BiV/October 2004 Investment strategy for the Petroleum Fund Lecture at UiO October 6, 2004 Birger Vikøren Norges Bank

BiV/October 2004 Norges Bank’s organization Governor Financial stability Investment 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

BiV/October 2004 The Government Long Term Programme Net cash flow from the petroleum sector and pension expenditures (per cent of GDP) Pension expenditures Net cash flow from the petroleum 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 wealth Percentage distribution

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/Asia 50 % Europe 50 % America 35 % Europe 55 % Asia 10 %

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

BiV/October 2004 Return Risk Risk preferences II Efficient frontier Risk 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 frontier 100% bonds 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!

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

BiV/October 2004

Return on US bonds and stocks,

BiV/October 2004 Rolling fixed window (10 years)

BiV/October 2004 Equity premium (rolling fixed window (3, 5 and 10 years))

BiV/October 2004 Equity premium in 9 countries (average annual return)

BiV/October 2004 Dividend discount model (DDM):

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”

BiV/October 2004 How to use the DDM Y, D and P is observable rp, g and P fair 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?

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 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

BiV/October 2004 Siegel (1998): US data from 1802 to 1997

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 US and Japanese bondsUS and European bonds

BiV/October 2004 Relationship between return differentials and exchange rate changes in equity markets in the US, Japan and Europe US and Japanese equitiesUS and European equities

BiV/October 2004 Correlation coefficients for selected countries in the Fund's bond portfolio (in local currency) in the period The colour code for the correlation coefficients is: Red: , Pink: , Green: , Blue: < 0.24

BiV/October 2004 Correlation coefficients for selected countries in the Fund's equity portfolio (in local currency) in the period The colour code for the correlation coefficients is: Red: , Pink: , Green: , Blue: < 0.24.

BiV/October 2004 Correlation between regions

BiV/October 2004

What is most important for the performance - sector or region

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

BiV/October 2004 Exchange rate model

BiV/October 2004

Interest rate parity

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/USD

BiV/October 2004 Accumulated P&L from the model (EUR/USD)

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

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 Not many managers beat the benchmarks consistently over time Risk must be controlled

BiV/October 2004 Example: Large US pension funds

BiV/October 2004