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Norges Bank Investment Management

Rationale for the Strategic Asset Allocation in the Norwegian

Government Petroleum Fund

Presentation to The Actuarial Profession Investment Conference,

26 June 2000 by Knut N. Kjær,Norges

Bank Investment Managementwww.norges-bank.no [email protected]

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Agenda

• Background - Norway, oil and fund

• Strategic issues

• The benchmark composition

• Division of responsibilities

• Strategy to achieve excess performance

• Results

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Norway at a glance

• Population 4.5 mill.• GDP $ 155 bill. • GDP/person $ 34,600 • Surplus at the central government budget:

$ 15.5 bill. 10% of GDP

• Surplus at the current account: $ 17.8 bill.

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The petroleum sector

• Norway is the world’s second largest net exporter of oil

• Value added in production of petroleum is 16 percent of GDP

• Petroleum exports representis 43 percent of total exports

• 10 percent of the government petroleum revenues will be spent on the central government budget in 2000

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The Petroleum Fund

• The Government Petroleum Fund was established by law in 1990

• The inflow to the Fund is the yearly surplus of the central government account

• The first transfer occurred in May 1996 • The fund is not formally a pension fund but is used

by the government to manage the budget surplus / deficit

• The fund may become an important tool for coping with the financial challenges connected with an ageing population and declining oil revenues

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Growth of the Petroleum Fund

0

20

40

60

80

100

120

1996

1997

1998

1999

2000

2001

2002

2003

2004

Capital (Bill. USD)Net budget surplus Estimate

s

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Strategic issues

• From petroleum to financial assets

• Macroeconomic concerns

• Pension system and expenditures

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From petroleum to financial assets

• Investments in the Petroleum Fund represent a diversification of national wealth from petroleum in the ground to financial assets

• Simple efficient frontier analysis based on historical data shows that this transformation reduces risk and increases return

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Petroleum and financial wealth

0

50

100

150

200

250

1970 1980 1990 2000 2010 2020 2030 2040 2050

Illustration from Government Long Term Programme 1997

Pe

rce

nta

ge

of

GD

P

Financial w ealth

Petroleumw ealth

Sum

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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

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Macroeconomic concerns

• How much of the petroleum revenues can be used in the mainland economy?

• How can one avoid turning the Petroleum Fund investments into a “second budget”, undermining the role of the parliament in the ordinary budget process?

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Use of the Petroleum Fund

• Petroleum Fund Act:

– The capital of the Fund may only be used for transfers to the central government budget pursuant to a resolution by the Storting (Norwegian parliament). The capital of the Fund may not be used for any other purpose, including the provision of credit to central government or to private sector entities.

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Why does the Fund invest abroad?

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

• Monetary policy concern– The petroleum activity yields substantial currency

income

– Accumulation of foreign reserves counteracts appreciation of the currency

• Sector balance concern– Real appreciation would shift resources to non-

competitive sectors ; avoid “Dutch disease”

• Investment concern – Better return on risk abroad

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0 %

20 %

40 %

60 %

80 %

100 %

1995 1996 1997 1998 1999 2000

Share of government petroleum income invested in the Petroleum Fund

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Pension system and expenditures

• The core of the Norwegian pensions are publicly financed

• The public pension system is a two tier compulsory system

• The public pension expenditures will almost double as a share of GDP over the next 30 years

• While the petroleum revenues must be expected to decrease significantly

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Net cash flow from petroleum sector and pension expenditures (% of GDP)

02468

1012141618

1970 1980 1990 2000 2010 2020 2030 2040 2050

%

Pension expenditures

Petroleum revenues

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The benchmark composition

• Following from the strategic background:The Fund shall only invest in financial assets abroad

• Important issues in deciding the investment strategy-Asset classes and asset allocation-Regional allocation-Risk tolerance

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Strategic asset allocation

• 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)

• Two implications– should not focus on short-term fluctuations

in return– should not measure return in Norwegian

kroner• The strategy was changed in January 1998 to

include equities

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Asset classes

• Fixed income: At least 90 per cent of the bond portfolio shall be securities with a government guarantee and the last 10 per cent must be of investment grade quality

• Private equities and properties are not yet considered

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OLD (UNTIL NEW (AFTER31.12.97) 31.12.97)

Fixed income 100% 60%Equity 40%

Number of markets 8 21

Europe: 75% 50%America: 18% 30%Asia: 7% 20%

Regional weighting Trading weights FI: GDPscheme Eq: market cap

Tracking error: 1.5%

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Determining the equity portion

• “Using these historical returns (1926-1990), it would take 139 years of investing in Treasury bills to double one’s real wealth while it would take only 11 years of stock investment” Siegel (1992)

• In 1997, Norges Bank advised the Ministry of Finance to invest in equities

• The benchmark weight of 40 per cent can be viewed as the owners’ return-to-risk preference

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Country allocation

• As always: A trade-off between return and risk

• Return – assume that expected returns in the long run are

equal in all (industrial) countries

• Risk - a compromise between– Hedge for currency risk of imports– Diversification of market risk– Diversification of national wealth

• Size of the markets could be a restriction

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Regional weights mainly determined by GDP-weights:

Americas Europe Asia

Old guidelines 18 75 7

Import weights 10 81 9

GDP weights 42 38 20

Market weights - bonds 33 47 20

Market weights - equities 55 32 13

New guidelines 30 50 20

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Country weights within regions

• Equities: Market capitalisation weightsFTSE index

• Fixed Income: GDP weightsSalomon Smith Barney Government Bond index

• Emerging markets included in the investment universe from 1 January, 2000. Not in the benchmark yet.

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Benchmark for the Petroleum Fund

Benchmark

Equities 40 % Bonds 60 %

America

30 %

Europe

50 %

Asia and Oceania

20 %

America

30 %

Europe

50 %

Asia and Oceania

20 %

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The risk tolerance given in the Fund Management Mandate

• Direct restrictions on asset allocation

• Limits on expected deviations from the benchmark portfolio

• Bond duration between 3 and 7

• Maximum 3 per cent ownership of any one company

• Limits on credit risk

• General clause: Norges Bank shall ensure that satisfactory risk systems and control routines exist for those instruments to be used in the management of the Fund

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Expected tracking error

• Tracking error as a risk measure is used to limit the difference in expected return between the actual portfolio and benchmark

• An upper limit of tracking error implies that the actual return with a certain probability will vary within a band around the return of the benchmark

• Maxium expected tracking error is 1.5 per cent

• Expected tracking error is calculated based on historical fluctuations in the price of individual securities and on the correlation in price changes between individual securities

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Division of responsibilities

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Petroleum Fund - Division of responsibilities

• Owner: Ministry of Finance– Strategic asset

allocation and investment universe

– Benchmarks

– Risk limits

– Evaluates manager (uses consultant)

– Reports to Stortinget

• Manager: Norges Bank– Achieve as high return

as possible given investment mandate and restrictions

– Risk control

– Reports to MOF

Adviser: Norges Bank

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Properties of the fund management model

• Accountability

• Transparency

• Focus on the contribution to value added in the operational management

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Organisation within Norges Bank

• Norges Bank Investment Management (NBIM) was established as a separate investment management unit in 1998 - with “Chinese walls” to the ordinary central bank functions

• NBIM manages the Petroleum Fund, the Petroleum Insurance Fund and the long- term portfolio of the foreign exchange reserves (more than NOK 400 bn in all)

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Strategy to achieve excess performance

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Ambition: Outperform the benchmark portfolio

– Excess return should be higher than extra costs associated with active management

– Outperformance must be achieved at lowest possible risk

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Excess return at lowest possible extra cost

• Distinguish between index management and active management

• The core of the portfolios is index-managed

Low management and transaction costs

Forms a basis for focused active management

• Active managers are to take advantage of competitive edges and take risks - performance-based fees

• Continuous monitoring of transaction costs

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Highest possible return at lowest possible risk

• Many small positions rather than a few large ones

• Greatest possible independence in position-taking

• Specialisation of expertise

• Reasonably safe revenues receive highest priority

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Independence in position-taking

• Division into three management units

• Each of these are involved in both external and internal management

• In choosing external managers, great emphasis is placed on diversification

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The basic investment decision is allocation of risk units

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Tacticalasset

allocation

Equities Fixedincome

Ris

k u

nit

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External

Internal

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Organisation of management (1)

Internal management• Lending/repos - fixed income instruments• Futures overlay - risk management• Active funding of managers and investing of new

capital into the market (transition)• Enhanced index management (equities and fixed-i

ncome instruments)• Active management in selected areas

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Organisation of management (2)

External management• External index management of equities (internal c

apacity for index management of fixed-income instruments)

• External active management to achieve increased breadth in focused position-taking

• External lending arrangement for equities

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Manager selection: 4 main groups of criteria

• Management ability

• Expected performance

Organisation Track record Inv.controlsAssets/clients

Pf constructionResearch Pf implementation

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External managers today

• 2 global index equity managers

• 7 active equity managers, 9 mandates - one manager is a sector specialist

• Trend in equity management: sector focus

• 3 global fixed income managers

• 2 - 3 tactical asset allocation mandates from third quarter

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Monitoring external managers

• Daily transfer of data on transactions and holdings via our global custodian to Norges Bank's Investment Management data records

• Programme for continuous monitoring: - Compliance with guidelines

- Analysis of results (attribution)- Valuation analysis- Risk analysis- Monitoring of transactions/costs

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External management Internal management

Norges BankBack Office

Custody

PerformanceOtheruses

Risk models

Fixed dataMarket feeds

Manager 2

Manager n

Manager 1

Manager 2

Manager 1

Manager n

Information flows

DATAWAREHOUSE

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Real Time AttributionECONOMIC SECTOR

Average AveragePercent Total Percent Percent Total Percent Percent Total Percent

Cap Return Contrib Cap Return Contrib Cap Return Contrib

Technology 19.40 24.68 4.59 12.47 25.62 2.96 6.93 -0.94 1.63Communication Services 15.69 33.24 4.81 10.35 28.12 2.62 5.33 5.12 2.19[Unassigned] 1.77 -3.43 -0.04 0.00 0.00 0.00 1.77 -3.43 -0.04Energy 6.08 2.06 0.15 5.01 1.40 0.09 1.07 0.66 0.06Consumer Cyclicals 10.12 19.12 1.92 9.49 13.30 1.25 0.62 5.82 0.67Transportation 0.89 10.85 0.10 1.03 7.81 0.09 -0.14 3.04 0.02Miscellaneous 0.00 0.00 0.00 0.16 6.84 0.01 -0.16 -6.84 -0.01Consumer Staples 9.86 21.97 2.08 10.41 9.61 0.99 -0.55 12.37 1.09Utilities 1.48 0.61 0.00 2.23 -0.22 0.00 -0.75 0.83 0.00Basic Materials 5.43 9.17 0.57 6.32 10.24 0.67 -0.89 -1.07 -0.10Capital Goods 7.62 16.55 1.26 8.88 11.35 1.01 -1.26 5.20 0.25Health Care 3.17 -3.81 -0.14 7.31 -4.04 -0.34 -4.15 0.23 0.20Financials 18.50 6.55 1.25 26.34 6.72 1.78 -7.84 -0.17 -0.53

Total 100.00 16.55 16.55 100.00 11.14 11.14 5.41 5.41

ECONOMIC SECTOR

Security TotalAllocation Selection Interaction Effect Currency Total

Effect Effect Effect Local Effect Effect

Technology 0.97 -0.10 -0.06 0.81 0.00 0.81Communication Services 0.90 0.46 0.22 1.58 0.00 1.58[Unassigned] -0.24 0.00 0.00 -0.24 0.00 -0.25Energy -0.10 0.03 0.02 -0.05 0.00 -0.06Consumer Cyclicals 0.02 0.54 0.03 0.58 0.00 0.58Transportation 0.01 0.04 0.00 0.05 0.00 0.05Miscellaneous 0.01 0.00 0.00 0.01 0.00 0.01Consumer Staples 0.03 1.24 -0.11 1.16 0.00 1.16Utilities 0.09 0.03 -0.02 0.10 0.00 0.10Basic Materials 0.01 -0.04 0.02 -0.01 0.00 -0.01Capital Goods 0.00 0.46 -0.06 0.39 0.00 0.39Health Care 0.68 0.04 -0.02 0.71 0.00 0.71Financials 0.35 -0.03 0.02 0.34 0.00 0.34

Total 2.71 2.66 0.05 5.42 -0.01 5.41

MANAGER EUROPE EX UK PORTFOLIO VARIATION

ATTRIBUTION ANALYSIS

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Results

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The Government Petroleum Fund 1997-99

1997 1998 1999 97-99Actual return 9,1 9,3 12,4 10,2

Inflation 1,8 1,0 1,2 1,3

Real return 7,2 8,2 11,1 8,8

Excess return 0,21 0,20 1,11 0,5

Transfers in billions NOK

60,9 32,8 24,5 165,7incl. 1996

Market valueby the end of the year

113,4 171,8 222,4

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Excess return in the Petroleum Fund

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1998 1 1998 2 1998 3 1998 4 1999 1 1999 2 1999 3 1999 4 2000 1

Per c

ent

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Expected tracking error

• Maximum expected tracking error is 1.5 per cent

0

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60

70

80

90

31-Dec

07-Jan

14-Jan

21-Jan

28-Jan

04-Feb

11-Feb

18-Feb

25-Feb

03-Mar

10-Mar

17-Mar

24-Mar

31-Mar

Equities

Total

Fixed income

Basis points

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Management costs

1999 1998

Equity management 0.l45 0.082

Fixed income man. 0.048 0.039

Total 0.087 0.052

Measured as a percentage of the average portfolio

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The Fund’s Equity Assets 31 December 1999

• Number of companies 2025of which included in the FTSE index 1880 (93%)

• Average holding 46 mill. (NOK)

• Largest single holding Nokia, 1,445 mill. (ownership 0.086%)

• Largest ownership share Buhrmann NV, 0.67%(holdings 62 mill. )

• Share of total marketcapitalisation 0.039%

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Website: www.norges-bank.no