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

Norges Bank Investment Management KAPKNK/ Agenda Background - Norway, oil and fund Strategic issues The benchmark composition Division of responsibilities Strategy to achieve excess performance Results

Norges Bank Investment Management KAPKNK/ 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.

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ Growth of the Petroleum Fund Estimates

Norges Bank Investment Management KAPKNK/ Strategic issues From petroleum to financial assets Macroeconomic concerns Pension system and expenditures

Norges Bank Investment Management KAPKNK/ 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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Norges Bank Investment Management KAPKNK/ Norway’s national wealth Percentage distribution

Norges Bank Investment Management KAPKNK/ 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?

Norges Bank Investment Management KAPKNK/ 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.

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ Share of government petroleum income invested in the Petroleum Fund

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ Pension expenditures Petroleum revenues

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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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Norges Bank Investment Management KAPKNK/ Determining the equity portion “ Using these historical returns ( ), 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ Regional weights mainly determined by GDP-weights: Americas Europe Asia Old guidelines18757 Import weights GDP weights Market weights - bonds Market weights - equities New guidelines305020

Norges Bank Investment Management KAPKNK/ 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, Not in the benchmark yet.

Norges Bank Investment Management KAPKNK/ 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 %

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ Division of responsibilities

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ Properties of the fund management model Accountability Transparency Focus on the contribution to value added in the operational management

Norges Bank Investment Management KAPKNK/ Organisation within Norges Bank Norges Bank Investment Management (NBIM) was established as a separate investment management unit in 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)

Norges Bank Investment Management KAPKNK/ Strategy to achieve excess performance

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ The basic investment decision is allocation of risk units

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ Manager selection: 4 main groups of criteria Management ability Expected performance OrganisationTrack recordInv.controlsAssets/clients Pf constructionResearch Pf implementation

Norges Bank Investment Management KAPKNK/ 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 tactical asset allocation mandates from third quarter

Norges Bank Investment Management KAPKNK/ 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

Norges Bank Investment Management KAPKNK/ External managementInternal management Norges Bank Back Office Custody Performance Other uses Risk models Fixed dataMarket feeds Manager 2 Manager n Manager 1 Manager 2 Manager 1 Manager n Information flows DATA WAREHOUSE

Norges Bank Investment Management KAPKNK/ Real Time Attribution

Norges Bank Investment Management KAPKNK/ Results

Norges Bank Investment Management KAPKNK/ The Government Petroleum Fund

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Norges Bank Investment Management KAPKNK/ Expected tracking error Maximum expected tracking error is 1.5 per cent

Norges Bank Investment Management KAPKNK/ Management costs Equity management0.l Fixed income man Total Measured as a percentage of the average portfolio

Norges Bank Investment Management KAPKNK/ The Fund’s Equity Assets 31 December 1999 Number of companies2025 of which included in the FTSE index1880 (93%) Average holding 46 mill. (NOK) Largest single holding Nokia, 1,445 mill. (ownership 0.086%) Largest ownership shareBuhrmann NV, 0.67% (holdings 62 mill. ) Share of total market capitalisation 0.039%

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