Active management of the Government Pension Fund – Global
Norges Bank's letter of 12 March 2009 to the Ministry of Finance
In connection with the Ministry’s work on its annual Report to the Storting (Norwegian parliament) on the management of the Government Pension Fund – Global, Norges Bank would like to comment on certain matters concerning active management.
The markets in which the Government Pension Fund – Global invests, especially the liquid equity and fixed income markets of Europe and the US, are nearly efficient. This means that market prices will at all times reflect all relevant information about the securities in question, and it will be hard to generate consistent added value by forming expectations as to how market prices will move in the future.
This insight forms the foundation for the operational management of the Government Pension Fund – Global. When we develop our investment strategies, we begin with the Fund’s unique characteristics. The most important are its size and long-term investment horizon. Our potential to achieve results as an investor lies in turning these factors to the Fund’s benefit through active strategies, and our most important advantage is the possibility of implementing these strategies at low cost. Over time, the level of active management will depend on the results that can be achieved.
Our view of the role as a large financial investor
Efficient capital markets depend on a sufficient number of market participants actively participating in price formation. Were large institutional investors such as the Government Pension Fund – Global to rely exclusively on other participants to ensure efficient price formation, this could undermine the function of capital markets. The Fund is now probably the largest equity investor in Europe. Exclusively pursuing a passive strategy and not contributing to efficient price formation would not be compatible with this role.
There are great expectations for the Fund’s active ownership activities. It is important that large institutional investors such as Norges Bank are not passive but exercise their rights as minority shareholders. In our dealings with companies, our legitimacy and influence depend on us being seen as a long-term investor pursuing financial interests. In our dealings with national authorities in the countries in which we invest, it is also important that we are perceived as pursuing financial interests when we take up our active ownership agenda. All in all, an element of active management will be essential for Norges Bank’s legitimacy in the implementation of important parts of its management mandate.
Aspects of the investment strategy
The Fund’s long-term investment horizon is the starting point for its investment strategy and for its benchmark portfolio and asset allocation. Risk premiums on different asset classes in capital markets vary over time. An investor with a sufficient time horizon and risk capacity should be able to exploit this and collect risk premiums that are not fully reflected in the benchmark portfolio. A sharp distinction between overarching investment strategy and operational management may be inappropriate. Our strategic advice to the Ministry must be based on analyses of these risk premiums and be taken into account when important strategic decisions are made.
Possibility of adding value through active management
The aim of active management is to make a positive contribution to the return on the Fund over time. The Fund differs from the average investor through its size and long-term approach. Our active strategies must have this as their basis.
The Fund’s size can be an advantage in its management, because it makes it possible to take relatively large positions in specific situations without a significant change in the risk in its management. An active manager is able to participate in the primary market for equities, based on specific insight and expertise. A large investor in particular will be able to achieve favourable terms in this market. As a passive investor, the Fund would not purchase equities until they are included in the benchmark index at a later, arbitrary point in time, and in a situation where our size may impact on prices.
The Fund’s long-term approach means that we have a better basis for riding out fluctuations in the return on the Fund. This risk capacity sets us apart from the average investor. Our positions are leveraged to only a small degree. We are not forced to realise losses in the short term if funding falls away. Unlike some other large institutional investors, we are not subject to rules forcing us to make adjustments to the portfolio in critical phases. Also important is that the Fund has a long-term owner that does not make significant changes in the management framework in situations with unusual or stressed markets.
Our approach to the composition of active investment strategies is based on diversification, specialisation and delegation, and aims to ensure the best possible trade-off between risk and return in active management. Over time, we have had good experience of this approach.
The Fund has a broadly diversified portfolio which largely mirrors the size of the various submarkets. The risk in the management of such a well-diversified global portfolio will, in the first instance, depend on volatility in these broad markets and covariance between them. Active management in itself will not serve to increase the Fund’s market risk, provided that it does not expose the Fund to structural risk factors.
One important reason why, on average, active management does not add value for investors is high fees and management costs. Low costs are an important advantage for NBIM. This gives us greater potential to generate excess returns than the average investor.
Now that the Fund’s investment universe and benchmark portfolio are gradually being expanded, there is growing exposure to markets where there is little reason to expect the efficient markets hypothesis to hold. This increases the potential to add value through active management.
As manager and adviser, Norges Bank can combine theoretical insight, proximity to the markets and a knowledge of individual investments. Management costs are low. Given the Fund’s size and long-term approach, few investors are better placed to exploit the fact that many markets are not totally efficient.