Jon Nicolaisen: Responsible investment and active ownership
Speech by Mr Jon Nicolaisen, Deputy Governor of Norges Bank (Central Bank of Norway), at
Norges Bank, Oslo, 19 November 2019.
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The graphs can be found on the Norges Bank's website.
Introduction
In 1990, visionary politicians decided to establish the Government Petroleum Fund, later
renamed the Government Pension Fund Global (GPFG). On Tuesday of this week, the value of
the fund passed NOK 11 000 billion - or over 31⁄2 times Norwegian mainland GDP. The fund is
now among the largest shareholders in many of the world's listed companies.
Chart: From natural resources to financial wealth
What started as oil wealth in the ground has been transformed into savings and financial wealth
abroad. Under the fiscal rule, we should only spend the expected real return on the fund. As long
as we only spend the return, we ensure that the fund will benefit future generations. In 2020,
withdrawals from the fund accounted for more than one krone in five in the central government
budget. This means that the fund indirectly finances tens of thousands of public sector
employees and ensures that taxes are lower than they would otherwise be. We might say that
Norway has moved from being an oil nation to being an investment fund nation.
The assets in the fund belong to the Norwegian people. The most important decisions, such the
choice of the fund's equity share, are anchored in the Storting (Norwegian parliament). The
Ministry of Finance decides how the fund is to be managed and lays down guidelines in a
mandate for Norges Bank. The Bank is tasked with making investment decisions and exercising
the fund's ownership rights. Norges Bank's Executive Board sets the limits for the Bank's asset
management within the guidelines in the mandate. Operational management and investment
decisions linked to individual companies are the responsibility of the Bank's investment
management organisation - Norges Bank Investment Management (NBIM).
Chart: Management objectives
Central to the mandate is the benchmark index. It is set by the Ministry of Finance and is
constructed on the basis of sub-indexes from external index providers. The benchmark index
divides the funds' assets into global investments in equities and bonds. On the equities side, the
benchmark index comprises 8 000 companies in 47 countries. The Ministry also sets risk limits
for the Bank's asset management. The objective of the management of the fund is to achieve the
highest possible return net of costs within the limits set in the mandate.
Chart: Enhanced indexing
The fund's investment strategy reflects the mandate's requirement to track the benchmark index
fairly closely. Since the fund is subject to an index-tracking requirement, the fund's return largely
follows the return on the benchmark index. Moreover, fluctuations in the benchmark index provide
a good proxy for the risk in the fund. But this does not mean that asset management is
unimportant. On the contrary. Even minor deviations from the benchmark portfolio can have a
large impact over time. Since inception, the annual excess return from asset management has
amounted to 24 basis points, or 0.24 percent. Given the fund's current size, the annual excess
return after costs is around NOK 20 billion. This is money worth having.
The Bank's investment strategies
The excess return is a result of hundreds of active decisions made by asset managers. We
make such active choices every single day. To be able to safeguard society's wealth in the best
possible way, these choices must be based on a well founded strategy that seeks to benefit from
the fund's defining characteristics. The fund is among the world's largest and is a global investor.
It also has a very long investment horizon and a limited need for liquidity. These are the
characteristics that we must try to make the most of to achieve excess returns. The Bank's
investment management organisation has built up unique experience in this work after having
managed the fund for over 20 years.
The risk in the active part of asset management is diversified across sub-strategies. These
substrategies complement one another. This means that the different sub-strategies cannot
automatically be assessed in isolation, precisely because they are part of an integrated
diversification strategy.
Chart: Contribution to relative return by strategy
This table shows relative return by main strategies in the period between 2013 and 2019. It
illustrates how the different strategies have influenced excess return from our management of
the fund. I would now like to spend a little time commenting on some of these figures.
The first observation we can make is that the different strategies have contributed differently to
excess return. The contributions of some strategies have been negative, while the contributions
of others have been positive.
The second observation we can make is the relatively high contribution to excess return from our
enhanced index strategies. This strategy is not passive. It requires active decisions, every single
day. It is up to NBIM's equity and fixed income traders to decide on the details of purchases. They
must decide when, where and how trades are to be made. Such choices affect day-to-day asset
management - also where indexes are tracked the closest. The organisation trades on over 250
exchanges and sees to settlement, valuation, custody and risk management. In 2019, we
executed around 30 million equity trades, or an average of approximately 100 000 trades per day.
This is more than all of Oslo Børs. Trading runs full steam around the clock, despite large
operational challenges owing to the Covid-19 pandemic and considerable market volatility.
Allocation divides the fund's assets among asset classes and markets. As a part of this, a
relatively substantial negative contribution to the fund's return has come from our fixed income
investments in emerging markets. Our experience is that we have not been paid enough for the
risk to which some of these markets are exposed. In 2019, the Ministry of Finance decided that
fixed income securities in emerging markets would no longer be a part of the fund's benchmark
index.
The Covid-19 year 2020 has been a peculiar one. When the pandemic spread in March, global
exchanges fell sharply. Since then they have recovered to a great extent, but there are
considerable differences across sectors. The real estate sector has been particularly hard hit,
along with some services. At the other end of the scale, we find the tech giants. The news of a
vaccine breakthrough has generated renewed optimism in equity markets in recent weeks.
In spite of the turbulence and large market movements, the overall value of the fund has held
steady, also in USD terms. We have avoided large losses - in both absolute terms and relative
to the benchmark index against which the fund is compared. But volatility has been high through
the year, and it remains to be seen where we end up.
One characteristic of developments over the past seven years has been the solid results from
the more traditional part of our active management - security selection. As we see in the table,
our external asset managers have performed particularly well.
In my view, these results are linked to the key words appearing in the title of today's speech:
Responsible investment and active ownership. The fund's size and long horizon are unique
characteristics that have an impact on this part of asset management. I would therefore like to
spend a little time going into these areas in detail
Responsible investment
The work in the area of responsible investment has undergone substantial changes since the
fund began investing in equities in 1998. From the start, the approach was that the fund should
be invested in the world as it is. At that time, the fund was not supposed to exercise ownership
rights. As the fund has grown, its size and international position have made such an approach
virtually impossible.
In 2004, on the basis of discussions in the Storting, the Ministry of Finance laid down ethically
motivated guidelines for the observation and exclusion of companies from the fund. Today, the
fund must not be invested in companies that produce certain types of weapons, base their
operations on coal, or produce tobacco. Nor shall the fund be invested in companies whose
activities otherwise contribute to violations of fundamental ethical norms.
In 2004, the Ministry also established an independent Council on Ethics to make ethical
assessments of companies. Following a change in 2015, the Council on Ethics sends its
recommendations to Norges Bank. The decision is taken by Norges Bank's Executive Board,
which is tasked with assessing the policy tool that is most appropriate. At the end of 2019, 134
companies had been excluded from the fund's investment universe.
Chart: Responsible investment
But the fund's responsible investment involves more than merely questions of what we
will not own. Our key policy tool is the exercise of our ownership rights in companies. As owner,
we have both rights and obligations.
The exercise of ownership rights rests on the fund's long-term perspective, the Bank's long-term
investment horizon, which is one of the fund's defining characteristics. Value creation in the long
term depends on how well the companies are managed, on business models that are
sustainable, as well as on markets that are well functioning, legitimate and efficient.
As a large, long-term owner, we are ethically obliged to exercising ownership rights actively.
Voting is the most important tool we have. Each year, we vote on around 115 000 individual
proposals at nearly 12 000 annual general meetings. That is, to put it in somewhat exaggerated
terms, we must make 115 000 choices. In order to protect our investments in a systematic
manner, we have formulated expectations, guidelines and positions. We base our ownership
work on these public documents.
In order to make good choices, we need to know the companies well. For our long-term work to
succeed, we need to have an active relationship with as many companies as possible. We
conduct more than 3500 meetings with close to 2000 companies in the course of a year. In these
discussions, we bring up matters such corporate governance and sustainability that are relevant
to the fund's long-term return. At the same time, our ownership work can also lead to investment
decisions. This underpins our ownership work.
Responsible investment requires active ownership. Active management and active ownership
are closely related.
The Bank's investment management organisation analyses these companies thoroughly, in
order to identify long-term investment opportunities, reduce the Bank's exposure to undesirable
risk and the like. We use such analyses in order to safeguard the portfolio. There are companies
where we prefer not to be an owner. If we see that a company has a business model that we do
not regard as sustainable, it may lead to divestment. But unlike the ethically justified divestments,
these risk-based divestments are justified by purely commercial considerations.
All together, the fund has made risk-based divestments of 282 companies since 2012. The first
divestments were of palm oil companies, whose activities entail destruction of rainforests. Since
then, the fund has divested of a number of other companies, where the common denominator
has been that we have observed inadequate management of risks such as those related to the
environment and climate change, corruption and human rights.
Chart: Return effects of risk-based divestments
Our experience from this work has been favourable. We exploit the fund's characteristics,
primarily its long-term horizon, to reduce risk and - in any case as it appears today - also to
improve the fund's return. Since 2012, risk-based divestments have contributed to increasing the
return by an amount equivalent to around 0.27 percentage point of the value of the fund's equity
portfolio, measured against the benchmark index. This is the equivalent of around NOK 7 billion.
While risk-based divestments concern companies that we prefer not to invest in, there are other
companies that we want more of. These are companies that, in our opinion, provide opportunities
for solid returns in the longer term.
In the mandate, the Ministry of Finance has also set a requirement for the Bank to establish
separate environment-related investment mandates. At the end of 2019, these mandates
amounted to NOK 79 billion invested in 77 companies and bonds. In 2019, the Ministry also
decided to permit unlisted investments in renewable energy infrastructure. NBIM has a group in
place that has begun to seek out opportunities in this sector. We set the same risk and return
requirements for the investments under these mandates as for the rest of the fund's
investments.
Everything we do in the area of ownership is, and must be, a result of an active approach. In our
active management, we seek at all times to make the most of analyses we have performed and
the knowledge we have acquired over the past 20 years. Our internal asset managers closely
follow the largest European companies in particular. Knowing the companies well puts the fund
in position where it is possible to earn excess returns.
External management
In emerging markets, we benefit greatly from our use of external asset managers. Knowledge of
and proximity to markets are essential for being able to assess the risk of investments. In view of
challenges associated with responsible investment, a passive investment strategy is not really
appropriate in these markets. This is an area where active choices must be made.
We look at the choice of external asset managers as an investment decision. Since 1998, we
have invested through 319 different external active equity managers. To retain their mandates,
they must show over time that they can identify profitable investments. They must also take
responsible investment into account. The fund's size and breadth enable us to follow up the
external asset managers systematically over time. Internally, we employ portfolio managers who
perform their own analyses and monitor the external asset managers' portfolios. All aspects of
the activities of these managers are evaluated to ensure that they meet our requirements and
expectations.
Chart: Net relative return. External asset managers
We get back much more from external asset managers than we have paid for their services. In
the period to 2019, cumulative excess return after costs associated with external mandates has
been NOK 48 billion. The results have exceeded expectations. At the same time, these
investments spread the fund's risk across more markets. External asset managers also help the
fund to steer clear of problematic business models and companies and sectors with weak
ownership structures. It would have been difficult to achieve without local knowledge.
The Executive Board intends to raise the limit for the external management mandates to 5
percent of the fund next year.
Conclusion
The fund has become larger than anyone could have imagined only a few years ago. How we
manage the fund in the best way possible and ensure that its assets benefit current and future
generations alike is a question that is more relevant than ever.
A part of the answer is to make the most of the fund's defining characteristics - size, liquidity and
long-term horizon - to create excess return. The experience of the past 20 years shows that this
is possible.
As a large, long-term investor, we manage the fund responsibly. This requires active ownership.
We engage in dialogue with companies worldwide in order to improve their long-term earnings
and weed out companies with business models that are not sustainable. Here we must also take
active investment decisions.
Such a large fund cannot be managed passively. Responsible investment requires active
ownership. Active management and active ownership are closely related. This interaction has
huge potential.
Active management entails risk. To mitigate this risk, the Bank's Executive Board and investment
management organisation have established a set of investment strategies. These strategies
complement one another and constitute a whole. Over time, they have yielded excess returns,
well within the risk limits set in the Bank's mandate.
Finally, we depend on the people in the organisation to achieve our set objectives. Many of our
asset managers have built up unique expertise by monitoring companies closely through many
years' work. Others contribute ideas and approaches to developing new methods and analyses.
Still others help to make choices large and small every day to create excess returns. The
employees of Norges Bank Investment Management can be proud of their expertise and their
efforts on behalf of the fund, the Bank and the country. I am certain that they will do their utmost
to succeed even better in the years to come.
Thank you for your attention.