to the Ministry of Finance on the management of the Fund, quarterly and annually. The reports are also made public.

The Ministry of Finance has specified countries and currencies that are to be included in the Fund's benchmark portfolio. The benchmark portfolio consists of specific equities and fixed income instruments and reflects the delegating authority's investment strategy for the Pension Fund. The benchmark portfolio provides the basis for managing risk in the operational management and for evaluating NBIM's management performance. The composition of the benchmark portfolio and how it is changed are described in a separate box.

Table 3-1 shows the weights in the actual benchmark at 31 December 2006. The weights in the fixed income benchmark apply to the currency in which the securities are issued. Therefore, the weight for each country in the euro area is not listed.

Table 3-1: Benchmark portfolio at 31.12.2006. Per cent

	Equities		Fixed income instruments
Country for equity benchmark Currency for fixed income benchmark	Strategic benchmark portfolio	Actual benchmark portfolio	Strategic benchmark portfolio	Actual benchmark portfolio
Asset class weights	40.0	40.6	60.0	59.4
Belgium		0.8
Finland		0.9
France		8.2
Greece		0.5
Ireland		0.6
Italy		3.3
Netherlands		2.7
Portugal		0.3
Spain		3.4
Germany		5.6
Austria		0.4
Euro area		26.5		48.1
UK		16.8		9.8
Denmark		0.6		0.9
Switzerland		4.9		0.5
Sweden		2.0		1.1
Total Europe	50.0	50.8	60.0	60.5
US		30.4		32.6
Brazil		0.7
Canada		1.9		2.0
Mexico		0.5
South Africa		0.6
Total Americas / Africa	35.0	34.1	35.0	34.6
Australia		2.3		0.2
Hong Kong		1.3
Japan		8.7		4.4
New Zealand		0.1		0.1
Singapore		0.4		0.2
South Korea		1.4
Taiwan		1.1
Total Asia / Oceania	15.0	15.1	5.0	4.9

Table 3-2: Market value of the Fund in 2006. In millions of NOK

	31.12.2005	31.03.2006	30.06.2006	30.09.2006	31.12.2006
Equity portfolio	582 304	606 890	609 879	687 887	725 922
Fixed income portfolio	816 746	877 019	895 143	1 024 385	1 057 761
Total portfolio	1 399 050	1 483 909	1 505 022	1 712 272	1 783 683

3.1.2 Return in 2006

At end-2006, the market value of the Government Pension Fund – Global was NOK 1 783.7 billion, an increase of NOK 384.6 billion since the beginning of the year. The Ministry of Finance transferred NOK 288.3 billion in new capital and the return measured in the international currency basket increased the market value by NOK 124.1 billion. The value of the currencies in which the Fund is invested fell in relation to NOK, thereby reducing the Fund by NOK 27.8 billion. Changes in the krone exchange rate have no effect on the Fund's international purchasing power, however. Table 3-2 shows the size of the equity and fixed income portfolios at the end of each quarter in 2006.

In the course of the year, the Ministry of Finance transferred NOK 288.3 billion to the Fund's krone account, and the equivalent of this capital was transferred simultaneously to the Fund's portfolio of international securities. The transfers are distributed between the two sub-portfolios so as to maintain the Fund's equity and fixed income shares at 40 and 60 per cent respectively (see discussion of the rebalancing regime in Section 3.1.1). As a result, the Fund normally buys more of the asset class that has had the least favourable return. Table 3-3 shows that over 80 per cent of the capital transferred in 2006 was invested in fixed income markets, but a considerable amount was also invested in equity markets.

Table 3-3: Transfers to the Government Pension Fund – Global in 2006. In billions of NOK

	To the equity portfolio	To the fixed income portfolio	Total to the Fund
January		31.1	31.1
February		31.1	31.1
March		20.2	20.2
April		21.4	21.4
May	24.2		24.2
June	8.7	15.3	23.9
July	12.7	11.4	24.1
August		24.0	24.0
September	4.0	27.3	31.4
October		30.3	30.3
November	2.9	23.7	26.6
December
Total 2006	52.5	235.8	288.3

Table 3-4: Return on the Fund by quarter and for 2006 as a whole. Per cent

	Return measured in terms of the portfolio's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	2.24	2.04	0.25	0.06	0.20
Q2	–1.55	–1.45	–3.30	–3.20	–0.10
Q3	3.94	4.09	8.30	8.46	-0.16
October	1.49	1.47	2.56	2.54	0.02
November	0.93	0.79	–2.89	–3.02	0.14
December	0.70	0.66	1.27	1.23	0.03
Q4	3.15	2.95	0.86	0.66	0.20
2006	7.92	7.76	5.89	5.74	0.15

In 2006, the return on the Fund was 7.9 per cent measured in terms of the currency basket which corresponds to the country weights in the benchmark portfolio. In absolute figures, the return measured in terms of the currency basket was NOK 124.1 billion. With the exception of the second quarter, when there was a sharp fall in global equity prices, the return was positive in all quarters in 2006 (see Table 3-4). The return on the Fund was high in the second half of 2006 in particular. The last column of Table 3-4 shows the difference between the actual return and the benchmark return. The excess return was negative in the second and third quarters, but positive in the first and fourth quarters. The excess return for the year as a whole was 0.15 percentage point, equivalent to approximately 2.5 billion.

In investment management, it is usual to look at excess return over a time horizon of more than one year. The red line in Chart 3-1 shows developments in three-year rolling excess return for the past three years. At end-2006, the annualised excess return, based on figures from the past three years, was 0.58 percentage point.

Chart 3-1: Monthly return (right-hand scale) and 3-year rolling return (left-hand scale). Per cent

Chart 3-2: The contribution of individual mandates to the excess return in 2006

The excess return in 2006 was largely attributable to internal equity management. External equity management had a weak year in comparison with 2005. As a result, the overall return on equity investments was somewhat lower than the return on the benchmark. Both the internal and especially the external fixed income management contributed positively to the excess return in 2006 (cf. Table 3-5). Overall, the excess return achieved through internal management was higher in 2006 than in 2005.

Chart 3-2 shows the contribution in NOK of each internally managed and each externally managed mandate to the excess return in 2006. The orange bars show externally managed mandates, while the blue bars show internally managed. A large preponderance of externally managed mandates contributed negatively to the excess return in 2006. The line in the chart shows the distribution of the contributions of individual mandates to the excess return in 2005. In 2005, the distribution was clearly more favourable, with a larger share of mandates with a high excess return and a smaller share with a negative contribution.

Table 3-5: Contributions to gross excess return in 2006. Percentage points

	External management	Internal management	Total	Excess return in each asset class
Equity management	–0.32	0.31	–0.01	–0.05
Fixed income management	0.03	0.13	0.16	0.24
Total	– 0.29	0.44	0.15

Table 3-6: Contributions to gross excess return after operating costs in 2006. Percentage points

	External management	Internal management	Total	Excess return in each asset class
Equity management	–0.37	0.29	–0.08	–0.20
Fixed income management	0.02	0.11	0.13	0.22
Total	–0.35	0.40	0.05

Table 3-7: Annualised contributions to gross excess return. 2004-2006. Percentage points

	External management	Internal management	Total	Excess return in each asset class
Equity management	0.18	0.20	0.38	0.95
Fixed income management	0.04	0.16	0.20	0.32
Total	0.22	0.36	0.58

Table 3-6 shows the contributions to the excess return after operating costs for 2006. Total operating costs for management of the Fund amounted to NOK 1 526 million or 9.8 basis points of the average assets under management in 2006 (see more detailed information in Section 3.1.7). The excess return after accrued operating costs is approximately NOK 1.0 billion.

The annualised excess return for the past three years came to 0.58 per cent (cf. Table 3-7). Internal and external equity management combined contri-buted approximately 66 per cent to the excess return. Internal equity and fixed income management contributed appre-ciably more than external management.

Table 3-8 shows contributions to excess return after accrued operating costs for the three-year period 2004-2006. Total operating costs for management of the Fund amounted to NOK 3 748 million or 10.3 basis points of the average assets under management during the period.

The information ratio is the ratio of excess return to market risk. It shows the excess return in relation to the risk taken. Table 3-9 shows the information ratio, or the risk-adjusted excess return, for the various profit centres in the period 2004-2006.

Table 3-8: Contributions to gross excess return after operating costs. 2004-2006. Percentage points

	External management	Internal management	Total	Excess return in each asset class
Equity management	0.13	0.18	0.31	0.78
Fixed income management	0.03	0.14	0.17	0.28
Total	0.16	0.32	0.48

Table 3-9: Information ratio. 2004-2006

	External management	Internal management	Total
Equity management	0.48	1.44	1.08
Fixed income management	1.69	2.58	2.77
Total	0.61	2.55	1.60

The gross excess return is comparable to the excess return reported by other managers. However, it does not provide a measure of NBIM's net contribution to performance. The Fund could have been managed passively, with a portfolio that was very similar to the benchmark at all times. Instead, NBIM has chosen to engage in active management. Costs are higher, but expected returns are also higher.

The value added by active management is an estimate of the net contribution from this strategy to the Fund's return in 2006. Table 3-10 presents the estimated net value added through active management. The starting point is the Fund's gross excess return. With passive indexing, transaction costs accrue when the benchmark portfolio's composition is changed. The normal annual transaction costs of maintaining index management amount to about 0.04 per cent of the total portfolio.

Table 3-10: Estimated net value added by active management. Percentage points

Gross excess return	0.15
+ Transaction costs associated with indexing	0.04
+ Other transaction costs	0.04
- Extra costs of active management	0.07
- Lending income associated with index management	0.04
= Value added by active management	0.12

When estimating gross excess return, costs relating to phasing new capital into the markets, adjusting the actual portfolio when the Ministry of Finance excludes companies from the investment universe, and other changes in the benchmark portfolio are not taken into account. The methodology for calculating such costs is described in a separate article published on Norges Bank's website in 2005 and in a box in this section of the Annual Report.

For 2006, NBIM has estimated the cost of phasing in new capital at approximately NOK 497 million. This was 0.17 per cent of the amount transferred (NOK 288 billion) and 0.03 per cent of the Fund's market value.

NBIM has estimated the cost of disposals in connection with the exclusion of companies at roughly NOK 10 million in 2006 or 0.001 per cent of the Fund's market value. These estimates assume that disposals will be made over a 60-day period, which is in accordance with the procedures established by the Ministry of Finance for company exclusions.

In April 2006, the Ministry of Finance decided to change the regional weights in the benchmark portfolio for both equity and fixed income management. NBIM has estimated the costs of adjusting the portfolios at NOK 121 million: NOK 69 million for equity management and NOK 52 million for fixed income management.

If passive indexing had been employed, the Fund's operating costs in connection with asset management would have been low. The Fund's normal management costs for indexing are estimated at 0.03 per cent of the total portfolio. In 2006, total management costs amounted to 0.10 per cent, i.e. the costs associated with active management are estimated at 0.07 per cent.

On the other hand, passive management would also have generated some income from securities lending. Income from securities lending in 2006 amounted to 0.07 per cent of the total portfolio. An estimated return of approximately 0.04 per cent would have been achieved by using a more passive management style.

These estimates indicate that the net value added by active management was 0.12 percentage point in 2006 (cf. Table 3-10). This is equivalent to about NOK 1.7 billion.

NBIM's average net contribution to the excess return over the period 1998-2006 was 0.45 percentage point (see Table 3-11). This is equivalent to NOK 26.3 billion.

Table 3-12 presents the Fund's return measured in various currencies. The return measured in terms of the currency basket was 7.9 per cent, whereas measured in NOK it was 5.9 per cent. The difference is due to an approximately 1.9 per cent appreciation of the krone in relation to the currency basket in 2006. Changes in the krone's international value have no effect on the Fund's international purchasing power. Calculated in EUR, the return was 3.0 per cent, whereas in USD it was a full 15.2 per cent. This is because the dollar depreciated against most other currencies, the euro in particular, in 2006.

Table 3-11: NBIM's contribution to the return on the Fund 1998-2006. Percentage points

Total	1998	1999	2000	2001	2002	2003	2004	2005	2006	1998- 2006
Excess return	0.20	1.25	0.28	0.15	0.25	0.59	0.53	1.10	0.15	0.48
Value added by active management	0.19	1.18	0.20	0.11	0.21	0.54	0.49	1.05	0.12	0.45

Table 3-12: Total return in 2006 measured against various benchmark currencies. Per cent

Return measured in terms of:	Total portfolio
Benchmark portfolio's currency basket	7,92
Import-weighted currency basket	4,25
USD	15,16
EUR	3,01
NOK	5,89

Chart 3-3: Capital in large international funds in 2006. In billions of NOK

3.1.3 The size of the Fund from an international perspective

Measured by capital under management, the Government Pension Fund – Global is large compared with the largest international pension funds. In Chart 3-3, the Fund is compared with the largest pension fund in the US, the two largest funds in Europe and the combined assets of the Swedish National Pension Funds (AP Funds). At end-2006, the Fund was somewhat larger than both the largest European pension fund (ABP in the Netherlands) and the largest US pension fund (CalPERS in California).

The Pension Fund is far from being among the largest asset managers in the world, however. At end-2006, the largest international asset manager (UBS in Switzerland) had more than USD 2 016 billion in total assets. The world's largest pension fund is the Japanese Government Pension Investment Fund. This fund invests a large portion of its assets in Japanese bonds (primarily government bonds). At end-March 2006, this fund had total assets of USD 874 billion. A number of central banks also invest substantial assets in international capital markets through their foreign exchange reserves. At end-2006, the Chinese central bank's foreign exchange reserves totalled USD 1 066 billion.

Chart 3-4 shows the Fund's average ownership interests in listed companies in three geographic regions, calculated as a share of the market value of the companies in the FTSE index for the countries in which the Fund is invested. At end-2006, the average ownership interest in European companies was 0.63 per cent, in US companies 0.26 per cent, and in Asian/Oceanian companies 0.37 per cent.

Chart 3-5 shows the Fund's ownership interests in the various fixed income markets in each of the three geographic regions,¹⁾ calculated in relation to the securities in the Lehman Global Aggregate index in the currencies in which the Fund has been invested. The ownership interest is highest in Europe, where the Fund owned 1.07 per cent of all outstanding securities at end-2006. The ownership interests in the Americas and Asia/Oceania were 0.59 per cent and 0.27 per cent respectively.

Chart 3-4: The Fund's ownership interests in equity markets at year-ends 1998-2006 as a percentage of market capitalisation in the FTSE indices

Chart 3-5: The Fund's ownership interests in fixed income markets at 31 December at year-ends 1998-2006 as a percentage of market capitalisation in the Lehman indices

3.1.4 Internal and external management

NBIM's management of the Fund's assets is based on an investment philosophy where excess returns are achieved by means of a large number of individual decisions that are independent of one another. The investment philosophy is described in more detail in articles published on Norges Bank's website in 2000 and 2004. The Fund's assets are managed by both internal and external portfolio managers. Decisional authority is delegated to individuals internally and, in the form of investment mandates, to external management organisations. The choice between internal and external management is governed by expected profitability. NBIM allows external managers with specialist expertise to take responsibility for over half of the overall active risk-taking, while NBIM, through internal management, seeks to take advantage of the economies of scale inherent in the Fund's size as well as to engage in active management in selected areas.

On average, about 78 per cent of the Fund was managed internally in NBIM in 2006. Internal management costs accounted for about 38 per cent of total management costs.

External management is more expensive than internal management. In 2006, external and internal management costs represented 0.28 per cent and 0.05 per cent, respectively, of the assets under management. Internal managers were responsible for about 39 per cent of the overall risk associated with active management. There is no absolutely correct method for calculating the distribution of active risk. The distribution in chart 3-6 is based on a summation of the value at risk (VaR) of each mandate, irrespective of correlation between mandates.

Chart 3-7 shows that the number of external managers and external mandates in the Government Pension Fund – Global, increased in 2006. At end-2006, 50 external managers had a total of 80 mandates.

Chart 3-6: Distribution of portfolios, management costs and active risk between internal and external management. Per cent

Chart 3-7: Number of external managers and external management mandates

3.1.5 Fixed income management

The market value of the Fund's fixed income portfolio rose by NOK 241 billion to NOK 1 058 billion in 2006. NOK 239 billion²⁾ of new capital was transferred to the portfolio during the year. Positive returns on the fixed income portfolio contributed NOK 19 billion, while a stronger krone in relation to the investment currencies reduced the portfolio's market value in NOK by 17 billion.

The return on the fixed income port-folio in 2006 was 1.93 per cent measured in terms of the currency basket (cf. Table 3-13). The return was negative in the first two quarters of the year, but positive in the final two quarters. The third quarter return was particularly high.

The managers contributed to outperforming the benchmark in every quarter of 2006. The total return on the fixed income portfolio was 0.24 percentage point higher than the return on the benchmark portfolio. About 20 per cent of the excess return was attributable to external management, while approximately 80 per cent was attributable to NBIM's internal management. The total contribution was roughly NOK 2 500 million in 2006.

Table 3-13: Fixed income return for each quarter and for the year 2006. Per cent

	Measured in terms of the portfolio's currency basket		Measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	–1.13	–1.23	–3.05	–3.15	0.10
Q2	–0.39	–0.43	–2.16	–2.20	0.04
Q3	3.13	3.09	7.45	7.41	0.04
Q4	0.35	0.30	–1.88	–1.93	0.05
2006	1.93	1.68	0.01	–0.23	0.24

Chart 3-8: Individual countries' contributions to fixed income return in 2006, measured in terms of the currency basket. Per cent

Chart 3-8 shows how contributions to the fixed income return measured in terms of the currency basket are distributed among the currencies in which the Fund is invested. By far the largest positive contribution came from investments in euro area countries and the UK. Contributions from the other currency areas were small. Investments in Japan and the US made the largest negative contributions. The weak contribution from the US is attributable to the depreciation of USD against the other investment currencies in the course of the year.

Since 1999, aggregate gross excess return on the fixed income portfolio has amounted to approximately NOK 11.5 billion. Of this, 22 per cent, or NOK 2.5 billion, represents the contribution of external managers. Until end-2006, 80 per cent of the specialist units (external mandates and internal groups) made a positive contribution to performance since start-up.

The return figure includes income from securities lending, which is equivalent to 0.04 per cent of the average fixed income portfolio. The figure has not been adjusted for transaction costs in connection with indexing and costs in connection with the investment of new capital in markets.

At the end of 2006, about 89 per cent of the fixed income portfolio was managed internally by NBIM. However, the share of total risk associated with fixed income management that was attributable to internal management was lower. This is because the majority of the external fixed income mandates are managed actively and have a high risk profile.

There are two main types of management. One is indexing and active management that is directly related to the indexing task. The objective of this enhanced indexing is to adjust the portfolio so that it remains relatively close to the benchmark, while taking advantage of special pricing situations to achieve an excess return. Three sub-portfolios are indexed: government-guaranteed bonds, corporate bonds and securitised bonds. The three sub-portfolios are indexed internally, with the exception of securitised bonds in the US, which are managed externally.

The other main area is active management based on an investment philosophy of specialisation and delegation of decisions. This type of management is carried out by both internal and external managers. A group structure has been established to achieve the objective of specialisation. Each group is assigned a mandate with a limited investment universe. The groups are specialised to achieve effective utilisation of risk (through diversification gains). In practice, this is not sufficient to ensure profitability because both quality (information ratio) and scaling possibilities vary between groups. Profitable management thus requires effective diversification, dynamic risk allocation between groups (in relation to information advantages) and critical review of possible scaling obstacles.

In active management, the main distinctions are between micro- and macro-positions and the degree of credit risk. This is reflected in the fixed income management group structure, both internally and externally. As in previous years, the highest excess return generated by fixed income management has been achieved via micro-strategies and active indexing strategies. Elements of credit risk have also been important for value added. The most important reason for not increasing the risk-taking in these strategies is a lack of profitability at group level (within a reasonable horizon). At the same time, increased breadth and specialisation imply a constant need to expand the investment universe at instrument level. This is a challenge in purely operational terms, and requires a dynamic organisational structure and expertise.

Each manager in a group is given a risk limit. There is very little overall coordination of positions, and there is no overriding market view that restricts the positions in the portfolio. All positions may be attributed to one owner.

In 2006, the hit ratio was generally very high at the group, mandate and personal level. This more than outweighed the relatively conservative risk-taking through the year and is consistent with previous experience marked by high quality and moderate risk-taking. Even with a substantial improvement in results measured in NOK, this was not sufficient to make up for the portfolio growth, so that results measured in basis points were somewhat lower than in the two previous years.

An important element of the investment strategy is to diversify among many independent positions. NBIM achieves this diversification by selecting independent specialists, both internally and externally. At the end of 2006, there were 45 specialist mandates within fixed income management, ten of which were internal. Eleven new external mandates were allocated in 2006.

NBIM considers the choice of external managers to be an investment decision, where different mandates receive capital allocations or are terminated on the basis of liquidity analyses and expected future excess returns. At the end of 2006, NBIM had 35 different externally managed mandates. The majority of these are regional specialist mandates.

3.1.6 Equity management

The market value of the equity portfolio increased from NOK 582 billion to NOK 726 billion in 2006. NOK 50 billion³⁾ in new capital was transferred to the portfolio during the year. Gains in equity markets were high and market returns increased the value of the portfolio by NOK 106 billion. A stronger krone in relation to the investment currencies reduced the portfolio's market value by about NOK 12 billion.

Table 3-14 shows that the return on the equity portfolio measured in terms of the Fund's currency basket was 17.04 per cent in 2006. The return was positive for all quarters of the year except the second.

Table 3-14: The return on the equity portfolio for each quarter and for 2006 as a whole. Per cent

	Return measured in terms of the portfolio's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	7.17	6.86	5.08	4.79	0.29
Q2	–3.31	–3.00	–5.02	–4.72	–0.30
Q3	5.14	5.57	9.54	9.99	–0.45
Q4	7.43	7.00	5.04	4.62	0.41
2006	17.04	17.09	14.84	14.89	–0.05

Chart 3-9: The individual countries' contributions to equity returns measured in terms of the currency basket in 2006. Per cent

Chart 3-9 shows the various markets' contributions to the return on the Fund's equity portfolio in 2006 measured in terms of the currency basket. The euro countries, the UK and the US made the largest positive contributions.

The actual return on the equity portfolio was 0.05 percentage point lower than the benchmark return. In the second quarter, the whole excess return of the first quarter was reversed, while the substantial negative excess return in the third quarter was almost cancelled out in the fourth quarter. The months May to July were particularly negative for the portfolio. In these figures, account is not taken of the transaction costs associated with excluding individual companies, or the costs of phasing in new capital into the Fund's equity portfolio. Nor is account taken of the costs associated with changing the share of the portfolio invested in Asia. These costs accounted for 0.5, 3.2 and 1.3 basis points of the results.

In 2006, the return on the externally managed portfolios was far weaker than expected. The external managers lost a total of NOK 6.1 billion compared with their benchmark portfolios. 2006 is the first year since the inception of the Fund that the externally managed portfolios underperformed the benchmark portfolio. Almost half of the negative excess returns is attributable to the mandates in Japan. Both regional and sector mandates contributed negatively as groups. The weak results in 2006 must be considered in relation to exceptional performance in 2005. The negative contributions from both the European and Asian regional mandates, and from the sector mandates, were far smaller than the positive excess return contributed by the same groups in 2005. It is normal to evaluate manager performance based on a long-term assessment horizon, and losses of this order have to be expected in occasional unfavourable years.

At end-2006, NBIM had 45 different externally managed equity mandates distributed among 27 fund managers. Of these mandates, 30 represented regional and country-specific mandates and 15 represented various industry sectors. At year-end, the share of the equity portfolio under external management was unchanged at 37.7 per cent. The market value of the aggregate externally managed portfolio increased by 24 per cent, from NOK 217 billion to NOK 271 billion.

The share of the external portfolio allocated as specialist mandates in industry sectors rose somewhat in 2006, to 29 per cent. There were unusually extensive changes in these mandates, owing to the termination of many of the smaller sector mandates in connection with a major portfolio reorganisation, and not to performance. In 2006, new specialist mandates were awarded for countries like Canada and China, and NBIM also allocated three global mandates.

The internal management strategies delivered an excess return of NOK 5.6 billion. Thus, the underperformance of the external mandates was nearly offset by the excess return of the internal mandates. At the end of the year, 62.3 per cent of the equity portfolio was managed in an internal indexing portfolio. The remainder of the internal active management has been built up gradually over the past few years and currently comprises 24 portfolio managers who use fundamental analysis of companies in the industry sectors finance, telecommunications, energy, and consumer services globally, as well as relative value and strategy mandates. Of all the mandates within these three strategies, plus the active indexing mandates, which were managed throughout the year, 88 per cent were on the plus side. This is higher than in 2005, but somewhat lower than in 2004, and far higher than can be expected over time.

At the beginning of the year, the internal portfolios accounted for approximately 30 per cent of the total risk in the equity portfolio, a share that was unchanged at the end of the year. This share will increase somewhat in the year ahead. Experiences of internal equity management and the results of the past five years are described in more detail in a separate feature article.

Equity management underwent substantial changes in the course of 2006. The most important of these were a further reduction in transaction costs, both direct (taxes, excise duties and commissions) and indirect (market impact and opportunity costs). Considerable emphasis was placed on increasing the share of transactions made directly in relation to stock exchanges. Algorithm trading was implemented, and new methods of borrowing and lending equities were introduced. Changes were also made in the IT-system architecture, and outsourcing of a large part of system operations commenced.

3.1.7 Risk

There are many risk factors associated with investing capital in international financial markets. Asset management is largely a question of managing this risk. Therefore, NBIM places considerable emphasis on measuring and controlling risk factors. Part of the risk is a result of conscious investment choices, and is desirable. Other risk elements shall be kept to a minimum, given the operating conditions that are inherent in being an investor in international capital markets.

Investments in international securities markets entail considerable market risk and a relatively high probability of wide variations in annual financial performance. For the Government Pension Fund – Global, the level of market risk is determined primarily by the composition of the benchmark portfolio. The most important elements of market risk are the share of equities in the portfolio, fluctuations in equity prices, exchange rates and the general interest rate level, as well as changes in the fixed income portfolio's credit risk.

In addition to the absolute level of market risk, which is determined by the investment strategy expressed by the benchmark portfolio, NBIM tries to achieve an excess return through active management. So far, NBIM's active management has only led to a limited increase in the Fund's market risk. Market risk must be seen in relation to expected returns, and an increase in market risk means higher expected returns.

NBIM also faces a number of operational risk factors. There is the risk of financial losses or an impaired reputation as a result of a failure in internal procedures, human error or system error, or other losses that are due to external factors that are not a consequence of the market risk in the portfolio.

Market risk

Market risk of the Fund is largely determined by the market risk of the benchmark portfolio. NBIM also takes on some risk through its active management. NBIM measures the Fund's absolute and relative market risk. The standard deviation of the return on the actual portfolio is used to measure absolute risk, and the standard deviation of the difference between the returns on the actual portfolio and the benchmark portfolio is used to measure relative risk. Standard deviation is a statistical concept that provides some indication of the variations in return that may be expected in normal periods. It is one of the most common measures of portfolio risk.

Chart 3-10: Absolute market risk in the Government Pension Fund - Global. Month-end. Per cent

Chart 3-10 shows developments in the Fund's absolute market risk during the past four years, measured as expected volatility of the return. The level fluctuates with market volatility, but the actual portfolio risk and the benchmark risk differs only slightly through the entire period. At the end of 2006, the actual portfolio had an absolute market risk, measured in NOK, of 7.5 per cent, which is somewhat higher than at the beginning of the year.

At year-end, the value of the actual portfolio was NOK 1 784 billion. Historical return figures provide grounds for expecting an annual return on the Fund of 6.5 per cent. Given the estimated absolute tracking error at the end of the year, the return in two of three years may be expected to be 7.5 percentage points higher or 7.5 percentage points lower than the expected market value. Translated into NOK, assuming no transfers of new capital, and including expected historical return, this means that with a 68 per cent probability, the value of the Fund in any one year will be between NOK 1 757 billion and NOK 2 042 billion.

Absolute market risk is largely determined by the Fund's benchmark port-folio. The Ministry of Finance has also set a limit for expected tracking error in management which limits how much the Fund's portfolio can differ from the benchmark portfolio.

This expected tracking error shall always be less than 1.5 percentage points (150 basis points) (see box). The Fund's tracking error was relatively stable until summer 2006, when it increased appreciably as a result of the higher absolute volatility of the equity portfolio (see Chart 3-11). In the second half of the year, the relative risk of the equity portfolio fell, and as a result the Fund's risk also fell back to the level at the start of the year. At the end of 2006, it was 0.28 per cent for the total portfolio.

Chart 3-11: Expected tracking error at each month-end in 2006. Basis points

Chart 3-12: Expected and actual tracking error at the end of each month. 1999-2006. Basis points

Chart 3-12 shows developments in tracking error between the actual portfolio and the benchmark portfolio since 1999. Two different measures of risk are used in the chart. Expected tracking error is calculated in advance on the basis of market volatility during the past few years. This risk measure shows relatively small variations over time and during the entire period has been well below 1.5 percentage points, which is the upper limit set by the Ministry of Finance for NBIM's risk-taking in connection with the management of the Fund. Actual tracking error is calculated retrospectively on the basis of the variation in the actual return differential in the past 12-month period. The two measures show very different levels of risk-taking in 2000 when there were unusually large fluctuations in stock prices for companies with similar risk properties. During the past six years the two measures show roughly the same level of risk-taking.

NBIM is testing whether actual excess return on the Fund varies in line with what might be expected in the light of the risk model used. This is illustrated in Chart 3-13. The points in the chart show the realised monthly excess return since October 2002 (diamonds) and the confidence interval measured by the standard deviation. The model indicates that in approximately 67 per cent of the cases, the actual return should be within the interval formed by the green lines. The model further indicates that in 95 and 99 per cent of the cases, the actual return should be within the intervals defined by the orange and red lines respectively. The chart indicates that the actual return is in line with what might be expected on the basis of the risk model used. Analyses of longer time series provide similar results.

Chart 3-13: Confidence interval for risk and realised excess return. Basis points

Credit risk

Credit risk arises in the Fund's fixed income portfolio, partly as a result of the Ministry of Finance's investment strategy, and partly as a result of NBIM's active management (credit portfolio risk). In both the equity and the fixed income portfolios, NBIM is exposed to counterparty risk, risk vis-à-vis custodian institutions, and risk vis-à-vis international settlement and payment systems (counterparty risk).

The regulation on the management of the Fund stipulates the countries and/or currencies in which the Fund's portfolio of fixed income instruments may be invested. Special rules apply to bonds issued by the government sector in other countries, but in a currency used by one of the countries or areas specified in the regulation. Up to 0.5 per cent of the market value of the fixed income port-folio may be invested in bonds issued by the government sector with ratings of BB, Ba, BB as their highest long-term credit rating from at least one of the three international credit rating agencies Fitch, Moody's and Standard & Poor's (S&P) respectively. There are no credit rating requirements for bonds issued by others than the government sector. Table 3-15 shows the Fund's fixed income portfolio by credit rating.

The equity and fixed income portfolios include investments in unsecured bank deposits and unlisted derivatives. The Ministry of Finance has decided that no counterparties involved in such transactions may have a credit rating lower than A-, A3 or A- from Fitch, Moody's or S&P respectively.

Table 3-15: The fixed income portfolio at 31.12.06. By credit rating. Per cent of market value

Moody's		Standard & Poor's
Rating	Percentage of total	Rating	Percentage of total
Aaa	56.84	AAA	54.73
Aa	15.75	AA	10.18
A	14.88	A	18.50
Baa	7.57	BBB	8.40
Ba	0.46	BB	0.56
Lower	0.16	Lower	0.16
No rating	4.34	No rating	7.47

Operational risk

Market risk and credit portfolio risk are important factors in connection with the establishment of an investment strategy and in active management. The objective is to achieve the highest possible risk-adjusted return and not necessarily the lowest possible risk. On the other hand, operational risk is an intrinsic risk, and there is not necessarily a payback for taking higher risk. At the same time, it is often necessary to take somewhat higher operational risk in order to achieve the objectives set. The objective is low operational risk in the execution of the assignment in order to achieve the highest possible return. NBIM uses recognised standards and current market practice to identify and monitor operational risk. It is more difficult to quantify operational risk than market risk and credit portfolio risk.

Operational risk cannot be isolated from market and credit portfolio risk, but it is more comprehensive and affects the entire organisation. NBIM has defined operational risk as the risk of financial loss or loss of reputation as a result of a failure in internal procedures, human error or system error, or other losses that are due to external factors that are not a consequence of market risk in the portfolio. Examples of risk categories are errors in transaction settlements, in our ability to recruit and retain employees with the right expertise, down-time in IT systems or failure to deliver by external suppliers.

Norges Bank has decided that Kredittilsynet's (Financial Supervisory Authority) regulation on internal control in financial institutions shall be complied with. It has been adapted to the Bank's management system. In 2006, NBIM established a new framework for managing operational risk based on COSO⁴⁾ and the Bank's own internal control guidelines. The framework is used by all parts of the organisation, and clear lines of responsibility have been established for the management of operational risk. A risk analysis is to be performed annually, or in connection with major changes in, for example, organisation or infrastructure. The analysis consists of an established procedure inluding description of work processes, identification of main risks, ranking of risks according to a set of criteria, identification of risk indicators and corrective action and measurement of the effect of the corrective action. The risk picture is updated through the year, and the risk indicators are measured regularly.

Table 3-16: The regulation's risk exposure limits

	Risk	Limits	Actual
			31.12.05	31.03.06	30.06.06	30.09.06	31.12.06
§5	Market risk	Maximum tracking error 1.5 percentage point	0.33	0.34	0.50	0.33	0.28
§4	Asset mix	Fixed income instruments 50-70%	58.4	59.1	59.8	59.8	59.3
		Equity instruments 30-50%	41.6	40.9	40.5	40.2	40.7
§4	Market distribution, equities*	Europe 40–60%	47.3	48.5	49.0	49.1	50.1
		Americas and Africa 25–45%			36.1	35.5	34.4
		Asia and Oceania 5–25%			14.9	15.4	15.5
		Americas, Africa, Asia and Oceania 40-60%	52.7	51.5
	Currency distribution fixed income instruments*	Europe 50–70%	55.1	55.5	60.8	59.8	60.4
		Americas and Africa 25–45%	34.8	34.2	32.6	34.7	34.3
		Asia and Oceania 0–15%	10.1	10.4	6.6	5.5	5.3
§6	Ownership interest	Maximum 5% of a company	2.7	3.9	4.7	4.5	4.5

Fund management guidelines

The Ministry of Finance has issued a number of guidelines for the management of the Government Pension Fund – Global. Table 3-16 summarises the risk exposure limits stipulated in the regulation on the management of the Fund. The table shows that exposures at the end of each quarter were within the stipulated limits.

There was one minor breach of the guidelines during the year when an external manager bought equities in an unlisted company. The breach was rapidly discovered, and the manager unwound the position immediately.

3.1.8 Costs

Table 3-17 shows the costs of managing the Fund in 2006. Fees to external managers and external settlement and custodian institutions are invoiced separately for each of the funds managed by Norges Bank. The other operating costs are overheads shared by all funds under management. These shared overheads are distributed among the three funds by means of a cost distribution key. Besides NBIM's direct costs, these overheads include the costs of support functions provided by other parts of Norges Bank. These latter costs are calculated in accordance with the guidelines that apply to business operations at Norges Bank.

Table 3-17: Management costs in 2006. In thousands of NOK and basis points of the average portfolio

	2006		2005
	NOK 1 000	Basis points	NOK 1 000	Basis points
Internal costs. equity management	223 889		169 438
Costs of equity custodians and fund administration	95 689		54 629
Total costs, internal equity management	319 578	8.1	224 067	7.8
Internal costs, fixed income management	184 178		165 243
Costs of fixed income custodians and fund administration	79 858		57 729
Total costs, internal fixed income management	264 036	3.2	222 973	3.6
Minimum fees to external managers	431 829		360 509
Performance-based fees to external managers	387 816		320 182
Other costs, external management	122 340		110 951
Total costs, external management	941 985	28.3	791 642	31.1
Total all management costs	1 525 599	9.8	1 238 681	10.6
Total management costs, excluding performance-based fees	1 137 784	7.3	918 499	7.8

The Management Agreement between the Ministry of Finance and Norges Bank establishes the principles for Norges Bank's remuneration for managing the Government Pension Fund – Global. For 2006, remuneration shall cover the Bank's actual costs, provided that these costs are less than 0.10 per cent (or 10 basis points) of the average market value of the Fund. In addition the Ministry reimburses NBIM for perfermance-based fees paid to external fund managers. Norges Bank has entered into agreements concerning performance-based fees with the majority of external active managers, in accordance with principles approved by the Ministry of Finance.

Management costs in 2006 totalled NOK 1 525.6 million. There was a decline from 10.6 basis points in 2005 to 9.8 basis points in 2006 in relation to the average portfolio under management. Excluding performance-based fees to external managers, Norges Bank's management costs came to NOK 1 137.8 million in 2006, a 24 per cent increase on 2005. The average size of the Fund increased by 33 per cent, so that costs in relation to the average portfolio fell from 7.8 basis points in 2005 to 7.3 basis points in 2006.

Costs can be distributed between internal and external management by using a cost distribution key for internal and custodian costs. Approximately 62 per cent of the costs were related to external management, while about 21 per cent of the Fund's assets are under external management. Unit costs for internal management were roughly 0.05 percentage point, compared with 0.28 percentage point for external management. This is partly attributable to the fact that index management is largely internal.

Recorded performance-based fees to external managers increased by 21 per cent from 2005 to NOK 320.2 million in 2006. The accounts show the costs actually accrued in 2006. Most performance-based fees to external managers are based on the average excess return achieved over a period of several years, so that there is no direct relationship between recorded costs and excess return achieved in a single year. Although external managers contributed negatively to the excess return in 2006, a higher performance-based fee was paid in 2006 than in 2005. This is largely because of the favourable results achieved by external managers in 2005 and earlier years. Total costs for external management amounted to 28.3 basis points of the average assets under external management.

3.2 Norges Bank's foreign exchange reserves

3.2.1 Mandate

The foreign exchange reserves shall be available for interventions in the foreign exchange market in connection with the implementation of monetary policy and to promote financial stability. The reserves are divided into a money market portfolio and an investment portfolio. In addition, a buffer portfolio is used for the regular foreign exchange purchases for the Government Pension Fund – Global. Within Norges Bank, the investment portfolio and buffer portfolio are managed by NBIM, while the money market portfolio is managed by Norges Bank Monetary Policy.

Norges Bank's Executive Board lays down guidelines for the management of the foreign exchange reserves and has delegated responsibility for issuing supplementary rules to the Governor. The Executive Board's guidelines are available on Norges Bank's website. In November 2005, the Executive Board decided to increase the equity portion of the investment portfolio from 30 per cent to 40 per cent. The phase-in to increase the equity portion was completed on 30 April 2006. With effect from 1 January 2006, the Executive Board decided that the maximum ownership interest in any one company shall be 5 per cent, compared with 3 per cent earlier. If the combined holdings in the foreign exchange reserves and the Government Pension Fund – Global exceed 5 per cent, a separate report must be submitted to the Executive Board.

The Executive Board has laid down joint guidelines for corporate governance of the two Funds, and has also ruled that companies which the Ministry of Finance has decided to exclude from the Pension Fund shall also be excluded from the foreign exchange reserves. Section 4.1 provides an overview of corporate governance in 2006, and Section 4.2 provides an overview of the companies that have been excluded from the investment universe.

The strategic benchmark portfolio for the investment portfolio is composed of FTSE equity indices for large and medium-sized companies in 27 countries and of Lehman Global Aggregate fixed income indices in the currencies of 18 countries. Equities account for 40 per cent of the Fund's strategic benchmark portfolio, while fixed income instruments account for 60 per cent. The equity portion of the benchmark consists of equities listed on stock exchanges in Europe (50 per cent), the Americas and Africa (35 per cent), and Asia and Oceania (15 per cent). The regional distribution of the fixed income benchmark is 58 per cent in Europe, 37 per cent in the Americas and 5 per cent in Asia/Oceania.

Table 3-18 shows the weights in the actual benchmark at 31 December 2006. The weights in the fixed income benchmark apply to the currency in which the securities are issued. Therefore, the weight for each country in the euro area is not listed.

Table 3-18: Benchmark portfolio on 31.12.06. Per cent

	Equities		Fixed income instruments
Country for equity benchmark Currency for fixed income benchmark	Strategic benchmark portfolio	Actual benchmark portfolio	Strategic benchmark portfolio	Actual benchmark portfolio
Asset class weights	40.0	41.1	60.0	58.9
Belgium		0.8
Finland		0.9
France		8.4
Greece		0.5
Ireland		0.6
Italy		3.4
Netherlands		2.7
Portugal		0.3
Spain		3.5
Germany		5.8
Austria		0.4
Euro area		27.3		47.2
UK		17.3		9.6
Denmark		0.6		0.9
Switzerland		5.1		0.6
Sweden		2.1		1.1
Total Europe	50.0	52.3	58.0	59.3
US		29.9		32.4
Brazil		0.7
Canada		1.9		3.6
Mexico		0.4
South Africa		0.6
Total Americas and Africa	35.0	33.5	37.0	36.0
Australia		2.2		0.2
Hong Kong		1.2
Japan		8.1		4.5
New Zealand		0.1
Singapore		0.4
South Korea		1.3
Taiwan		1.0
Total Asia and Oceania	15.0	14.2	5.0	4.7

3.2.2 Return in 2006

The investment portfolio's market value was NOK 224.5 billion at the end of 2006, an increase of NOK 13.0 billion since the beginning of the year. During the year, a total of NOK 2.0 billion was transferred from the money market portfolio of the foreign exchange reserves to the investment portfolio. The return on investments totalled NOK 15.5 billion in 2006, while a stronger krone in relation to the investment currencies led to a reduction of NOK 4.5 billion in the portfolio's market value. The negative contribution from a stronger krone has no effect on the international purchasing power of the foreign exchange reserves. Table 3-19 shows the size of the equity and fixed income portfolios at the end of each quarter in 2006.

Table 3-19: Market value of the investment portfolio in 2006. In millions of NOK

	31.12.2005	31.03.2006	30.06.2006	30.09.2006	31.12.2006
Equity portfolio	70 669	83 495	79 754	87 672	92 143
Fixed income portfolio	140 817	129 174	125 934	135 407	132 374
Total portfolio	211 486	212 670	205 688	223 079	224 517

Chart 3-14: Market value of the investment portfolio 1998-2006. In billions of NOK

Chart 3-14 shows developments in the portfolio's market value since 1998, measured in NOK.

The return on the investment portfolio in 2006 was 7.30 per cent measured in terms of the benchmark portfolio's currency basket and 5.2 per cent measured in NOK. The lower return in NOK is due to the appreciation of the krone against the currencies in the benchmark during the year, resulting in a depreciation of the portfolio's currency basket in relation to the krone.

Table 3-20: Return on the investment portfolio by quarter and for 2006 as a whole. Per cent

	Return measured in terms of the portfolio's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	1.62	1.54	–0.37	–0.45	0.08
Q2	–1.53	–1.48	–3.28	–3.24	–0.04
Q3	4.10	4.09	8.46	8.44	0.01
October	1.47	1.44	2.52	2.50	0.03
November	0.79	0.78	–3.07	–3.07	0.00
December	0.72	0.67	1.27	1.23	0.04
Q4	3.00	2.92	0.64	0.57	0.08
2006	7.30	7.17	5.18	5.05	0.13

Table 3-21: Contributions to gross excess return in 2006. Percentage points

	External management	Internal management	Total	Excess return in each asset class
Equity portfolio	–	–0.08	–0.08	–0.23
Fixed income portfolio	0.02	0.19	0.21	0.33
Total investment portfolio	0.02	0.11	0.13

Table 3-20 presents the return figures. The actual return in 2006 was 0.13 percentage point higher than the benchmark return and amounted to NOK 271 million.

Table 3-21 shows that internal fixed income management in particular contributed positively to the overall excess return of the portfolio.

Chart 3-15 shows the return on the investment portfolio since 1998 measured in international currency. The return has been positive in 29 of 36 quarters.

Chart 3-15: Quarterly return measured in international currency. 1998-2006. Per cent

The gross excess return of 0.13 percentage point for the portfolio as a whole is comparable to the excess return reported by other managers. However, it does not provide an expression of NBIM's net contribution to management performance. The investment portfolio could have been managed passively and could have been kept very close to the benchmark at all times. Instead, NBIM has chosen to engage in active management, which involves higher costs but also higher expected returns. The value added by active management, which is estimated in Table 3-22, is a measure of the net contribution of this strategy to the portfolio's return in 2006.

Table 3-22: Estimated net value added by active management. Percentage points

Gross excess return	0.13
+ Transaction costs associated with indexing	0.04
+ Other transaction costs	0.02
- Extra costs of active management	0.03
- Lending revenues associated with passive management	0.04
= Value added by active management	0.11

The starting point is the portfolio's gross excess return. If passive indexing is employed, transaction costs will accrue when the composition of the benchmark is changed. Normal transaction costs associated with indexing are estimated at about 0.04 percentage point of the total portfolio.

When estimating gross excess return, the costs of phasing in new capital into the markets, adjusting the actual portfolio when companies are excluded from the investment universe and other changes in the benchmark portfolio are not taken into account. For 2006, NBIM has estimated the costs of phasing in new capital at NOK 9 million, the costs of disposal in connection with the exclusion of companies at NOK 1 million, and the costs associated with adjustments in the benchmark at NOK 26 million. The combined transaction costs amount to just under 0.02 per cent of the portfolio's market value.

Passive indexing of the portfolio would also involve some operating costs associated with portfolio management. For the investment portfolio, the normal management costs associated with indexing may be estimated at 0.03 percentage point of the total portfolio. In 2006, total management costs amounted to 0.06 percentage point, i.e. the extra costs associated with active management are estimated at 0.03 percentage point. On the other hand, with passive management there would also have been some revenues from securities lending, which are estimated at 0.04 percentage point in 2006.

With these items, the net value added by active management in 2006 is estimated at 0.12 percentage point or about NOK 250 billion.

Table 3-23: Excess return on the investment portfolio each year in the period 1998 -2006 and the average for the period. Percentage points

	1998	1999	2000	2001	2002	2003	2004	2005	2006	Average 1998- 2006
Gross excess return	–0.03	0.13	0.12	0.15	0.32	0.58	0.08	0.35	0.13	0.20
Value added through active management*	–0.03	0.10	0.10	0.13	0.29	0.55	0.09	0.31	0.11	0.18

The first line of Table 3-23 shows that the gross excess return was 0.13 percentage point in 2006 and that the annual average since 1998 is 0.20 percentage point. This is equivalent to NOK 2.1 billion for the period as a whole.

Line 2 of the table shows net value added through active management. The method used to calculate this is described above. The average net contribution to the excess return for the period 1998-2006 was 0.18 percentage point.

When evaluating the quality of active management, it is also important to consider the market risk involved in achieving the excess return. The Executive Board's guidelines for the investment portfolio stipulate that market risk, defined as the deviation from the benchmark portfolio, shall not exceed an expected tracking error of 1.5 percentage point.

Chart 3-16: Expected and actual tracking error at the end of each month. 1999-2006. Basis points

Chart 3-16 shows developments in the market risk of the actual portfolio relative to the market risk of the benchmark portfolio since 1999.

Two different measures of risk are used in the chart. Expected tracking error is calculated in advance on the basis of market volatility during the past few years.

This risk measure shows relatively small variations over time, and expected tracking error has been well below the upper limit set by the Executive Board for risk-taking in connection with the management of the portfolio during the entire period. The actual tracking error (ex post) is calculated retrospectively on the basis of the variation in the actual return differential in the past 12-month period.

The information ratio is one indicator of skills in investment management. It is calculated as the ratio of the annual excess return to the excess risk taken in relation to the benchmark (measured by tracking error). In other words, the information ratio shows how much excess return is achieved for each unit of risk. During the period from June 1998 (when responsibility for management was transferred to NBIM) until the end of 2006, the average information ratio for the investment portfolio was 0.82. See also Table 1-3 in Part I for an overview of the return on and risk associated with the portfolio in recent years.

Fixed income management

The market value of the fixed income portfolio fell by NOK 8.4 billion to NOK 132.4 billion in the course of the year. The value of the portfolio fell by NOK 7.8 billion when the equity share of the investment portfolio was increased from 30 to 40 per cent during the year. A stronger krone in relation to the investment currencies reduced the portfolio's market value by NOK 2.6 billion. A positive return on investments increased the value by NOK 2.0 billion.

At the end of the year, about 84 per cent of the portfolio was managed internally in Norges Bank. The management strategies used include enhanced indexing, where the primary objective is to achieve a market exposure that is in line with the benchmark, and active strategies that are designed to outperform the benchmark. Approximately 16 per cent of the portfolio is managed by external managers, who primarily employ active strategies designed to outperform the benchmark. Some mandates for the enhanced indexing of securitised bonds in the US have also been assigned to external managers.

Table 3-24 shows the return on the fixed income portfolio in 2006. The return was 1.83 per cent measured in international currency. The gross excess return was 0.33 percentage point. Internal fixed income management in particular made a positive contribution to the return, although the external managers also made a positive contribution.

Table 3-24: Fixed income return for each quarter and for the year 2006. Per cent

	Return measured in terms of the portfolio's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Return differential
Q1	–1.13	–1.29	–3.07	–3.22	0.15
Q2	–0.47	–0.50	–2.25	–2.27	0.02
Q3	3.20	3.12	7.52	7.44	0.08
Q4	0.27	0.19	–2.03	–2.10	0.07
2006	1.83	1.49	–0.18	–0.51	0.33

Equity management

At the end of 2006, the market value of the equity portfolio was NOK 92.1 billion, an increase of NOK 21.5 billion in the course of the year. High equity market returns contributed NOK 13.5 billion to the increase. A total of NOK 9.8 billion was transferred to the portfolio. NOK 2.0 billion was transferred from the money market portfolio and NOK 7.8 billion was transferred from the fixed income portfolio in connection with the increase in the equity portion. A stronger krone in relation to the investment currencies reduced the portfolio's market value by NOK 1.8 billion.

The whole equity portion of the investment portfolio is managed internally, largely by means of active indexing and relative value strategies. However, the portfolio has also been adjusted to reflect parts of the risk profile in the external mandates. This had a negative effect in 2006.

Table 3-25 shows the return on the equity portfolio in 2006. The return was 17.0 per cent measured in international currency, or 0.23 percentage point below the benchmark portfolio. Account is not taken in these figures of transaction costs associated with the exclusion of individual companies. Nor is account taken of the costs of increasing the equity portion of the investment portfolio from 30 to 40 per cent. These costs accounted for 0.2 and 4.1 basis points of the results.

Table 3-25: Return on the equity portion of the investment portfolio in 2006. Per cent

	Return measured in terms of the portfolio's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Return differential
Q1	6.81	6.87	4.72	4.77	–0.05
Q2	–3.14	–2.99	–4.87	–4.72	–0.15
Q3	5.51	5.60	9.93	10.02	–0.09
Q4	7.21	7.11	4.76	4.66	0.09
2006	17.03	17.26	14.72	14.95	–0.23

Chart 3-17: Expected tracking error at each month-end in 2006. Basis points

3.2.3 Risk

The Executive Board's guidelines define a limit for the market risk associated with the actual portfolio compared with the benchmark portfolio. This relative market risk shall always be less than 1.5 percentage points expected tracking error. Chart 3-17 shows that relative market risk remained well within this limit throughout 2006. At the end of the year, expected tracking error was 0.17 percentage point.

Table 3-26 shows the composition of the bond portfolio (fixed income portfolio excluding cash) based on Moody's and Standard and Poor's (S&P) credit ratings. In the table, government bonds and government-guaranteed bonds without credit ratings have been assigned the credit rating of the issuer country.

Table 3-27 provides an overview of risk and market exposure in the investment portfolio in 2006. The table shows that at the end of each quarter portfolio management has complied with the limits for market risk and ownership interest laid down in the Executive Board's guidelines. There was a minor breach of the Executive Board's guidelines in the third quarter. The fixed income benchmark was incorrectly weighted for Canadian fixed income instruments. The weighting was corrected and did not cause a loss for the Fund.

Table 3-26: Bond portfolio at 31.12.06 by credit rating. Percentage of market value

Moody's		Standard & Poor's
Rating	Percentage of total	Rating	Percentage of total
Aaa	55.88	AAA	54.05
Aa	20.00	AA	10.63
A	11.59	A	16.39
Baa	5.98	BBB	6.81
Ba	1.66	BB	2.16
Lower rating	0.97	Lower rating	0.68
No rating	3.92	No rating	9.28

Table 3-27 Key figures for risk and exposure

Risk		Actual
		31.12.05	31.03.06	30.06.06	30.09.06	31.12.06
Market risk (percentage points)	Tracking error	0.31	0.16	0.25	0.21	0.17
Asset mix	Fixed income	66.58	60.74	61.23	60.70	58.96
	Equities	33.42	39.26	38.77	39.30	41.04
Market distribution equities	Europe	48.56	50.00	50.91	51.18	52.40
	Americas	39.79	36.58	35.58	35.51	34.61
	Asia and Oceania	11.65	13.42	13.51	13.31	12.99
Market distribution fixed income	Europe	52.79	56.43	61.34	58.42	59.70
	Americas	39.28	37.38	32.44	35.70	35.01
	Asia and Oceania	7.93	6.19	6.22	5.88	5.29
Ownership stake (per cent)	Largest ownership stake 5%	0.97	0.68	0.82	0.95	1.23

Costs

The costs of managing the investment portfolio consist partly of fees to external managers, custodian institutions, providers of settlement services and other external service providers, and partly of Norges Bank's internal operating costs.

NBIM is responsible for managing the Government Pension Fund – Global and the Government Petroleum Insurance Fund as well as the foreign exchange reserves' investment portfolio and buffer portfolio. The fees of external managers and external settlement and custodian institutions are invoiced separately for each fund. The other operating costs are overheads shared by all the funds and are distributed by means of a cost distribution key. These overheads include all support functions provided by parts of Norges Bank other than NBIM. These latter costs are calculated in accordance with the guidelines that apply to business operations at Norges Bank.

The costs of managing the investment portfolio amounted to NOK 130 million in 2006. This included performance-based fees to external managers. The costs were equivalent to 0.06 percentage point of the average portfolio under management.

Table 3-28: Transfers to and from the buffer portfolio in 2006. In millions of NOK

Period	Capital from SDFI	Foreign exchange purchased in the market	Transferred to Government Pension Fund – Global	Market value at end- quarter/ month-end
Q1	46 115	16 175	82 366	4 322
Q2	40 660	28 321	69 550	3 497
Q3	40 645	37 768	79 467	2 700
October	11 030	19 574	30 348	2 758
November	12 814	20 013	26 567	8 374
December	15 288	–	–	23 688
Q4	39 132	39 587	56 915	–
2006	166 552	121 852	288 298	–

3.2.4 The buffer portfolio

Table 3-28 provides an overview of transfers of capital to the buffer portfolio and transfers from the buffer portfolio to the Government Pension Fund – Global in 2006. NOK 166.5 billion was transferred to the portfolio from the State's Direct Financial Investment in petroleum activities (SDFI) in the course of the year. In addition, foreign exchange for a total of NOK 121.9 billion that was purchased by Norges Bank in the market was added to the portfolio.

A total of NOK 288.3 billion was transferred to the Government Pension Fund – Global in 2006.

At the end of 2006, the market value of the buffer portfolio was NOK 23.7 billion, compared with NOK 24.1 billion on 31 December 2005. The fourth quarter return on the buffer portfolio was -1.2 per cent measured in NOK. This is equivalent to NOK 418 million. The negative return was due to a stronger krone exchange rate. In 2006, the return on the buffer portfolio was 1.90 per cent.

3.3 Government Petroleum Insurance Fund

3.3.1 Mandate

Pursuant to the Act relating to the Government Petroleum Insurance Fund, Norges Bank is responsible for the operational management of the fund. The management mandate is stipulated in a regulation and written guidelines issued by the Ministry of Petroleum and Energy. A management agreement, which regulates the relationship between the Ministry of Finance as delegating authority and Norges Bank as operational manager, has also been drawn up. The guidelines and management agreement are available on Norges Bank's website.

The Ministry of Petroleum and Energy has established a strategic benchmark portfolio for the Fund. The currency distribution of the benchmark portfolio is 50 per cent EUR, 15 per cent GBP and 35 per cent USD. The benchmark index consists of Lehman Global Aggregate Treasury (government bond indices) for the three currencies and a money market deposit to weight the interest rate risk, measured by modified duration in each currency, to 4. During the year, the currency weights fluctuate with market developments. However, at the beginning of July each year, the weights are readjusted to the strategic currency weights.

Table 3-29 shows the currency weights in the Fund's strategic and actual benchmark at 31 December 2006.

The Ministry of Petroleum and Energy has decided that market risk, defined as deviation from the benchmark portfolio, must never exceed an expected tracking error of 0.75 percentage point. The Ministry has also decided that the interest rate risk, measured by the modified duration of the total portfolio of fixed income instruments and related derivatives, shall not exceed 5.

Table 3-29: Benchmark portfolio at 31.12.06

Currency	Strategic benchmark portfolio	Actual benchmark portfolio
EUR	50.0	50.0
GBP	15.0	15.4
USD	35.0	34.6
Total	100.0	100.0

3.3.2 Return in 2006

At end-2006, the market value of the Government Petroleum Insurance Fund was NOK 15.2 billion, an increase of NOK 1.0 billion since the beginning of the year. The insurance premium from the Ministry of Petroleum and Energy for 2006 was NOK 1.2 billion. NOK 462.2 million in claims was paid during the year.

The market value of the Petroleum Insurance Fund's foreign exchange portfolio at the end of each quarter in 2006 is shown in Table 3-30. The portfolio is managed internally by Norges Bank and has always been kept very close to the benchmark.

The portfolio is primarily invested in government bonds and other bonds included in the LGA Government-related sub-sector. In addition, the portfolio may be invested in German bonds that have been issued against collateral in the form of loans to the public sector (Öffentliche Pfandbriefe), in short-term money market instruments and in unlisted fixed income derivatives.

Table 3-30: Market value of the Petroleum Insurance Fund at the end of each quarter. In millions of NOK

	31.12.2005	31.03.2006	30.06.2006	30.09.2006	31.12.2006
EUR	7 038	6 906	7 389	7 696	7 596
GBP	2 120	2 073	2 220	2 349	2 343
USD	5 039	4 835	5 092	5 492	5 248
Total market value	14 197	13 814	14 700	15 535	15 187

Table 3-31: The return on the Government Petroleum Insurance Fund. Per cent

	Measured in terms of the benchmark currency basket		Measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Return differential
Q1	–0,71	–0,72	–2,38	–2,39	0,00
Q2	–0,07	–0,08	–1,63	–1,64	0,01
Q3	2,52	2,50	7,06	7,04	0,01
Qctober	0,39	0,41	1,43	1,45	–0,02
November	0,60	0,58	–3,01	–3,04	0,02
December	–0,55	–0,54	0,20	0,21	–0,01
Q4	0,44	0,44	–1,42	–1,42	0,00
2006	2,17	2,14	1,34	1,31	0,03

In 2006, the return on the Government Petroleum Insurance Fund was 2.17 per cent measured in terms of the currency basket corresponding to the composition of the benchmark portfolio (see Table 3-31). Measured in NOK, the return was 1.34 per cent. The difference is due to the appreciation of the krone against the currencies in the benchmark in 2006, so that the Fund's currency basket depreciated in relation to the krone. The actual return was 0.03 percentage point higher than the benchmark return. This is equivalent to approximately NOK 3.0 million.

The actual return figures include normal transaction costs associated with indexing the portfolio. These costs are not included when calculating the benchmark return. Norges Bank estimates that these costs amount to about 0.01 per cent of the portfolio value per year. On the other hand, the actual return includes income from lending of fixed income instruments, while the benchmark return does not. Norges Bank and some of the external custodian institutions conduct lending operations. In 2006, income from this type of activity totalled NOK 10.6 million, which is equivalent to an annual rate of 0.07 per cent, calculated as a share of the Fund's average market value.

Table 3-32 shows the return and excess return on the Government Petroleum Insurance Fund each year since 1998. The annual average excess return in the period of 0.08 percentage point is equivalent to NOK 78.8 million.

Table 3-32: Return on the Government Petroleum Insurance Fund in the period 1998-2006

	1998	1999	2000	2001	2002	2003	2004	2005	2006	Average 1998- 2006
Actual return	3,27	–1,06	6,92	5,68	7,90	3,56	5,64	4,28	2,17	4,23
Benchmark return	3,38	–0,85	6,78	5,48	7,74	3,46	5,42	4,15	2,14	4,16
Excess return	–0,11	–0,21	0,15	0,19	0,16	0,10	0,22	0,14	0,03	0,08

Chart 3-18: Expected tracking error in the past 12 months. Basis points

3.3.3 Risk

Market risk

The guidelines from the Ministry of Petroleum and Energy establish a limit for market risk associated with the actual portfolio compared with the benchmark portfolio. This relative market risk shall always be less than a tracking error of 0.75 percentage point. Relative market risk has remained well within this limit throughout 2006 (see Chart 3-18).

According to the guidelines of the Ministry of Petroleum and Energy, the average modified duration of each currency shall be 4 in the benchmark portfolio and no higher than 5 in the actual portfolio overall. Table 3-33 shows the modified duration of the portfolio at 31 December 2006.

Table 3-33: The portfolio's modified duration by currency at 31 December 2006

Currency	Actual portfolio	Benchmark portfolio
EUR	3.88	3.96
GBP	3.86	4.10
USD	4.13	4.05
Total	3.97	4.01

Credit risk

Table 3-34 shows the composition of the bond portfolio based on credit ratings from Moody's and S&P. In the table, the agencies' detailed subdivisions have been grouped together into main rating classifications – for example, Moody's Aa includes the sub-ratings Aa1, Aa2 and Aa3. Government bonds and government-guaranteed bonds without credit ratings have been assigned the credit rating of the issuing country. The portion of the portfolio that Moody's assigned to the highest credit rating class is larger than the portion Standard & Poor's assigned to the highest credit rating class.

Table 3-34: The bond portfolio on 31 December 2006, by credit rating. Per cent

Moody's		Standard & Poor's
Rating	Per cent of total	Rating	Per cent of total
Aaa	65.74	AAA	59.20
Aa	29.24	AA	16.01
A	3.41	A	23.20
No rating	1.61	No rating	1.59

Compliance with the regulation

Table 3-35 provides an overview of the limits for risk exposure set out in the regulation and guidelines, and shows the portfolio's actual exposure in relation to these limits at the end of the quarter.

Table 3-35: Risk exposure limits stipulated in the regulation and the guidelines

Risk	Limits	Actual
		31.12.05	31.03.06	30.06.06	30.09.06	31.12.06
Market risk	Maximum tracking error 0.75 percentage point	0.03	0.04	0.08	0.06	0.06
Interest rate risk	Modified duration max. 5	3.93	3.92	3.98	3.98	3.97

Costs

The Management Agreement between the Ministry of Petroleum and Energy and Norges Bank establishes the principles for Norges Bank's remuneration for managing the Petroleum Insurance Fund's portfolio. For 2006, a remuneration rate of 0.06 per cent of the average market value of the portfolio was stipulated. Total remuneration in 2006 was NOK 8 741 086.

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