BiV/October 2004

Investment strategy for the Petroleum Fund

Lecture at UiO

October 6, 2004

Birger Vikøren

Norges Bank

www.norges-bank.no

BiV/October 2004

Norges Bank’s organization

Governor

Financial stabilityInvestment management

Staff

Monetary policy

Support/services

Board

BiV/October 2004

Outline

• Background of the Fund• Portfolio models• Equity portion• Regional allocation • Currency risk• Active management

BiV/October 2004

Background of the Fund

BiV/October 2004

The petroleum sector and the Norwegian economy (in 2003)

• Share of Norwegian export: 43 per cent

• Share of government revenue: 27 per cent

• Share of GDP: 20 per cent

• Share of employees: 1 per cent

BiV/October 2004

The Petroleum Fund: • The Norwegian Government Petroleum Fund was established

by law in 1990

• The inflow to the Fund is the the central government budget surplus each year

• The first transfer occurred in May 1996

• The size of the fund is now more than 130 billion USD (third largest fund in the world), and it is growing rapidly

• The fund is invested in financial assets outside Norway

BiV/October 2004

The main purposes of the Petroleum Fund:

• A buffer for the government budget to shelter the domestic economy from volatility in petroleum revenue

• An instrument for meeting the long-term challenges of a combination of an expected decline in petroleum resource revenue and an increase in government pension expenditures

BiV/October 2004

Transfers from the Government Petroleum Revenue

State net cash flow from Petroleum

0.0

50.0

100.0

150.0

200.0

250.0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Bil

lio

n 2

002

NO

K

Transfers to the Petroleum Fund

Financing budget defisits

BiV/October 2004

The Government Long Term Programme 2002-2005

Net cash flow from the petroleum sector and pension expenditures (per cent of GDP)

0

3

6

9

12

15

18

1970 1980 1990 2000 2010 2020 2030 2040 20500

3

6

9

12

15

18Pension expenditures

Net cash flow from thepetroleum sector

BiV/October 2004

Why is the Fund invested abroad?

• Budget concern• The Petroleum Fund should not be a second budget

• Investment concern• The Fund does not affect international rates of return - better

returns abroad

• Monetary policy concern• The petroleum activity yields substantial currency incomes• Accumulation of foreign reserves in the Fund counteracts appreciation

of the currency

• The Fund as a buffer• Drawing on a domestic fund could destabilize the economy when

activity is low

BiV/October 2004

The size of the Petroleum Fund in an international perspective

BiV/October 2004

Norway’s national wealthPercentage distribution

6.51.2 0.6

6.613.315.6

79.676.6

0

10

20

30

40

50

60

70

80

Oil and gas Financialassets

Fixed assets Humancapital

19972030

BiV/October 2004

Experiences: Spain in the 1600s

• “Spain, in other words, became (or stayed) poor because it had too much money. The nations that did the work learned and kept good habits, while seeking new ways to do the job faster and better. The Spanish, on the other hand, indulged their penchant for status, leisure, and enjoyment (...).”

• ”Easy money is bad for you. It represents short-run gain that will be paid for in immediate distortions and later regrets.”

– David Landes: “The wealth and poverty of nations”

BiV/October 2004

The investment strategy could be divided into:

• Long-term (passive) investment strategy– Strategic Asset Allocation (SAA)

– reflected in the benchmark

• Short-term (active) investment strategy– deviation from the benchmark

– increase returns

– reduce costs

BiV/October 2004

Petroleum Fund - Division of responsibilities

• Owner: Ministry of Finance– Passive investment strategy

– Strategic asset allocation and investment universe

– Benchmarks

– Risk limits

– Evaluates manager (uses consultant)

– Reports to the Parliament

• Manager: Norges Bank– Active investment strategy

– Achieve higher return than benchmark given investment mandate and restrictions

– Risk control

– Reports to MOF

– Give advice to MOF on Strategic Asset Allocation

BiV/October 2004

Strategic asset allocation depends on:

• Purpose of the Fund• “In terms of the Petroleum Fund, it is natural to apply a long

investment horizon and to recognize the importance of preserving the Fund's international purchasing power". (Revised National Budget 1997)

• Owner’s risk tolerance

• The expected return and risk of the various assets classes

BiV/October 2004

Benchmark

Equities 40 % Bonds 60 %

America/Asia50 %

Europe50 %

America35 %

Europe55 %

Asia10 %

BiV/October 2004

Portfolio models

BiV/October 2004

Portfolio models

• The portfolio choice is based on expected return, variance (risk) and risk tolerance

• The efficient front and indifference curves are based on subjective assessments

• Portfolio choice is sensitive to changes in input

• Investment horizon and availability of data

BiV/October 2004

Efficient front

M inim ize :

jiijj

n

i

n

jip ww

1 1

2

G ive n :

n

iiip REwRE

1

)()( ,

11

n

iiw ,

S ho rt-sa le co n stra in t:

10 iw , fo r a ll i

BiV/October 2004

Return

Risk

Risk preferences II

Efficient frontierRisk preferences I

BiV/October 2004

Return

Risk

It follows from this model that the degree of risk aversion determines the allocation between risk free rate and market portfolio (which has a fixed allocation between bonds and stocks)

Asset allocation puzzle: The degree of risk aversion should determine the allocation between bonds and stocks

BiV/October 2004

Efficient frontier

BiV/October 2004

Efficient frontier1993-1997 1998-2002

Return stocks 15.46 -0.63Return bonds 8.63 5.70Risk stocks 9.83 17.84Risk bonds 3.38 3.09Correlation 0.42 -0.38

-2

0

2

4

6

8

10

12

14

16

18

0 2 4 6 8 10 12 14 16 18 20

1998-2002 1993-1997

100% bonds

100% stocks

100% stocks

BiV/October 2004

Equities

Government

bonds

Non - govt.

bonds

Real

estate

A global market cap portfolio

BiV/October 2004

Market cap weighted bonds and equity portfolios are time-varying!

Stocks

0

10

20

30

40

50

60

70

jan.86

jan.87

jan.88

jan.89

jan.90

jan.91

jan.92

jan.93

jan.94

jan.95

jan.96

jan.97

jan.98

jan.99

jan.00

jan.01

jan.02

US

Europe

Japan

Government bonds

0

10

20

30

40

50

60

70

jan.85

jan.87

jan.89

jan.91

jan.93

jan.95

jan.97

jan.99

jan.01

US

Europe

Japan

BiV/October 2004

Equity portion

BiV/October 2004

Determinig the equity portion

• What is the return on equity investment (the equity premium puzzle)

• How should we assess the risk associated with equity investment

• Is the optimal equity portion independent of the investment horizon?

BiV/October 2004

CAPM

FmiFi RRERRE )()(

w h e r e :

FR - r i s k f r e e r a t e

)( mRE - e x p e c t e d r e t u r n o n m a r k e t p o r t f o l i o

2)var(

),cov(

m

im

m

mii R

RR

- s y s t e m a t i c r i s k o n a s s e t ” i ”

BiV/October 2004

BiV/October 2004

BiV/October 2004

Return on US bonds and stocks, 1926-2002

-60

-40

-20

0

20

40

60

1926

1931

1936

1941

1946

1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

Obligasjoner Aksjer

BiV/October 2004

Rolling fixed window (10 years)

-5

0

5

10

15

20

25

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

Pro

sent

Aksjeavkastning Obligasjonsavkastning

Gj snitt (1926-2002) Gj snitt (1926-2002)

BiV/October 2004

Equity premium(rolling fixed window (3, 5 and 10 years))

-40

-30

-20

-10

0

10

20

30

40

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

10 år 5 år 3 år

BiV/October 2004

Equity premium in 9 countries1900 - 2002 (average annual return)

-40 %

-30 %

-20 %

-10 %

0 %

10 %

20 %

30 %

US

A

Ca

na

da

UK

Ita

lia

Ne

de

rl.

Ty

sk

lan

d

Fra

nk

rik

e

Sv

eit

s

Ja

pa

n

1900-2000

1995-1999

2000-2002

BiV/October 2004

Dividend discount model (DDM):

T

tt

t

y

CFB

10 )1(

1

~

0 )1(tt

t

rpy

CFEP ,

A s s u m e c o n s t a n t g r o w t h r a t e ( g ) i n d i v i d e n d ( D ) :

grpy

D

rpy

gDP

tt

t

0

1

00 )1(

)1(.

gP

Drpy

BiV/October 2004

Three reasons for an increase in equity prices:

• Lower interest rates (y)• Reduced risk premium (rp)• Higher dividend (and

earnings) growth (g)

• Could also be a “bubble”

grpy

DP

BiV/October 2004

How to use the DDM

• Y, D and P is observable

• rp, g and Pfair are unobservable

• Q1: What should dividend (and earnings) growth be to justify current pricing?

• Q2: For given g, what rp is implied in current pricing?

• Q3: For given g and rp, what is fair price?

grpy

DP

ygP

Drp

P

Drpyg

fair

BiV/October 2004

Dividend/Price ratios in the US

Current D/P ratio in the US could indicate a positive, but low equity premium going forward

BiV/October 2004

Time-varying correlation

BiV/October 2004

Time-varying risk

BiV/October 2004

0

5

10

15

20

25

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

05101520253035404550

1 year (left axe) 5 year (right axe)

Portfolio risk

• Mean reverting equity returns implies that equity investments are less risky at long investments horizons

USA 1926 - 2000

BiV/October 2004

Siegel (1998): US data from 1802 to 1997

Investmenthorizon

1 år 5 år 10 år 30 år

Equity portionthat minimizerisk

7% 25% 40.6% 71.3%

BiV/October 2004

Regional allocation

BiV/October 2004

Relationship between return differentials and exchange rate changes in bond markets in the US, Japan and Europe

Exchange rate changes and return on American and Japanese bonds

50

100

150

200

250

jan.86

jan.87

jan.88

jan.89

jan.90

jan.91

jan.92

jan.93

jan.94

jan.95

jan.96

jan.97

jan.98

jan.99

jan.00

jan.01

jan.02

Exchange rate index (USD/JPY) Relative return index (USD/JPY)

Exchange rate changes and return on American and European bonds

50

100

150

200

jan.86

jan.87

jan.88

jan.89

jan.90

jan.91

jan.92

jan.93

jan.94

jan.95

jan.96

jan.97

jan.98

jan.99

jan.00

jan.01

jan.02

Exchange rate index (USD/EUR) Relative return index (USD/EUR)

US and Japanese bonds US and European bonds

BiV/October 2004

Relationship between return differentials and exchange rate changes in equity markets in the US, Japan and Europe

Exchange rate changes and return on American and Japanese stocks

0

100

200

300

400

500

600

700

800

jan.86

jan.87

jan.88

jan.89

jan.90

jan.91

jan.92

jan.93

jan.94

jan.95

jan.96

jan.97

jan.98

jan.99

jan.00

jan.01

jan.02

Exchange rate index (USD/JPY) Relative return index (USD/JPY)

Exchange rate changes and return on American and European stocks

50

100

150

200

jan.86

jan.87

jan.88

jan.89

jan.90

jan.91

jan.92

jan.93

jan.94

jan.95

jan.96

jan.97

jan.98

jan.99

jan.00

jan.01

jan.02

Exchange rate index (USD/EUR) Relative return index (USD/EUR)

US and Japanese equities US and European equities

BiV/October 2004

Correlation coefficients for selected countries in the Fund's bond portfolio (in local currency) in the period 1994-2001. The colour code for the correlation coefficients is: Red: 0.75-1, Pink: 0.50-0.74, Green: 0.25-0.49, Blue: < 0.24

US 1 0.77 0.23 0.68 0.65 0.77 0.79 0.77 0.78 0.69Canada 0.77 1 0.22 0.77 0.65 0.69 0.70 0.69 0.70 0.69

Japan 0.23 0.22 1 0.26 0.31 0.14 0.11 0.14 0.15 -0.13Australia 0.68 0.77 0.26 1 0.72 0.58 0.57 0.58 0.60 0.54NewZealand 0.65 0.65 0.31 0.72 1 0.71 0.70 0.71 0.72 0.60

Netherlands 0.77 0.69 0.14 0.58 0.71 1 0.99 1.00 1.00 0.81Italy 0.79 0.70 0.11 0.57 0.70 0.99 1 0.99 0.99 0.81France 0.77 0.69 0.14 0.58 0.71 1.00 0.99 1 1.00 0.81Germany 0.78 0.70 0.15 0.60 0.72 1.00 0.99 1.00 1 0.81UK 0.69 0.69 -0.13 0.54 0.60 0.81 0.81 0.81 0.81 1

US Can Jap Aust NewZ Neth Ital Fran Germ UK

BiV/October 2004

Correlation coefficients for selected countries in the Fund's equity portfolio (in local currency) in the period 1994-2001. The colour code for the correlation coefficients is: Red: 0.75-1, Pink: 0.50-0.74, Green: 0.25-0.49, Blue: < 0.24.

US 1 0.77 0.54 0.56 0.49 0.37 0.48 0.62 0.62 0.57 0.57 0.73 0.52 0.71 0.73 0.79Canada 0.77 1 0.61 0.58 0.40 0.37 0.40 0.62 0.62 0.52 0.55 0.67 0.52 0.71 0.68 0.70Mexico 0.54 0.61 1 0.57 0.39 0.41 0.36 0.54 0.55 0.51 0.40 0.50 0.34 0.49 0.44 0.56Brasil 0.56 0.58 0.57 1 0.54 0.32 0.30 0.45 0.51 0.60 0.51 0.55 0.50 0.62 0.60 0.59

Japan 0.49 0.40 0.39 0.54 1 0.32 0.40 0.33 0.38 0.44 0.31 0.50 0.35 0.47 0.48 0.44Taiwan 0.37 0.37 0.41 0.32 0.32 1 0.46 0.38 0.38 0.31 0.33 0.33 0.32 0.34 0.40 0.34Korea 0.48 0.40 0.36 0.30 0.40 0.46 1 0.52 0.50 0.41 0.45 0.36 0.29 0.39 0.35 0.56HongKong 0.62 0.62 0.54 0.45 0.33 0.38 0.52 1 0.81 0.63 0.48 0.50 0.22 0.43 0.49 0.58Singapore 0.62 0.62 0.55 0.51 0.38 0.38 0.50 0.81 1 0.58 0.55 0.55 0.33 0.51 0.51 0.59Australia 0.57 0.52 0.51 0.60 0.44 0.31 0.41 0.63 0.58 1 0.57 0.59 0.44 0.48 0.55 0.66NewZealand 0.57 0.55 0.40 0.51 0.31 0.33 0.45 0.48 0.55 0.57 1 0.55 0.44 0.52 0.53 0.62

Netherlands 0.73 0.67 0.50 0.55 0.50 0.33 0.36 0.50 0.55 0.59 0.55 1 0.68 0.84 0.84 0.80Italy 0.52 0.52 0.34 0.50 0.35 0.32 0.29 0.22 0.33 0.44 0.44 0.68 1 0.75 0.70 0.59France 0.71 0.71 0.49 0.62 0.47 0.34 0.39 0.43 0.51 0.48 0.52 0.84 0.75 1 0.84 0.76Germany 0.73 0.68 0.44 0.60 0.48 0.40 0.35 0.49 0.51 0.55 0.53 0.84 0.70 0.84 1 0.71UK 0.79 0.70 0.56 0.59 0.44 0.34 0.56 0.58 0.59 0.66 0.62 0.80 0.59 0.76 0.71 1

US Can Mex Bra Jap Taiw Kor HK Sing Aust NewZ Neth Ital Fran Germ UK

BiV/October 2004

Correlation between regions

Correlations between bond markets(measured in local currency, 60 month window)

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

jan.91

jan.92

jan.93

jan.94

jan.95

jan.96

jan.97

jan.98

jan.99

jan.00

jan.01

US,Japan

US,Europe

Japan,Europe

Correlations between stock markets(measured in local currency, 60 month window)

00.10.20.30.40.5

0.60.70.80.91

jan.91

jan.92

jan.93

jan.94

jan.95

jan.96

jan.97

jan.98

jan.99

jan.00

jan.01

US,Japan

US,Europe

Japan,Europe

BiV/October 2004

BiV/October 2004

BiV/October 2004

What is most important for the performance - sector or region

US

0

1

2

3

4

5

6

1994-1997 1998-2001

sector

country

Japan

0

2

4

6

8

10

12

1994-1997 1998-2001

sector

country

Euro-block

0

1

2

3

4

5

6

7

1994-1997 1998-2001

sector

country

UK

0

1

2

3

4

5

6

1994-1997 1998-2001

sec tor

country

LGS XX 21

LSX

BiV/October 2004

Currency risk

BiV/October 2004

Decomposition of the variance of the return on equity and bond investments in the US, Japan and Europe. Monthly data for the period 1986-2001

-20

-10

0

10

20

30

40

50

60

70

US Japan Europe US Japan Europe

Correlation betweenexchange ratechanges and return onstocks and bondsrespectively

Variance of exchangerate changes

Variance of return onstocks and bondsrespectively

BiV/October 2004

Exchange rate model

BiV/October 2004

BiV/October 2004

Interest rate parity

0

50

100

150

200

250

300

350

400

jan.

75

jan.

77

jan.

79

jan.

81

jan.

83

jan.

85

jan.

87

jan.

89

jan.

91

jan.

93

jan.

95

jan.

97

jan.

99

jan.

01

jan.

03

Valutakursindeks (USD/JPY)

Indeks for rentedifferanse (USD-JPY)

0

20

40

60

80

100

120

140

160

180

200

jan

.75

jan

.77

jan

.79

jan

.81

jan

.83

jan

.85

jan

.87

jan

.89

jan

.91

jan

.93

jan

.95

jan

.97

jan

.99

jan

.01

jan

.03

Valutakursindeks (USD/EUR)

Indeks for rentedifferanse (USD-EUR)

BiV/October 2004

Purchasing power parity

BiV/October 2004

Four explanatory variables for exchange rate changes:

• Fundamental: Deviation from PPP• Carry: Nominal interest rate differentials• Business cycle: Changes in business and

consumer confidence• Technical: Difference between spot exchange rate

and 12 month moving average

BiV/October 2004

Explanatory varaiables for EUR/USDFIG 1A: Konjunktur-indikator

Januar 2003: Sterkere euro

-260

-240

-220

-200

-180

-160

-140

-120

-100

Glattet confidence (EUR-USD) Faktisk confidence (EUR - USD)

FIG 1C: Avvik fra likvekts-realvalutakurs (value signal)Januar 2003: Sterkere euro

0

20

40

60

80

100

120

140

160

180

jan.

84

jan.

86

jan.

88

jan.

90

jan.

92

jan.

94

jan.

96

jan.

98

jan.

00

jan.

02

Øvre grense

Gj snitt 10 år

Nedre grense

USD/EUR

FIG 1B: Nominell rentedifferanse (EUR - USD)Januar 2003: Sterkere euro

-8

-6

-4

-2

0

2

4

6

8

jan.

84

jan.

86

jan.

88

jan.

90

jan.

92

jan.

94

jan.

96

jan.

98

jan.

00

jan.

02

Gj.snitt rentediff Faktisk rentediff

FIG 1D: Momentum (teknisk signal)Januar 2003: Sterkere euro

0.60.70.80.9

11.11.21.31.41.51.6

jan.

84

jan.

86

jan.

88

jan.

90

jan.

92

jan.

94

jan.

96

jan.

98

jan.

00

jan.

02

Gj.snitt EUR/USD - 1 år EUR/USD

BiV/October 2004

Accumulated P&L from the model (EUR/USD)

-40

-20

0

20

40

60

80

100

120

140

160ja

n.8

4

jan

.86

jan

.88

jan

.90

jan

.92

jan

.94

jan

.96

jan

.98

jan

.00

jan

.02

Aktive posisjoner Long EUR (naiv posisjon)

BiV/October 2004

Active management

BiV/October 2004

The benchmark is the starting point for the operative management

• The benchmark is defined by the Ministry of Finance

• Norges Bank has ambition to outperform the benchmark within the risk limits set by MoF

• To main alternatives:• index management

• active management

BiV/October 2004

Index management

• Among large international pension funds there is a tendency towards using index management for a large share of the equity portfolio

• Index management is a “standard product”

• Competitive gains seem to be achieved with an increase in the volume under management (economies of scale)

• Management costs are very low

BiV/October 2004

Index management

• Low cost and low risk

100

105

110

115

120

125

130

135

Benchmark

Index management

BiV/October 2004

Active management can be carried out in four different ways:

• by changing the country allocation• by changing the equity portion• within the equity portfolio: by increasing

investments in sectors or companies that are expected to perform better than others

• within the bond portfolio: by changing interest-rate risk or credit risk.

BiV/October 2004

Active management

100

105

110

115

120

125

130

135

140

Benchmark

Index management

Active management

• Not many managers beat the benchmarks consistently over time

• Risk must be controlled

BiV/October 2004

Example: Large US pension funds

BiV/October 2004