Governor’s
Staff
Investment strategy for the
Petroleum Fund
Lecture at UiO
February 14, 2001
Birger Vikøren
Governor’s Staff
Norges Bank
www.norges-bank.no
BiV/February 2001
Governor’s
Staff
Outline
•
•
•
•
•
Background of the Fund
Portfolio models
Country allocation
Equity portion
Active management
BiV/February 2001
Governor’s
Staff
Background of the Fund
BiV/February 2001
Governor’s
Staff
The Government Petroleum Fund
• A buffer which allows greater room for
manoeuvre in economic policy should, for
example, oil prices decline
• A fiscal management tool which ensures
transparency in the use of petroleum revenues and
the reallocation of petroleum wealth
• A tool for coping with the financial challenges
connected with an ageing population and declining
oil revenues
BiV/February 2001
Governor’s
Staff
Fiscal surplus
Without oil
Total
150
100
50
0
-50
BiV/February 2001
3
20
0
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
-100
Governor’s
Staff
Government petroleum revenues and net pension
expenditure (% of GDP)
18
16
14
Pensions expenditures
12
10
8
6
Petroleum revenues
4
2
0
1970
BiV/February 2001
1980
1990
2000
2010
2020
2030
2040
2050
Governor’s
Staff
Production of petroleum
Mill. Sm3 o.e.
Actual production
Estimates
350
300
250
200
150
100
50
BiV/February 2001
20
30
20
26
20
22
20
18
20
14
20
10
20
06
20
02
19
98
19
94
19
90
19
86
19
82
19
78
19
74
19
70
0
Governor’s
Staff
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 counteracts appreciation of the
currency
• Sector balance concern
– Real appreciation would shift resources to non-competetive sectors
• The Fund as a buffer
– Drawing on a domestic fund could destabilise the economy when
activity is low
BiV/February 2001
Governor’s
Staff
Petroleum Fund
Allocations
BiV/February 2001
Size
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1200
1000
800
600
400
200
0
1990
Bn. NOK
Allocations and Size
Estimate
Governor’s
Staff
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
BiV/February 2001
6.6
0.6
Financial Fixed assets
assets
Human
capital
Governor’s
Staff
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
– Tactical Asset Allocation (TAA)
– deviation from the benchmark
BiV/February 2001
Governor’s
Staff
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
BiV/February 2001
• Manager: Norges Bank
– Active investment strategy
– Tactical assets allcoation
– Achieve higher return than
benchmark given
investment mandate and
restrictions
– Risk control
– Reports to MOF
Governor’s
Staff
Strategic asset allocation:
• Before setting the investment strategy we need to define:
– 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
• Two implications:
– should not focus on short-term fluctuations in return
– should not measure return in Norwegian kroner
BiV/February 2001
Governor’s
Staff
Guidelines for the Petroleum Fund
• Old (until 21.12.97):
• New (after 1.1.98):
– Europe:
– America:
– Asia:
75%
18%
7%
– Europe:
– America:
– Asia:
50%
30%
20%
– Equity:
0%
– Equity:
40%
– Government bond: 100%
– Number of countries: 8
• only industrialized
countries
BiV/February 2001
– Government bond: 60%
• 10% can be invested in
corporate bonds
– Number of countries: 28
• 22 industrialized countries
• 6 emerging markets
(included 1.2.2001)
Governor’s
Staff
Portfolio models
BiV/February 2001
Governor’s
Staff
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/February 2001
Governor’s
Staff
Efficient front
Minimize:
n
n
    wi w j  ij i j
2
p
i 1 j 1
Given:
n
E ( R p )   wi E ( Ri ) ,
i 1
n
w
i 1
i
 1,
Short-sale constraint:
0  wi  1
BiV/February 2001
, for all i
Governor’s
Staff
Risk preferences II
Return
Risk preferences
I
Efficient frontier
Risk
BiV/February 2001
Governor’s
Staff
Efficie nt frontie r int'l stocks and bonds (local curr.),
with short sale s constraints.
Blue square s: e fficie nt frontie r 1986-2000.
Re d square s: indiv idual asse ts.
Ye llow triangle : Pe trofund.
Ye llow cirle : FX re se rv e s.
Ye llow cross: FX re s. 20% stocks
0.18
0.16
Annual expected return
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.05
0.1
0.15
Annual volatility
BiV/February 2001
0.2
0.25
Governor’s
Staff
Effisient front i USA (1989-1999)
Avkastning
20
15
10
5
4
7
10
13
Standardavvik
Porteføljesammensetning
100 %
80 %
Akjser
60 %
Corporate BBB
Corporate A
40 %
Coporate AA
Statsobligasjoner
20 %
0%
1
BiV/February 2001
2
3
4
5
6
7
8
9 10 11
Governor’s
Staff
Time-varying correlation and volatility
7 countries - petrofond
1
16.00 %
14.00 %
12.00 %
10.00 %
8.00 %
6.00 %
4.00 %
2.00 %
0.00 %
0.8
0.6
0.4
0.2
0
-0.2
-0.4
Decem ber 1989 - May 1999
BiV/February 2001
korr
vol
Governor’s
Staff
Effisiensfronten - petro / EM
9.00 %
Historiske tall
6.00 %
avkastning
Beste periode
Dårligste periode
3.00 %
0.00 %
0.00 %
3.00 %
6.00 %
9.00 %
-3.00 %
standardavvik
BiV/February 2001
12.00 %
15.00 %
Governor’s
Staff
Country allocation
BiV/February 2001
Governor’s
Staff
Country allocation:
• As always: A trade-off between return and risk
• Return:
– assume that expected returns in the long-run are equal in
all countries
• Risk - a compromise between:
– Diversification of market risk
– Diversification of national wealth
• Size of the markets could be a restriction
BiV/February 2001
Governor’s
Staff
Regional weights mainly determined
by GDP-weights:
BiV/February 2001
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
Governor’s
Staff
Country weights within regions
• Equities: Market capitalization weights
• Fixed Income: GDP weights
BiV/February 2001
Governor’s
Staff
Petroleum Fund Benchmark 2000
Equities: 40 %
America: 30 % Europe: 50 % Asia/Oceania: 20 %
BiV/February 2001
Fixed income: 60 %
Governor’s
Staff
Equity portion
BiV/February 2001
Governor’s
Staff
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/February 2001
Governor’s
Staff
CAPM
E ( Ri )  RF   i  E ( Rm )  RF 
where:
RF - riskfree rate
E ( Rm ) - expected return on market portfolio
i 
cov( Ri , Rm )  im
 2 - systematic risk on asset ”i”
var( Rm )
m
BiV/February 2001
Governor’s
Staff
Consumption - CAPM
E ( Rm )  R f   (c) ( Rm )  (c, Rm ),
 - degree of risk aversion
 - correlatio n coefficien t (between consumptio n
growth and asset return
R f - riskfree rate
c - consumptio n growth
BiV/February 2001
Governor’s
Staff
How should we calculate average return?
(illustrated using US data for the period 1926-2000)
Arithmetic
Geometric
Continuesly
compounding
Aksjer Obligasjoner Aksjepremie
12.97
5.46
7.51
11.03
5.31
5.72
10.46
5.18
5.28
RA = RG + 1/2 A2
BiV/February 2001
Governor’s
Staff
Rullerende 10 årsperioder
25
20
15
Geo gj snitt
10
Arit gj snitt
Realavkastning
5
Kontinuerlig (ln) snitt
-10
BiV/February 2001
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
1945
1940
-5
1935
0
Governor’s
Staff
Rolling fixed window (10 years)
25
20
Equity return
15
Bond return
10
Average equity (19262000)
5
Average bond (19262000)
BiV/February 2001
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
1945
1940
-5
1935
0
-5.00 %
BiV/February 2001
0.00 %
Japan
Australia
USA
Canada
Sverige
Nederland
Italia
Irland
UK
Frankrike
Spania
Danmark
Tyskland
Sveits
Belgia
Østerrike
Governor’s
Staff
Equity premium 1987 - 2000
20.00 %
15.00 %
10.00 %
5.00 %
Governor’s
Staff
PE - USA (kilde: Siegel)
50
45
40
35
30
faktisk utvikling
25
20
15
10
5
0
gjennomsnitt
1881 - 1999
BiV/February 2001
1994
1987
1979
1972
1964
1956
1949
1941
1934
1926
1918
1911
1903
1896
1888
1881
snitt + 2 st avvik
Governor’s
Staff
PE - USA
35
30
25
faktisk utvikling
20
gjennomsnitt
15
snitt + 2 st avvik
10
5
1968 - 2000
BiV/February 2001
0
98
96
94
92
90
88
84
86
82
80
78
76
74
72
70
68
0
0
BiV/February 2001
Sveits
Nederland
Singapore
Hong Kong
Japan
Australia
USA
Canada
Sverige
Italia
Irland
UK
Frankrike
Spania
Danmark
Tyskland
Belgia
Østerrike
Governor’s
Staff
P/E-rater
60
50
40
30
Gj snitt (1973-2000)
Nivå 2000
20
10
Governor’s
Staff
Three explanations for current price levels:
¥
DIVt
P0  
t
(1

R)
t 1
Assume:
R = Rf + RP
DIV t = (1+g)t DIV0
DIV1
P0 
R F  RP  g
BiV/February 2001
High P0 (today):
=> LOW RP
=> HIGH g
=> INEFFICIENCY (BUBBLE!)
Governor’s
Staff
The equity premium puzzle
• “Standard economic models utterly fail to produce anything like the
historical average stock return. After 10 years of intense effort, there is
a range of drastic modifications to standard models that can explain the
equity premium. However, these models are truly drastic
modifications; they fundamentally change the description of the source
of risk that commands a premium in asset markets. Furthermore, they
have not yet been tested against the broad range of experience of the
standard models. These facts must mean one of two things. Either
the standard models are wrong and will change drastically; or the
phenomenon is wrong and will disappear.”
•
BiV/February 2001
Cochrane (1997)
Governor’s
Staff
Rolling fixed window (10 years)
40
35
Volatility - equity
30
Volatility - bonds
25
20
Average (1926-2000)
15
Average (1926-2000)
10
5
BiV/February 2001
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
1945
1940
1935
0
Governor’s
Staff
Correlation between bonds and equities
0.8
0.6
0.4
0.2
Fixed window 20
years
-0.4
-0.6
-0.8
BiV/February 2001
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
1945
1940
-0.2
1935
0
Fixed window 10
years
Governor’s
Staff
Portfolio model: Bonds: 5% and equities: 8%
Annual return (%).
Local currency, 5% / 8% return on bonds / stocks.
Value at horizon
and 95% confidence interval (initial value: 100).
Local currency, 5% / 8% return on bonds / stocks.
9
600
8
7
Value
%
400
6
200
5
4
0
0.0 0.1 0.2
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
0.8 0.9 1.0
Stock fraction
Stock fraction
Probability (%) of negative return a given year.
Local currency, 5% / 8% return on bonds / stocks.
Volatility (%).
Local currency, 5% / 8% return on bonds / stocks.
15
28
24
%
12
%
0.3 0.4 0.5 0.6 0.7
9
20
16
6
12
8
3
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
Stock fraction
BiV/February 2001
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
Stock fraction
Governor’s
Staff
Equity portion and investment
horizon
• Merton/Samuelsen
• Random walk
• Constant relative risk
aversion
• Mean reversion
• Long horizon - more
flexibility in labour supply
• Shortfall preferences
• Equity portion
independent of investment
horizon
• Equity portion depends on
investment horizon
BiV/February 2001
Governor’s
Staff
Standard deviation
Risk and investment horiozon
25
50
20
40
15
30
1 year
10
20
5 years
5
10
0
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Equity potion
BiV/February 2001
Governor’s
Staff
Siegel (1998): US data from 1802 to 1997
Investment
1 år 5 år 10 år 30 år
horizon
Equity portion 7% 25% 40.6% 71.3%
that minimize
risk
BiV/February 2001
Governor’s
Staff
Equities and long-term risk
• “We have a sample of 24 markets for which we have data
in 1931. Out of these, only seven experienced no
interruption (the US, Canada, the UK, Australia, New
Zealand, Sweden and Switzerland). Seven experienced a
temporary suspension of trading, less than a year. The ten
remaining markets suffered a long-term closure.”
•
BiV/February 2001
Jorion and Goetzmann (1998)
Governor’s
Staff
Active management
BiV/February 2001
Governor’s
Staff
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/February 2001
Governor’s
Staff
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
• An important assessment criterion for Norges Bank was
the manager’s ability to minimize total transaction costs
BiV/February 2001
Governor’s
Staff
Index management
135
130
125
Benchmark
Index management
120
115
110
105
100
7
7
7
7
8
8
8
8
9
9
9
9
0
0
99
99
99
99
99
99
99
99
99
99
99
99
00
00
la 1
la 1
la 1
la 1
la 1
la 1
la 1
la 1
la 1
la 1
la 1
la 1
la 2
la 2
rt
rt
rt
rt
rt
rt
rt
rt
rt
rt
rt
rt
rt
rt
va
va
va
va
va
va
va
va
va
va
va
va
va
va
.1 k
.2 k
.3 k
.4 k
.1 k
.2 k
.3 k
.4 k
.1 k
.2 k
.3 k
.4 k
.1 k
.2 k
BiV/February 2001
• Low cost and low
risk
Governor’s
Staff
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 interestrate risk or credit risk.
BiV/February 2001
Governor’s
Staff
Active management
140
135
130
Benchmark
Index management
Active management
125
120
115
110
105
1.k
va
rta
l1
99
2.k
7
va
rta
l1
99
3.k
7
va
rta
l1
99
4.k
7
va
rta
l1
99
1.k
7
va
rta
l1
99
2.k
8
va
rta
l1
99
3.k
8
va
rta
l1
99
4.k
8
va
rta
l1
99
1.k
8
va
rta
l1
99
2.k
9
va
rta
l1
99
3.k
9
va
rta
l1
99
4.k
9
va
rta
l1
99
1.k
9
va
rta
l2
00
2.k
0
va
rta
l2
00
0
100
BiV/February 2001
• Not many
managers beat the
benchmarks
consistently over
time
• Risk must be
controlled
Example: Large US pension funds
BiV/February 2001
Governor’s
Staff
Governor’s
Staff
Management costs
Equity management
Fixed income man.
Total
0.087
1999
0.l45
0.048
1998
0.082
0.039
0.052
Measured as a percentage of the average portfolio
BiV/February 2001
Governor’s
Staff
Risk-adjusted return:
• Fama and French (1993) three-factor model:
– broad stock index
– excess return on a portfolio of small stocks over a
portfolio of large stocks
– excess return on a portfolio of high book-to-market
stocks over a portfolio of low book-to-markets stocks
• Carhart (1997) augmented this model to include:
– a portfolio of stocks with high return over the past
months
BiV/February 2001
Governor’s
Staff
Considerable debate about the
interpretation of this results
• Entirely spurious and the result of data-snooping
• Inability of the the broad stock index to proxy for
the market portfolio return
• Genuine evidence against CAPM, but not against
a broader model in which there are multiple risk
factors
• Mistakes that disappear once market participants
become aware of them
• Enduring psychological biases that lead investors
to make irrational forecasts
BiV/February 2001
Governor’s
Staff
Website: www.norges-bank.no
BiV/February 2001