biv/october 2004 investment strategy for the petroleum fund lecture at uio october 6, 2004 birger...
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BiV/October 2004
Investment strategy for the Petroleum Fund
Lecture at UiO
October 6, 2004
Birger Vikøren
Norges Bank
www.norges-bank.no
BiV/October 2004
Norges Bank’s organization
Governor
Financial stabilityInvestment 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
State net cash flow from Petroleum
0.0
50.0
100.0
150.0
200.0
250.0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Bil
lio
n 2
002
NO
K
Transfers to the Petroleum Fund
Financing budget defisits
BiV/October 2004
The Government Long Term Programme 2002-2005
Net cash flow from the petroleum sector and pension expenditures (per cent of GDP)
0
3
6
9
12
15
18
1970 1980 1990 2000 2010 2020 2030 2040 20500
3
6
9
12
15
18Pension expenditures
Net cash flow from thepetroleum 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 wealthPercentage distribution
6.51.2 0.6
6.613.315.6
79.676.6
0
10
20
30
40
50
60
70
80
Oil and gas Financialassets
Fixed assets Humancapital
19972030
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/Asia50 %
Europe50 %
America35 %
Europe55 %
Asia10 %
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
M inim ize :
jiijj
n
i
n
jip ww
1 1
2
G ive n :
n
iiip REwRE
1
)()( ,
11
n
iiw ,
S ho rt-sa le co n stra in t:
10 iw , fo r a ll i
BiV/October 2004
Return
Risk
Risk preferences II
Efficient frontierRisk 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 frontier1993-1997 1998-2002
Return stocks 15.46 -0.63Return bonds 8.63 5.70Risk stocks 9.83 17.84Risk bonds 3.38 3.09Correlation 0.42 -0.38
-2
0
2
4
6
8
10
12
14
16
18
0 2 4 6 8 10 12 14 16 18 20
1998-2002 1993-1997
100% bonds
100% stocks
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!
Stocks
0
10
20
30
40
50
60
70
jan.86
jan.87
jan.88
jan.89
jan.90
jan.91
jan.92
jan.93
jan.94
jan.95
jan.96
jan.97
jan.98
jan.99
jan.00
jan.01
jan.02
US
Europe
Japan
Government bonds
0
10
20
30
40
50
60
70
jan.85
jan.87
jan.89
jan.91
jan.93
jan.95
jan.97
jan.99
jan.01
US
Europe
Japan
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
FmiFi RRERRE )()(
w h e r e :
FR - r i s k f r e e r a t e
)( mRE - e x p e c t e d r e t u r n o n m a r k e t p o r t f o l i o
2)var(
),cov(
m
im
m
mii R
RR
- s y s t e m a t i c r i s k o n a s s e t ” i ”
BiV/October 2004
BiV/October 2004
BiV/October 2004
Return on US bonds and stocks, 1926-2002
-60
-40
-20
0
20
40
60
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
Obligasjoner Aksjer
BiV/October 2004
Rolling fixed window (10 years)
-5
0
5
10
15
20
25
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
Pro
sent
Aksjeavkastning Obligasjonsavkastning
Gj snitt (1926-2002) Gj snitt (1926-2002)
BiV/October 2004
Equity premium(rolling fixed window (3, 5 and 10 years))
-40
-30
-20
-10
0
10
20
30
40
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
10 år 5 år 3 år
BiV/October 2004
Equity premium in 9 countries1900 - 2002 (average annual return)
-40 %
-30 %
-20 %
-10 %
0 %
10 %
20 %
30 %
US
A
Ca
na
da
UK
Ita
lia
Ne
de
rl.
Ty
sk
lan
d
Fra
nk
rik
e
Sv
eit
s
Ja
pa
n
1900-2000
1995-1999
2000-2002
BiV/October 2004
Dividend discount model (DDM):
T
tt
t
y
CFB
10 )1(
1
~
0 )1(tt
t
rpy
CFEP ,
A s s u m e c o n s t a n t g r o w t h r a t e ( g ) i n d i v i d e n d ( D ) :
grpy
D
rpy
gDP
tt
t
0
1
00 )1(
)1(.
gP
Drpy
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”
grpy
DP
BiV/October 2004
How to use the DDM
• Y, D and P is observable
• rp, g and Pfair 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?
grpy
DP
ygP
Drp
P
Drpyg
fair
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 2004
0
5
10
15
20
25
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
05101520253035404550
1 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 1926 - 2000
BiV/October 2004
Siegel (1998): US data from 1802 to 1997
Investmenthorizon
1 år 5 år 10 år 30 år
Equity portionthat minimizerisk
7% 25% 40.6% 71.3%
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
Exchange rate changes and return on American and Japanese bonds
50
100
150
200
250
jan.86
jan.87
jan.88
jan.89
jan.90
jan.91
jan.92
jan.93
jan.94
jan.95
jan.96
jan.97
jan.98
jan.99
jan.00
jan.01
jan.02
Exchange rate index (USD/JPY) Relative return index (USD/JPY)
Exchange rate changes and return on American and European bonds
50
100
150
200
jan.86
jan.87
jan.88
jan.89
jan.90
jan.91
jan.92
jan.93
jan.94
jan.95
jan.96
jan.97
jan.98
jan.99
jan.00
jan.01
jan.02
Exchange rate index (USD/EUR) Relative return index (USD/EUR)
US and Japanese bonds US and European bonds
BiV/October 2004
Relationship between return differentials and exchange rate changes in equity markets in the US, Japan and Europe
Exchange rate changes and return on American and Japanese stocks
0
100
200
300
400
500
600
700
800
jan.86
jan.87
jan.88
jan.89
jan.90
jan.91
jan.92
jan.93
jan.94
jan.95
jan.96
jan.97
jan.98
jan.99
jan.00
jan.01
jan.02
Exchange rate index (USD/JPY) Relative return index (USD/JPY)
Exchange rate changes and return on American and European stocks
50
100
150
200
jan.86
jan.87
jan.88
jan.89
jan.90
jan.91
jan.92
jan.93
jan.94
jan.95
jan.96
jan.97
jan.98
jan.99
jan.00
jan.01
jan.02
Exchange rate index (USD/EUR) Relative return index (USD/EUR)
US and Japanese equities US and European equities
BiV/October 2004
Correlation coefficients for selected countries in the Fund's bond portfolio (in local currency) in the period 1994-2001. The colour code for the correlation coefficients is: Red: 0.75-1, Pink: 0.50-0.74, Green: 0.25-0.49, Blue: < 0.24
US 1 0.77 0.23 0.68 0.65 0.77 0.79 0.77 0.78 0.69Canada 0.77 1 0.22 0.77 0.65 0.69 0.70 0.69 0.70 0.69
Japan 0.23 0.22 1 0.26 0.31 0.14 0.11 0.14 0.15 -0.13Australia 0.68 0.77 0.26 1 0.72 0.58 0.57 0.58 0.60 0.54NewZealand 0.65 0.65 0.31 0.72 1 0.71 0.70 0.71 0.72 0.60
Netherlands 0.77 0.69 0.14 0.58 0.71 1 0.99 1.00 1.00 0.81Italy 0.79 0.70 0.11 0.57 0.70 0.99 1 0.99 0.99 0.81France 0.77 0.69 0.14 0.58 0.71 1.00 0.99 1 1.00 0.81Germany 0.78 0.70 0.15 0.60 0.72 1.00 0.99 1.00 1 0.81UK 0.69 0.69 -0.13 0.54 0.60 0.81 0.81 0.81 0.81 1
US Can Jap Aust NewZ Neth Ital Fran Germ UK
BiV/October 2004
Correlation coefficients for selected countries in the Fund's equity portfolio (in local currency) in the period 1994-2001. The colour code for the correlation coefficients is: Red: 0.75-1, Pink: 0.50-0.74, Green: 0.25-0.49, Blue: < 0.24.
US 1 0.77 0.54 0.56 0.49 0.37 0.48 0.62 0.62 0.57 0.57 0.73 0.52 0.71 0.73 0.79Canada 0.77 1 0.61 0.58 0.40 0.37 0.40 0.62 0.62 0.52 0.55 0.67 0.52 0.71 0.68 0.70Mexico 0.54 0.61 1 0.57 0.39 0.41 0.36 0.54 0.55 0.51 0.40 0.50 0.34 0.49 0.44 0.56Brasil 0.56 0.58 0.57 1 0.54 0.32 0.30 0.45 0.51 0.60 0.51 0.55 0.50 0.62 0.60 0.59
Japan 0.49 0.40 0.39 0.54 1 0.32 0.40 0.33 0.38 0.44 0.31 0.50 0.35 0.47 0.48 0.44Taiwan 0.37 0.37 0.41 0.32 0.32 1 0.46 0.38 0.38 0.31 0.33 0.33 0.32 0.34 0.40 0.34Korea 0.48 0.40 0.36 0.30 0.40 0.46 1 0.52 0.50 0.41 0.45 0.36 0.29 0.39 0.35 0.56HongKong 0.62 0.62 0.54 0.45 0.33 0.38 0.52 1 0.81 0.63 0.48 0.50 0.22 0.43 0.49 0.58Singapore 0.62 0.62 0.55 0.51 0.38 0.38 0.50 0.81 1 0.58 0.55 0.55 0.33 0.51 0.51 0.59Australia 0.57 0.52 0.51 0.60 0.44 0.31 0.41 0.63 0.58 1 0.57 0.59 0.44 0.48 0.55 0.66NewZealand 0.57 0.55 0.40 0.51 0.31 0.33 0.45 0.48 0.55 0.57 1 0.55 0.44 0.52 0.53 0.62
Netherlands 0.73 0.67 0.50 0.55 0.50 0.33 0.36 0.50 0.55 0.59 0.55 1 0.68 0.84 0.84 0.80Italy 0.52 0.52 0.34 0.50 0.35 0.32 0.29 0.22 0.33 0.44 0.44 0.68 1 0.75 0.70 0.59France 0.71 0.71 0.49 0.62 0.47 0.34 0.39 0.43 0.51 0.48 0.52 0.84 0.75 1 0.84 0.76Germany 0.73 0.68 0.44 0.60 0.48 0.40 0.35 0.49 0.51 0.55 0.53 0.84 0.70 0.84 1 0.71UK 0.79 0.70 0.56 0.59 0.44 0.34 0.56 0.58 0.59 0.66 0.62 0.80 0.59 0.76 0.71 1
US Can Mex Bra Jap Taiw Kor HK Sing Aust NewZ Neth Ital Fran Germ UK
BiV/October 2004
Correlation between regions
Correlations between bond markets(measured in local currency, 60 month window)
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
jan.91
jan.92
jan.93
jan.94
jan.95
jan.96
jan.97
jan.98
jan.99
jan.00
jan.01
US,Japan
US,Europe
Japan,Europe
Correlations between stock markets(measured in local currency, 60 month window)
00.10.20.30.40.5
0.60.70.80.91
jan.91
jan.92
jan.93
jan.94
jan.95
jan.96
jan.97
jan.98
jan.99
jan.00
jan.01
US,Japan
US,Europe
Japan,Europe
BiV/October 2004
BiV/October 2004
BiV/October 2004
What is most important for the performance - sector or region
US
0
1
2
3
4
5
6
1994-1997 1998-2001
sector
country
Japan
0
2
4
6
8
10
12
1994-1997 1998-2001
sector
country
Euro-block
0
1
2
3
4
5
6
7
1994-1997 1998-2001
sector
country
UK
0
1
2
3
4
5
6
1994-1997 1998-2001
sec tor
country
LGS XX 21
LSX
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 1986-2001
-20
-10
0
10
20
30
40
50
60
70
US Japan Europe US Japan Europe
Correlation betweenexchange ratechanges and return onstocks and bondsrespectively
Variance of exchangerate changes
Variance of return onstocks and bondsrespectively
BiV/October 2004
Exchange rate model
BiV/October 2004
BiV/October 2004
Interest rate parity
0
50
100
150
200
250
300
350
400
jan.
75
jan.
77
jan.
79
jan.
81
jan.
83
jan.
85
jan.
87
jan.
89
jan.
91
jan.
93
jan.
95
jan.
97
jan.
99
jan.
01
jan.
03
Valutakursindeks (USD/JPY)
Indeks for rentedifferanse (USD-JPY)
0
20
40
60
80
100
120
140
160
180
200
jan
.75
jan
.77
jan
.79
jan
.81
jan
.83
jan
.85
jan
.87
jan
.89
jan
.91
jan
.93
jan
.95
jan
.97
jan
.99
jan
.01
jan
.03
Valutakursindeks (USD/EUR)
Indeks for rentedifferanse (USD-EUR)
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/USDFIG 1A: Konjunktur-indikator
Januar 2003: Sterkere euro
-260
-240
-220
-200
-180
-160
-140
-120
-100
Glattet confidence (EUR-USD) Faktisk confidence (EUR - USD)
FIG 1C: Avvik fra likvekts-realvalutakurs (value signal)Januar 2003: Sterkere euro
0
20
40
60
80
100
120
140
160
180
jan.
84
jan.
86
jan.
88
jan.
90
jan.
92
jan.
94
jan.
96
jan.
98
jan.
00
jan.
02
Øvre grense
Gj snitt 10 år
Nedre grense
USD/EUR
FIG 1B: Nominell rentedifferanse (EUR - USD)Januar 2003: Sterkere euro
-8
-6
-4
-2
0
2
4
6
8
jan.
84
jan.
86
jan.
88
jan.
90
jan.
92
jan.
94
jan.
96
jan.
98
jan.
00
jan.
02
Gj.snitt rentediff Faktisk rentediff
FIG 1D: Momentum (teknisk signal)Januar 2003: Sterkere euro
0.60.70.80.9
11.11.21.31.41.51.6
jan.
84
jan.
86
jan.
88
jan.
90
jan.
92
jan.
94
jan.
96
jan.
98
jan.
00
jan.
02
Gj.snitt EUR/USD - 1 år EUR/USD
BiV/October 2004
Accumulated P&L from the model (EUR/USD)
-40
-20
0
20
40
60
80
100
120
140
160ja
n.8
4
jan
.86
jan
.88
jan
.90
jan
.92
jan
.94
jan
.96
jan
.98
jan
.00
jan
.02
Aktive posisjoner Long EUR (naiv posisjon)
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
100
105
110
115
120
125
130
135
Benchmark
Index management
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
100
105
110
115
120
125
130
135
140
Benchmark
Index management
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