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					                                               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


                    -100



                                                                                       3
                       84


                              86


                                     88


                                            90


                                                   92


                                                          94


                                                                 96


                                                                         98


                                                                                00


                                                                                        0
                                                                                     20
                     19


                            19


                                   19


                                          19


                                                 19


                                                        19


                                                               19


                                                                       19


                                                                              20




BiV/February 2001
                                                                      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     1980   1990   2000     2010      2020    2030     2040   2050


BiV/February 2001
                                                                                                                Governor’s Staff



                                         Production of petroleum
                                                                      Mill. Sm3 o.e.



                                              Actual production                         Estimates

               350

               300

               250

               200

               150

               100

                    50

                     0
                 70

                           74

                                  78

                                         82

                                                86

                                                       90

                                                              94

                                                                     98

                                                                            02

                                                                                   06

                                                                                          10

                                                                                                 14

                                                                                                        18

                                                                                                               22

                                                                                                                      26

                                                                                                                             30
               19

                         19

                                19

                                       19

                                              19

                                                     19

                                                            19

                                                                   19

                                                                          20

                                                                                 20

                                                                                        20

                                                                                               20

                                                                                                      20

                                                                                                             20

                                                                                                                    20

                                                                                                                           20
BiV/February 2001
                                                                    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 and Size
                              1200
                              1000
                    Bn. NOK




                               800
                               600
                               400
                               200
                                 0
                                     1990

                                            1994

                                                   1995

                                                          1996

                                                                 1997

                                                                        1998

                                                                               1999

                                                                                      2000

                                                                                             2001

                                                                                                    2002

                                                                                                           2003

                                                                                                                  2004
                                     Allocations                          Size                  Estimate




BiV/February 2001
                                                                          Governor’s Staff



       Norway’s national wealth
       Percentage distribution

                    80                                          79.676.6
                    70
                    60
                    50
                    40
                                                                                      1997
                    30                                                                2030
                    20                                  15.6
                                                    13.3
                    10     6.5                6.6
                                 1.2    0.6
                     0
                         Oil and gas   Financial Fixed assets   Human
                                         assets                 capital


BiV/February 2001
                                                    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                   • Manager: Norges Bank
  Finance                                – Active investment strategy
    – Passive investment strategy        – Tactical assets allcoation
    – Strategic asset allocation and     – Achieve higher return than
      investment universe                  benchmark given
    – Benchmarks                           investment mandate and
    – Risk limits                          restrictions
    – Evaluates manager (uses            – Risk control
      consultant)                        – Reports to MOF
    – Reports to the Parliament




  BiV/February 2001
                                                                          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:           75%       – Europe:            50%
          – America:          18%       – America:           30%
          – Asia:             7%        – Asia:              20%

          – Equity:           0%        – Equity:            40%

          – Government bond: 100%       – Government bond: 60%
                                           • 10% can be invested in
                                             corporate bonds
          – Number of countries: 8      – Number of countries: 28
             • only industrialized         • 22 industrialized countries
               countries                   • 6 emerging markets
                                             (included 1.2.2001)
BiV/February 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 , for all i
BiV/February 2001
                                                        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

                                             0.14
                    Annual expected return




                                             0.12

                                              0.1

                                             0.08

                                             0.06

                                             0.04

                                             0.02

                                               0
                                                    0         0.05          0.1          0.15        0.2         0.25
                                                                            Annual volatility


BiV/February 2001
                                                                                                          Governor’s Staff


                                                  Effisient front i USA (1989-1999)

                                 20




                    Avkastning
                                 15


                                 10


                                  5
                                      4                         7                   10                  13
                                                                    Standardavvik



                                                       Porteføljesammensetning

                            100 %

                                 80 %                                                     Akjser

                                 60 %                                                     Corporate BBB
                                                                                          Corporate A
                                 40 %
                                                                                          Coporate AA
                                 20 %                                                     Statsobligasjoner

                                 0%
                                          1   2    3    4   5       6   7   8   9 10 11




BiV/February 2001
                                                           Governor’s Staff



       Time-varying correlation and volatility

                                7 countries - petrofond

                    1                                 16.00 %
                0.8                                   14.00 %
                0.6                                   12.00 %
                                                      10.00 %
                0.4                                                  korr
                                                      8.00 %
                0.2                                                  vol
                                                      6.00 %
                    0                                 4.00 %
               -0.2                                   2.00 %
               -0.4                                   0.00 %
                        Decem ber 1989 - May 1999

BiV/February 2001
                                                                                        Governor’s Staff




                                             Effisiensfronten - petro / EM
                            9.00 %




                                                                                                   Historiske tall
                            6.00 %
                                                                                                   Beste periode
               avkastning




                                                                                                   Dårligste periode

                            3.00 %




                            0.00 %
                                 0.00 %   3.00 %    6.00 %           9.00 %   12.00 %    15.00 %



                            -3.00 %

                                                         standardavvik




BiV/February 2001
                                    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:
                                                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




BiV/February 2001
                                               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 %                     Fixed income: 60 %




               America: 30 % Europe: 50 % Asia/Oceania: 20 %




BiV/February 2001
                                     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

        cov(Ri , Rm )  im
   i                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
 - correlation coefficient (between consumption
     growth and asset return
R f - riskfree rate
c - consumption growth
BiV/February 2001
                                                            Governor’s Staff



       How should we calculate average return?
                    (illustrated using US data for the period 1926-2000)

                          Aksjer Obligasjoner Aksjepremie
  Arithmetic              12.97      5.46         7.51
  Geometric               11.03      5.31         5.72
  Continuesly             10.46      5.18         5.28
  compounding


      RA = RG + 1/2 A2




BiV/February 2001
                                                                                                               Governor’s Staff


       Rullerende 10 årsperioder

   25

   20

   15
                                                                                                                 Geo gj snitt
   10                                                                                                            Arit gj snitt
     5                                                                                                           Realavkastning
                                                                                                                 Kontinuerlig (ln) snitt
     0
          1935
                    1940
                           1945
                                  1950
                                         1955
                                                1960
                                                       1965
                                                              1970
                                                                     1975
                                                                            1980
                                                                                   1985
                                                                                          1990
                                                                                                 1995
                                                                                                        2000
    -5

  -10



BiV/February 2001
                                                                                                               Governor’s Staff




       Rolling fixed window (10 years)
   25

   20                                                                                                           Equity return

   15
                                                                                                                Bond return

   10
                                                                                                                Average equity (1926-
                                                                                                                2000)
     5
                                                                                                                Average bond (1926-
     0                                                                                                          2000)
          1935
                    1940
                           1945
                                  1950
                                         1955
                                                1960
                                                       1965
                                                              1970
                                                                     1975
                                                                            1980
                                                                                   1985
                                                                                          1990
                                                                                                 1995
                                                                                                        2000
    -5
BiV/February 2001
BiV/February 2001
                         -5.00 %
                                    0.00 %
                                             5.00 %
                                                      10.00 %
                                                                15.00 %
                    Østerrike                                             20.00 %
                        Belgia

                       Sveits

                     Tyskland

                     Danmark

                       Spania

                    Frankrike

                                   UK

                        Irland

                          Italia
                                                                                    Equity premium 1987 - 2000




                    Nederland

                      Sverige

                      Canada

                            USA

                     Australia

                        Japan
                                                                                                                 Governor’s Staff
                                                                                                                                Governor’s Staff


                                                                    PE - USA (kilde: Siegel)


          50
          45
          40
          35
          30                                                                                                                         faktisk utvikling
          25                                                                                                                         gjennomsnitt
          20                                                                                                                         snitt + 2 st avvik
          15
          10
           5
           0
               1881
                      1888
                             1896
                                    1903
                                           1911
                                                  1918
                                                         1926
                                                                 1934
                                                                        1941
                                                                               1949

                                                                                      1956
                                                                                             1964
                                                                                                    1972
                                                                                                           1979
                                                                                                                  1987
                                                                                                                         1994
                                                                1881 - 1999



BiV/February 2001
                                                                                               Governor’s Staff



                                                             PE - USA


         35

         30

         25
                                                                                                    faktisk utvikling
         20
                                                                                                    gjennomsnitt
         15                                                                                         snitt + 2 st avvik

         10

            5

            0




                                                                                           0
                68
                     70
                          72
                               74
                                    76
                                         78
                                              80
                                                   82
                                                        84
                                                        86
                                                             88
                                                                  90
                                                                       92
                                                                            94
                                                                                 96
                                                                                      98
                                               1968 - 2000



BiV/February 2001
                                 0
                                     10
                                          20
                                                     30
                                                                      40
                                                                           50
                                                                                60
                     Østerrike




BiV/February 2001
                        Belgia
                     Tyskland
                     Danmark

                       Spania
                     Frankrike
                           UK
                         Irland

                          Italia
                      Sverige
                      Canada
                          USA

                     Australia
                        Japan
                                                                                     P/E-rater




                    Hong Kong

                    Singapore
                    Nederland
                        Sveits
                                               Nivå 2000
                                                                                                 Governor’s Staff




                                               Gj snitt (1973-2000)
                                                             Governor’s Staff


       Three explanations for current price levels:

                           ¥
                               DIVt
                    P0  
                         t 1 (1  R) t
                    Assume:
                    R = Rf + RP
                    DIV t = (1+g)t DIV0

                                          High P0 (today):
                             DIV1
                    P0 
                         R F  RP  g     => LOW RP
                                          => HIGH g
                                          => INEFFICIENCY (BUBBLE!)



BiV/February 2001
                                                                 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.”

       •                                                      Cochrane (1997)


BiV/February 2001
                                                                                                               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
         0
             1935

                    1940

                           1945

                                  1950

                                         1955

                                                1960

                                                       1965
                                                              1970

                                                                     1975

                                                                            1980

                                                                                   1985

                                                                                          1990

                                                                                                 1995

                                                                                                        2000

BiV/February 2001
                                                                                                                      Governor’s Staff




    Correlation between bonds and equities
             0.8

             0.6

             0.4

             0.2                                                                                                         Fixed window 20
                                                                                                                         years
                0
                                                                                                                         Fixed window 10
                    1935
                           1940
                                  1945
                                         1950
                                                1955
                                                       1960
                                                              1965
                                                                     1970
                                                                            1975
                                                                                   1980
                                                                                          1985
                                                                                                 1990
                                                                                                        1995
                                                                                                               2000
            -0.2                                                                                                         years
            -0.4

            -0.6
            -0.8


BiV/February 2001
                                                                                                                Governor’s Staff


       Portfolio model: Bonds: 5% and equities: 8%
                                            Value at horizon                                             Annual return (%).
                             and 95% confidence interval (initial value: 100).            Local currency, 5% / 8% return on bonds / stocks.
                            Local currency, 5% / 8% return on bonds / stocks.
                                                                                     9
                     600
                                                                                     8

                     400                                                             7




                                                                                 %
             Value




                                                                                     6
                     200
                                                                                     5

                                                                                     4
                      0
                                                                                          0.0 0.1 0.2   0.3 0.4 0.5 0.6 0.7     0.8 0.9 1.0
                             0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
                                              Stock fraction
                                                                                                            Stock fraction




                                           Volatility (%).                                 Probability (%) of negative return a given year.
                          Local currency, 5% / 8% return on bonds / stocks.               Local currency, 5% / 8% return on bonds / stocks.

                     15
                                                                                     28

                     12                                                              24

                                                                                 %   20
             %




                      9
                                                                                     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
                           0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
                                             Stock fraction
                                                                                                             Stock fraction


BiV/February 2001
                                                    Governor’s Staff


       Equity portion and investment
       horizon
       • Merton/Samuelsen            • Mean reversion
       • Random walk                 • Long horizon - more
       • Constant relative risk        flexibility in labour supply
         aversion                    • Shortfall preferences

       • Equity portion              • Equity portion depends on
         independent of investment     investment horizon
         horizon




BiV/February 2001
                                                                               Governor’s Staff



                                             Risk and investment horiozon

                                25                                             50
           Standard deviation




                                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.”

       •                             Jorion and Goetzmann (1998)




BiV/February 2001
                                   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
                    1.k
                        va




                                     100
                                           105
                                                 110
                                                       115
                                                             120
                                                                   125
                                                                                         130
                                                                                                     135
                          rta
                             l1
                               99
                    2.k
                        va       7
                          rta
                             l1
                               99




BiV/February 2001
                    3.k
                        va       7
                          rta
                             l1
                               99
                    4.k
                        va       7
                          rta
                             l1
                               99
                    1.k
                        va       7
                          rta
                             l1
                               99
                                 8


                                                                                         Benchmark
                    2.k
                        va
                          rta
                             l1
                               99
                    3.k
                        va       8


                                                                    Index management
                          rta
                             l1
                               99
                    4.k
                        va       8
                          rta
                             l1
                               99
                    1.k
                        va       8
                          rta
                             l1
                               99
                    2.k
                        va       9
                          rta
                             l1
                               99
                    3.k
                        va       9
                          rta
                             l1
                               99
                    4.k
                        va       9
                          rta
                             l1
                               99
                    1.k          9
                                                                                                            Index management




                        va
                          rta
                             l2
                               00
                    2.k
                        va       0
                          rta
                             l2
                               00
                                 0
                                                                                         risk
                                                                                       • Low cost and low
                                                                                                                               Governor’s Staff
                                               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 interest-
         rate risk or credit risk.



BiV/February 2001
                                            Governor’s Staff




       Active management
140
135                 Benchmark           • Not many
                    Index management      managers beat the
130
                    Active management
125                                       benchmarks
120                                       consistently over
115                                       time
110
                                        • Risk must be
105
                                          controlled
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
         l1

         l1

         l1

         l1

         l1

         l1

         l1

         l1

         l1

         l1

         l1

         l1

         l2

         l2
      rta

      rta

      rta

      rta

      rta

      rta

      rta

      rta

      rta

      rta

      rta

      rta

      rta

      rta
    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
                                          Governor’s Staff

        Example: Large US pension funds




BiV/February 2001
                                                                 Governor’s Staff




       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




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

				
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