Download Managing risk in the Petroleum Fund Presentation to AFIR 2000

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 Management
www.norges-bank.no
[email protected]
Norges Bank Investment Management
Agenda
•
•
•
•
•
Background - Norway, oil and fund
Strategic issues
The benchmark composition
Division of responsibilities
Strategy to achieve excess
performance
• Results
KAPKNK/260600
2
Norges Bank Investment Management
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.
KAPKNK/260600
3
Norges Bank Investment Management
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
KAPKNK/260600
4
Norges Bank Investment Management
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
KAPKNK/260600
5
Norges Bank Investment Management
Growth of the Petroleum Fund
120
100
80
60
40
20
Capital (Bill. USD)
Net budget surplus
KAPKNK/260600
04
20
03
20
02
20
01
20
00
20
99
19
98
19
97
19
19
96
0
Estimates
6
Norges Bank Investment Management
Strategic issues
• From petroleum to financial assets
• Macroeconomic concerns
• Pension system and expenditures
KAPKNK/260600
7
Norges Bank Investment Management
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
KAPKNK/260600
8
Norges Bank Investment Management
Percentage of GDP
Petroleum and financial wealth
250
200
150
Petroleum
w ealth
Sum
100
50
Financial w ealth
0
1970 1980 1990 2000 2010 2020 2030 2040 2050
Illustration from Governm ent Long Term Program m e 1997
KAPKNK/260600
9
Norges Bank Investment Management
Norway’s national wealth
Percentage distribution
79.676.6
80
70
60
50
40
1997
2030
30
20
10
0
13.315.6
6.5
1.2
Oil and gas
KAPKNK/260600
6.6
0.6
Financial Fixed assets
assets
Human
capital
10
Norges Bank Investment Management
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?
KAPKNK/260600
11
Norges Bank Investment Management
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.
KAPKNK/260600
12
Norges Bank Investment Management
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 noncompetitive sectors ; avoid “Dutch disease”
• Investment concern
– Better return on risk abroad
KAPKNK/260600
13
Norges Bank Investment Management
Share of government petroleum income invested in the Petroleum Fund
100 %
80 %
60 %
40 %
20 %
0%
1995
KAPKNK/260600
1996
1997
1998
1999
2000
14
Norges Bank Investment Management
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
KAPKNK/260600
15
Norges Bank Investment Management
Net cash flow from petroleum sector and
pension expenditures (% of GDP)
18
16
14
12
%10
8
6
4
2
0
1970
KAPKNK/260600
Pension expenditures
Petroleum revenues
1980
1990
2000
2010
2020
2030
2040
2050
16
Norges Bank Investment Management
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
KAPKNK/260600
17
Norges Bank Investment Management
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
KAPKNK/260600
18
Norges Bank Investment Management
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
KAPKNK/260600
19
Norges Bank Investment Management
OLD (UNTIL
31.12.97)
NEW (AFTER
31.12.97)
Fixed income
Equity
100%
60%
40%
Number of markets
8
21
Europe:
America:
Asia:
75%
18%
7%
50%
30%
20%
Regional weighting
scheme
Tracking error:
KAPKNK/260600
Trading weights
FI: GDP
Eq: market cap
1.5%
20
Norges Bank Investment Management
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
KAPKNK/260600
21
Norges Bank Investment Management
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
KAPKNK/260600
22
Norges Bank Investment Management
Regional weights mainly determined by
GDP-weights:
KAPKNK/260600
Americas
Europe
Asia
Old guidelines
Import weights
GDP weights
18
10
42
75
81
38
7
9
20
Market weights - bonds
Market weights - equities
New guidelines
33
55
30
47
32
50
20
13
20
23
Norges Bank Investment Management
Country weights within regions
• Equities: Market capitalisation weights
FTSE index
• Fixed Income: GDP weights
Salomon Smith Barney Government
Bond index
• Emerging markets included in the
investment universe from 1 January,
2000. Not in the benchmark yet.
KAPKNK/260600
24
Norges Bank Investment Management
Benchmark for the Petroleum Fund
Benchmark
Equities 40 %
America
30 %
KAPKNK/260600
Europe
50 %
Asia and
Oceania
20 %
Bonds 60 %
America
30 %
Europe
50 %
Asia and
Oceania
20 %
25
Norges Bank Investment Management
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
KAPKNK/260600
26
Norges Bank Investment Management
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
KAPKNK/260600
27
Norges Bank Investment Management
Division of responsibilities
KAPKNK/260600
28
Norges Bank Investment Management
Petroleum Fund - Division of
responsibilities
• Owner: Ministry of
• Manager: Norges
Finance
Adviser: Norges Bank
– Strategic asset
Bank
allocation and
investment universe
– Benchmarks
– Risk limits
– Evaluates manager
(uses consultant)
– Reports to Stortinget
KAPKNK/260600
– Achieve as high return
as possible given
investment mandate
and restrictions
– Risk control
– Reports to MOF
29
Norges Bank Investment Management
Properties of the fund management model
• Accountability
• Transparency
• Focus on the contribution to value added
in the operational management
KAPKNK/260600
30
Norges Bank Investment Management
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 longterm portfolio of the foreign exchange
reserves (more than NOK 400 bn in all)
KAPKNK/260600
31
Norges Bank Investment Management
Strategy to achieve excess performance
KAPKNK/260600
32
Norges Bank Investment Management
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
KAPKNK/260600
33
Norges Bank Investment Management
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
KAPKNK/260600
34
Norges Bank Investment Management
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
KAPKNK/260600
35
Norges Bank Investment Management
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
KAPKNK/260600
36
Norges Bank Investment Management
Risk units
The basic investment decision is
allocation of risk units
35
30
25
20
15
10
5
0
External
Internal
Tactical
asset
allocation
KAPKNK/260600
Equities
Fixed
income
37
Norges Bank Investment Management
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-income instruments)
• Active management in selected areas
KAPKNK/260600
38
Norges Bank Investment Management
Organisation of management (2)
External management
• External index management of equities
(internal capacity for index management of
fixed-income instruments)
• External active management to achieve
increased breadth in focused position-taking
• External lending arrangement for equities
KAPKNK/260600
39
Norges Bank Investment Management
Manager selection: 4 main groups of criteria
• Management ability
Organisation
Assets/clients
Track record
Inv.controls
• Expected performance
Research
KAPKNK/260600
Pf construction
Pf implementation
40
Norges Bank Investment Management
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
KAPKNK/260600
41
Norges Bank Investment Management
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
KAPKNK/260600
42
Norges Bank Investment Management
Information flows
External management
Internal management
Market feeds
Fixed data
Manager 1
Manager 1
Custody
Manager 2
Manager n
KAPKNK/260600
Performance
DATA
WAREHOUSE
Risk models
Norges Bank
Back Office
Other
uses
Manager 2
Manager n
43
Norges Bank Investment Management
Real Time Attribution
ECONOMIC SECTOR
Technology
Communication Services
[Unassigned]
Energy
Consumer Cyclicals
Transportation
Miscellaneous
Consumer Staples
Utilities
Basic Materials
Capital Goods
Health Care
Financials
Total
MANAGER
Total
Return
Percent
Contrib
Average
Percent
Cap
Total
Return
Percent
Contrib
Percent
Cap
Total
Return
Percent
Contrib
19.40
15.69
1.77
6.08
10.12
0.89
0.00
9.86
1.48
5.43
7.62
3.17
18.50
24.68
33.24
-3.43
2.06
19.12
10.85
0.00
21.97
0.61
9.17
16.55
-3.81
6.55
4.59
4.81
-0.04
0.15
1.92
0.10
0.00
2.08
0.00
0.57
1.26
-0.14
1.25
12.47
10.35
0.00
5.01
9.49
1.03
0.16
10.41
2.23
6.32
8.88
7.31
26.34
25.62
28.12
0.00
1.40
13.30
7.81
6.84
9.61
-0.22
10.24
11.35
-4.04
6.72
2.96
2.62
0.00
0.09
1.25
0.09
0.01
0.99
0.00
0.67
1.01
-0.34
1.78
6.93
5.33
1.77
1.07
0.62
-0.14
-0.16
-0.55
-0.75
-0.89
-1.26
-4.15
-7.84
-0.94
5.12
-3.43
0.66
5.82
3.04
-6.84
12.37
0.83
-1.07
5.20
0.23
-0.17
1.63
2.19
-0.04
0.06
0.67
0.02
-0.01
1.09
0.00
-0.10
0.25
0.20
-0.53
100.00
16.55
16.55
100.00
11.14
11.14
5.41
5.41
Total
Effect
Local
Currency
Effect
Total
Effect
ATTRIBUTION ANALYSIS
Allocation
Effect
Total
KAPKNK/260600
PORTFOLIO VARIATION
Average
Percent
Cap
ECONOMIC SECTOR
Technology
Communication Services
[Unassigned]
Energy
Consumer Cyclicals
Transportation
Miscellaneous
Consumer Staples
Utilities
Basic Materials
Capital Goods
Health Care
Financials
EUROPE EX UK
Security
Selection Interaction
Effect
Effect
0.97
0.90
-0.24
-0.10
0.02
0.01
0.01
0.03
0.09
0.01
0.00
0.68
0.35
-0.10
0.46
0.00
0.03
0.54
0.04
0.00
1.24
0.03
-0.04
0.46
0.04
-0.03
-0.06
0.22
0.00
0.02
0.03
0.00
0.00
-0.11
-0.02
0.02
-0.06
-0.02
0.02
0.81
1.58
-0.24
-0.05
0.58
0.05
0.01
1.16
0.10
-0.01
0.39
0.71
0.34
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.81
1.58
-0.25
-0.06
0.58
0.05
0.01
1.16
0.10
-0.01
0.39
0.71
0.34
2.71
2.66
0.05
5.42
-0.01
5.41
44
Norges Bank Investment Management
Results
KAPKNK/260600
45
Norges Bank Investment Management
The Government Petroleum Fund
1997-99
1997
1998
1999
97-99
Actual 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
60,9
32,8
24,5
165,7
incl. 1996
in billions NOK
Market value
113,4
171,8
222,4
by the end of the year
KAPKNK/260600
46
Norges Bank Investment Management
Per cent
Excess return in the Petroleum Fund
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
1998 1
KAPKNK/260600
1998 2
1998 3
1998 4
1999 1
1999 2
1999 3
1999 4
2000 1
47
Norges Bank Investment Management
Expected tracking error
Basis points
90
• Maximum expected
tracking error is 1.5
per cent
80
70
Equities
60
50
40
Total
30
Fixed income
20
10
0
31Dec
07Jan
14Jan
KAPKNK/260600
21Jan
28Jan
04Feb
11- 18Feb Feb
25Feb
03Mar
10- 17Mar Mar
24Mar
31Mar
48
Norges Bank Investment Management
Management costs
Equity management
Fixed income man.
Total
1999
0.l45
0.048
0.087
1998
0.082
0.039
0.052
Measured as a percentage of the average portfolio
KAPKNK/260600
49
Norges Bank Investment Management
The Fund’s Equity Assets 31 December 1999
• Number of companies
of which included in the FTSE index
2025
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 market
capitalisation
KAPKNK/260600
0.039%
50
Norges Bank Investment Management
Website: www.norges-bank.no
KAPKNK/260600
51