Management of the Government Petroleum Fund Report for the second quarter 2001
The report in PDF-format
The return on the Government Petroleum Fund in the second quarter of 2001 was 1.09 per cent, measured by the currency basket corresponding to the composition of the Fund’s benchmark portfolio. The upswing in the equity markets contributed positively, while a negative return on the Fund’s fixed income investments in the US and the euro area detracted from the result. The combined return for the first two quarters was negative, at –1.71 per cent.
Measured in NOK, the return in the second quarter was 2.00 per cent. The higher return in NOK is due to the depreciation of the krone against the currencies in the benchmark portfolio. However, it is the return measured against this currency basket that best expresses the Fund's international purchasing power, so that it is most appropriate to use this figure for measuring the return.
The return for the second quarter on the ordinary equity portfolio (excluding the Environmental Portfolio) was 3.20 per cent measured in terms of the benchmark portfolio’s currency basket. There was a net rise in prices in all the three main markets: the US, Europe and Japan. The fixed income portfolio, however, had a negative return for the quarter of -0.31 per cent, measured against the currency basket. Japan was the only main market with a positive fixed income return in the second quarter.
The return on the Petroleum Fund’s ordinary portfolio in the second quarter of 2001 was 0.14 percentage point higher than the return on the benchmark portfolio defined by the Ministry of Finance. The Petroleum Fund’s overall result for the first two quarters was an underperformance of 0.02 percentage point compared with the benchmark.
The Environmental Portfolio was established on 31 January with an initial market value of NOK 1 billion. The return on this equity portfolio in the second quarter was 2.97 per cent measured in terms of the Fund’s currency basket, and 4.16 per cent measured in NOK. The return since the portfolio’s inception, measured against the currency basket, has been -10.59 per cent.
On 31 May 2001, NOK 30 billion was transferred to the Petroleum Fund’s international equity and fixed income portfolios, and a further NOK 60 billion was transferred on 29 June, bringing the market value of the combined portfolio to NOK 522.8 billion at the end of the second quarter.
The Petroleum Fund’s average real annual return since 1 January 1998 has been 4.7 per cent. Table I shows the real return up to the end of the second quarter of 2001, calculated as annualised rates from 1 January 2000, 1 January 1999 and 1 January 1998 respectively. The price inflation is a weighted average of the price inflation rates in the countries in the benchmark portfolio defined by the Ministry of Finance. The right-hand column shows the excess return. This is the difference between the return on the actual portfolio and the return on the benchmark portfolio. Excess returns are calculated as arithmetic differentials, and then converted into annualised rates.
Table I: Annualised rates of return up to the end of the second quarter of 2001, measured against the benchmark portfolio’s currency basket. Per cent
| |
Nominal annual rate of return |
Annual price inflation |
Real annual return |
Annual excess return |
|
Since 01.01.2000 |
0.50 |
1.74 |
-1.24 |
0.13 |
|
Since 01.01.1999 |
5.12 |
1.80 |
3.31 |
0.52 |
|
Since 01.01.1998 |
6.28 |
1.58 |
4.71 |
0.41 |
The real return has been negative for the last six quarters, but the table shows that over a longer period of time it has been clearly positive. As might be expected when equities were included in the portfolio with a weight of around 40 per cent from 1998, there have been substantial fluctuations in the return from quarter to quarter and also from year to year. The average over long periods should be considered when the results are evaluated.
Chart I shows cumulative rates of return from 1 January 1998 for the fixed income and equity portfolios. In the 14 quarters since then, there has been a cumulative nominal return on equity instruments of 34 per cent and on fixed income investments of 19 per cent.
Chart I: Index for cumulative return on subportfolios in the Petroleum Fund 1998-2001. The Fund’s currency basket at 31 December 1997=100
Chart II shows cumulative rates of return for the whole Petroleum Fund since the beginning of 1998. The return up to the end of the second quarter of 2001 was 23.8 per cent. During the same period, the return on the benchmark portfolio was 22.0 per cent. The difference between the actual return and the return on the benchmark portfolio is the excess return achieved by Norges Bank. The cumulative excess return since 1998 has been 1.8 percentage points.
Chart II Index for cumulative return on the actual portfolio and on the benchmark portfolio, 1998-2001. The Fund’s currency basket as at 31 December 1997=100
Chart III: Relative market risk at the end of each month, measured by expected tracking error and the standard deviation of the return differential for the past 12 months. In basis points (hundredths of a percentage point)
Chart III shows developments in relative market risk from December 1998, measured in two different ways. In the guidelines from the Ministry of Finance, ‘expected tracking error’ (which is explained in Chapter 5 below) is used as a measure of market risk. In retrospect we can use the variation in the difference between the returns on the actual and benchmark portfolios (the differential return) as a measure of actual market risk in the period. In Chart III, this standard deviation is calculated as an annualised rate using 12-month moving windows. The actual variation in the monthly return differential has as a rule been somewhat higher than the figures for expected tracking error. In recent months, however, the figures have been very similar.
The increase in expected tracking error over time reflects the fact that Norges Bank has gradually increased the proportion of active management, with the objective of outperforming the benchmark portfolio. However, both expected tracking error and standard deviation measured retroactively are also influenced by various aspects of market development, such as changes in correlations between the various asset classes and securities.
The information ratio is a widely used measure of the skill of operational managers. The information ratio is the ratio between excess return for the year and relative market risk (measured here as the actual standard deviation of the return differential over the past 12 months). The average information ratio for the Fund from the second quarter of 1998 to the second quarter of 2001 has been 0.86, measured as an annual rate. A ratio of 0.2-0.3 is normally regarded as good, and it cannot be expected that the high level the Petroleum Fund has had up to now will be maintained.
Chart IV: Market value of the Government Petroleum Fund under internal and external management, 1996-2001. In billions of NOK
Chart IV shows how the market value of the Petroleum Fund’s international portfolio has increased since the end of 1996. In the second quarter of 2001, the Fund increased from NOK 424.9 billion at the beginning of the quarter to NOK 522.8 billion at the end of the quarter. The chart shows that more than half of the portfolio has been managed internally throughout, and that this proportion increased appreciably in the second quarter. This is largely because portfolios were transferred from external index management to internal enhanced indexing. This change is described in more detail in Chapter 3.
Chart V shows some key figures associated with the distribution of external and internal management. The chart shows that at the end of the second quarter, 76 per cent of the Petroleum Fund was managed internally by Norges Bank, whereas the costs of internal management amounted to only 31 per cent of overall management costs. Moreover, the active risk associated with internal management represented about one third of the total risk associated with active management.
Chart V: Distribution of portfolio, management costs and active risk* between internal and external management. Per cent
*There is no absolutely correct way to compute the distribution of active risk. The distribution shown in the graph is based on summation of the value at risk (VAR) of each mandate, disregarding the correlations between mandates.
As the figure shows, most of the risk associated with active management is assumed by external managers. Active management is distinctly more expensive than index management, which is part of the reason that the costs of external management are far higher than the costs of internal management, although the internally managed portfolio is far larger. A supplementary explanation is that because of economies of scale in capital management, internal management of large portfolios can be cost-effective compared with buying management services in the market. Norges Bank’s strategy is to allow external managers with specialist expertise to be responsible for a significant proportion of the overall active management. See also the article on this subject published on Norges Bank’s website, and the Bank’s submission of 5 September 2000 to the Ministry of Finance.
Norges Bank manages the Government Petroleum Fund pursuant to a regulation issued by the Ministry of Finance on 3 October 1997, last amended on 4 October 2000.
The Ministry of Finance has defined a benchmark portfolio for the Petroleum Fund pursuant to the Petroleum Fund regulation. The benchmark portfolio is composed of FTSE equity indexes in 27 countries, and of Schroder Salomon Smith Barney government bond indices in 19 countries.
The weighting of the companies in the FTSE index was changed on 15 June, to provide a more accurate reflection of the market value of the shares that in practice are available for trading. A more detailed account of this change is provided in Section 3.1.
Equities account for 40 per cent of the benchmark portfolio for the Petroleum Fund excluding the Environmental Portfolio, and bonds for 60 per cent. Securities listed in Europe make up 50 per cent, in the Americas 30 per cent and in Asia/Oceania 20 per cent. The benchmark portfolio constitutes the basis for managing the risk associated with the Petroleum Fund and for measuring the performance of Norges Bank’s management of the Fund.
Chart 1: Benchmark portfolio at 30 June 2001 for the Petroleum Fund’s ordinary portfolio (excluding the Environmental Portfolio)
On 31 January 2001 the Ministry of Finance allocated NOK 1 billion for the establishment of a separate portfolio of equities from enterprises that have been evaluated and found to fulfil environmental criteria – the Environmental Portfolio. This portfolio has the same regional distribution as the ordinary equity portfolio, and can be invested in the same countries, with the exception of the emerging markets of Brazil, South Korea, Mexico, Taiwan and Turkey.
The Environmental Portfolio may be invested in those enterprises in the FTSE index that fulfil certain requirements with respect to environmental reporting or certification. Companies that are considered to have little negative impact on the environment are also included, even if they do not fulfil the reporting and certification requirements. The British consulting company Ethical Investment Research Service (EIRIS) has been assigned by the Ministry of Finance to make a quarterly evaluation of the companies in the benchmark index in relation to these criteria.
At the time of establishment, the Environmental Portfolio’s benchmark portfolio had the same distribution over the main regions of Europe, America and Asia/Oceania as the ordinary portfolio. Over time, the regional weights will vary with developments in market values and the weights will not be restored to the original regional weights in Chart 1. In this respect the Environmental Portfolio differs from the ordinary portfolio, where the regional weights of the benchmark are restored to the original distribution each quarter.
The Ministry of Finance has set an upper limit for how far the Petroleum Fund's actual portfolio may deviate from the benchmark portfolio. In the ordinary portfolio, relative market risk, measured as expected tracking error in the BARRA risk management system, shall always be less than 1.5 percentage point. The limit for the Environmental Portfolio is 1 percentage point. Tracking error is explained in Chapter 5 below.
2.1 Main trends
The weak growth in the global economy continued into the second quarter. The economic downturn that started in the US just over a year ago has spread to Europe and Japan. The current cyclical downturn largely reflects surplus capacity in manufacturing, particularly in technology, media and telecoms (the TMT sectors).
The decline in demand for TMT products is primarily a result of unusually strong demand a couple of years ago. There was great demand for IT equipment in connection with the establishment of many new technology companies. At the same time, the telecoms market was deregulated, allowing new operators access to areas previously monopolised by state-owned telecoms agents. These factors in combination created an extraordinarily high level of demand for new telecommunications equipment, and led to the building up of high production capacity.
The costs associated with establishment in new markets and buying third generation mobile phone licences have resulted in severe debt problems in the telecoms sector. This in turn has led to cuts in these companies’ investment plans. The general global economic downturn has also affected the earnings of non-TMT businesses. The decline in demand has left record-high stocks. Developments have thus followed a classic cyclical pattern.
However, so far the drop in corporate earnings has had little impact on consumer demand. Demand for new and resale homes in the US was surprisingly strong also in the second quarter. Business and consumer optimism in the US appear to have increased somewhat, whereas in Europe and Japan there appears to have been growing pessimism.
The reasons for the greater optimism in the US are to be found in lower interest rates, extraordinary repayment of tax last autumn and an equity market that has been less volatile than previously. The Federal Reserve lowered interest rates in April, May and June by a total of 1.25 percentage points.
The ECB reduced its key rate by 0.25 percentage point in the second quarter, giving high inflation in the euro area as grounds for its caution. Inflation has risen largely as a result of high oil prices, combined with a weaker euro. Ever weaker figures for the real economy in the euro area have increased the pressure on the ECB to lower interest rates further.
A number of Asian countries, including Japan, have specialised in electronics manufacturing. These countries have been particularly hard hit by the decline in demand in this sector. Japan also has a number of problems relating to a rigid labour market, bad loan portfolios in the banking sector, overcapacity in manufacturing generally and sliding prices for everything from property to food and clothes. The interest rate in Japan is currently set at very close to zero, with a view to stimulating demand and lightening the burden of enterprises with debt problems. At the same time, a highly expansionary fiscal policy has been conducted in recent years, and large deficits have been financed through the issue of new government debt. Government debt in Japan currently amounts to roughly 130 percent of GDP, which is far higher than in other industrial countries.
Chart 2: Expected GDP growth in 2001 in the euro area, the US and Japan, measured at different times in 1999-2001
Chart 2 shows how consensus forecasts for growth rates in 2001 have changed since 1999. The GDP growth forecasts for the US and Japan have shown the largest decline. In autumn last year most market observers expected growth in the US to be over 5 per cent in 2001. Today, the same observers expect growth of little more than 2 per cent this year.
2.2 Fixed income markets
Interest rates in the US and Europe have partly paralleled developments in the equity market. Interest rates rose with equity prices in April and May, only to drop again in June. Since equities and fixed income instruments are alternative investment instruments, co-variation of this kind is common in periods when markets fluctuate widely.
In the second quarter, bond yields rose by about 0.25 percentage point in the US and Germany, but remained stable in Japan. The rise must primarily be viewed in the light of the extraordinarily low interest rates at the beginning of the quarter, and investors’ nascent expectations of somewhat stronger economic growth and hence higher interest rates in the long term. Since the Federal Reserve cut the intended federal funds rate by a full 1.25 percentage points during the quarter, money market rates have been at a historically low level. Short rates are therefore substantially lower than long bond yields. This is usual in periods when economic growth is below trend.
A number of the macroeconomic figures published in the US during the second quarter were stronger than expected, particularly in the automotive and construction sectors. Inflation figures were also higher than expected in both Europe and the US. High inflation coupled with stronger-than-expected purchasing power has kept long yields high. The discussion in the US as to whether future budget surpluses should be returned to the people in the form of tax cuts also influenced bond yields in the second quarter. The yield curve also became steeper, with a wider spread between short and long rates.
Chart 3: Developments in bond markets in the US, Europe and Japan during the first half of 2001. Yields on 10-year government bonds
Chart 4: Movements in Schroder Salomon Smith Barney’s government bond indices in the first half of 2001. 31.12.00=100
2.3 Equity markets
At the beginning of April, equity markets dropped to levels not seen for a couple of years. The reason was that many investors chose to sell when large technology companies issued profit warnings. As actual earnings figures for the first quarter arrived, the market became calmer, and equity prices rose in April and May. In June the market grew concerned about corporate earnings in the second quarter, and this was also a poor month for the great majority of equity markets.
In the second quarter, equity prices showed a more positive trend in the US than in Japan and Europe. One reason for this may be that the cyclical downturn began in the US before spreading to Europe and Japan. US companies were thus the first to observe weaker demand reflected in their results, and this was rapidly priced into equity prices. The global economic downturn did not affect European and Japanese companies until quite recently. Profit warnings are still mainly coming from IT companies, but other sectors are now also noticing that the global economy is more sluggish.
Prices for technology shares appear to have stabilised during the second quarter. A year ago, investors had great expectations of future earnings in technology companies, and share prices reached record heights in relation to current earnings. This past year has shown very clearly that also the TMT sectors are highly dependent on general economic developments. Equity market pessimism peaked in early April, when many investors chose to sell technology shares and units in technology funds. During the quarter, valuation in the equity market became more normal in relation to the current phase of the economic cycle.
Chart 5: Trends in the FTSE equity indices in the first half of 2001. 31.12.00=100
At the end of the quarter, leading indicators like the NAPM index of planned corporate purchasing and production levels, and the relationship between short and long yields in the US, pointed towards better times for the equity market 6-12 months ahead. Tax reductions and lower interest rates in the US pointed the same way. One important uncertainty factor in the equity market is whether US consumers will put on the brakes harder than they have up to now. Saving is at a record low, and both the repercussions of the sluggish equity market and the global economic downturn may lead to increased household saving in the US.
Table 1: Return on the Petroleum Fund’s equity benchmark portfolio in the second quarter of 2001, by main sector. As percentages, measured against local currency
|
Basic industries |
5.95 |
|
Cyclical consumer goods |
3.88 |
|
Cyclical services |
7.31 |
|
Financials |
4.86 |
|
General industrials |
7.74 |
|
Information technology |
6.97 |
|
Non-cyclical consumer goods |
1.41 |
|
Non-cyclical services |
-5.06 |
|
Utilities |
-0.10 |
|
Resources |
4.76 |
|
Total |
3.95 |
Source: Datastream
Table 1 shows returns in the second quarter for the most important sectors of the equity market. Technology and communications share prices recovered somewhat in the second quarter, after problems in the sector led to sharp price falls in the first quarter. Goods with exposure to the early phase of a cyclical upturn have also fared well. These are commodities, cyclical goods and services and resources.
The market value of the Petroleum Fund’s currency portfolio at the end of the first quarter was NOK 424.9 billion. On 31 May the Ministry of Finance transferred NOK 30 billion to the Fund’s krone account, and on 29 June a further NOK 60 billion. Total transfers to the Petroleum Fund’s portfolio of international securities in the second quarter thus amounted to NOK 90 billion. At the end of the second quarter of 2001, the market value of the Petroleum Fund's combined securities portfolio was NOK 522.8 billion.
Three departments in Norges Bank Investment Management are involved with the investment of the Petroleum Fund’s capital, both directly and by selecting external managers for the task. In addition to departments for managing equities and fixed income instruments, there is a Tactical Asset Allocation Department.
3.1. Management of the equity portfolio
NOK 12 billion were transferred to the equity portfolio at end-May, and a further NOK 19.5 billion at end-June, bringing the market value of the combined portfolio to NOK 207.8 billion. In addition, the Environmental Portfolio had a market value of NOK 0.9 billion.
The share that is managed internally increased substantially during the quarter, from 24 per cent at the beginning of the quarter to 51 per cent at the end. The increase is primarily due to the taking over of some index management from external managers. The internal index portfolios are managed by enhanced indexing, whereby one seeks to achieve a surplus return by exploiting special pricing situations, such as that arising from the restructuring of the FTSE index on 15 June (for further details, see below). Selected sectors ("Financials", "Telecommunications" and "Non-cyclical services") were under active management internally in Norges Bank. The indexing mandates of Deutsche Bank Asset Management were changed to enhanced indexing mandates on 15 May. The Environmental Portfolio is under internal indexing in Norges Bank.
The benchmark for the equity portfolio is based on the FTSE All World index, which underwent extensive changes on 15 June. The weights of individual companies in the index were adjusted from the value of the companies’ total equity capital to the market value of the shares that in practice are available for trading in the market – the "free float" portion. The new weight thus does not take account of shares restricted by cross-ownership, government ownership or other large non-traded holdings. The purpose of the change is that the index should provide a better representation of an investor’s real investment opportunities. Almost all major suppliers of indexes are adjusting or have adjusted their indices similarly.
The effect of the free float adjustment varies among the countries in the benchmark index. In all, the market capitalisation in the FTSE All World index was reduced by about 7 per cent. The market value in the Americas was reduced by 2.5 per cent, while in Europe and Asia it dropped by 8.5 per cent and 21 per cent respectively. The weight of the American markets therefore increased in the index, and the weights for Europe and Asia dropped.
Table 2: Market value of the Petroleum Fund’s equity and fixed income portfolios. In millions of NOK
|
|
31.12.00 |
31.03.01 |
30.04.01 |
31.05.01 |
30.06.01 |
|
Equities |
152 829 |
169 540 |
182 515 |
195 920 |
207 767 |
- external index management
|
80 895 |
88 036 |
103 138 |
116 736 |
58 323 |
- external active management
|
39 672 |
40 953 |
44 115 |
42 035 |
43 815 |
|
|
|
|
|
|
53 690 |
- internal active and sector management
|
30 816 |
28 336 |
30 542 |
30 796 |
34 779 |
- internal futures and rebalancing accounts
|
1 446 |
12 215 |
4 720 |
5 445 |
17 160 |
|
Environmental portfolio |
|
863 |
933 |
934 |
899 |
|
|
|
|
|
|
|
Fixed income instruments |
227 323 |
248 229 |
250 143 |
272 739 |
310 023 |
|
|
16 797 |
16 733 |
16 707 |
16 883 |
19 610 |
|
|
210 526 |
231 496 |
233 436 |
255 855 |
290 412 |
|
|
|
|
|
|
|
Tactical asset allocation |
6 297 |
6 315 |
3 320 |
3 265 |
4 146 |
|
- external management |
6 395 |
6 315 |
3 310 |
3 265 |
3 212 |
|
- internal management |
-98 |
0 |
10 |
0 |
934 |
|
Total |
386 450 |
424 948 |
435 978 |
471 924 |
522 835 |
* Tactical asset allocation comprises both equity and fixed income instruments.
However, the regional weights in the Petroleum Fund’s benchmark portfolio are strategically determined, and do not depend on market capitalisation in the regions. Compared with the weights in the FTSE All-World index, the Americas has a lower weight, and the other two regions have higher weights. Subsequent to the free-float adjustment to the FTSE index, the Petroleum Fund’s regional and country distribution therefore deviates even more strongly.
The equity portfolio was adjusted to free float during the second quarter. The adjustment did not involve moving capital between regions, since the regional weights in the Petroleum Fund’s benchmark portfolio are only changed in line with the regional return.
During the second quarter an agreement was signed with a new active manager, Blackrock International Ltd, regarding active management of a mandate for Europe excluding the UK. Capital was transferred to the manager at the beginning of July.
3.2. Management of the fixed income portfolio
NOK 18 billion was transferred to the fixed income portfolio on 31 May, and a further NOK 40.5 billion on 29 June, bringing the market value of the combined portfolio to NOK 310.0 billion. At the end of the second quarter, almost 94 per cent of the portfolio was managed internally in Norges Bank, while just over 6 per cent was managed externally. This is roughly the same distribution as before. Part of the internal management takes place from Norges Bank’s office in New York.
Active management was stepped up through the quarter in pace with the increase in assets under management. Internal active management is based primarily on strategies designed to exploit price differences between fixed income securities with fairly similar properties as well as the difference in yield trends in different market segments.
The three external fixed income managers employ the same general strategies. During the second quarter an agreement was signed with a new active manager, Pareto Partners of London, regarding management of a global mandate. Capital was transferred to the manager on 30 June.
3.3. Tactical asset allocation
In tactical allocation, managers seek to achieve an excess return by selecting a different combination of assets for their portfolio, ie a different distribution on aggregate markets, from that defined by the benchmark portfolio. The choice of countries in which to invest equities and fixed income instruments, respectively, is considered, the choice of what proportions of equities and bonds the portfolio should have, and the choice of currency composition.
Management takes place both by means of external managers and internally in Norges Bank. There is an internally managed portfolio consisting mainly of derivatives, ie equity and interest rate futures, which therefore has a low net market value.
In the second quarter of 2001 the Petroleum Fund, including the Environmental Portfolio, had a return of 1.09 per cent, measured in terms of the currency basket of the benchmark portfolio. Measured in NOK, the total return in the second quarter was 2.00 per cent. The higher figure is due to the depreciation of the krone during the quarter against most of the currencies in the benchmark portfolio, such that the Fund’s currency basket appreciated in value in relation to the krone. This has no effect on the international purchasing power of the Fund.
Table 3: Return on the Petroleum Fund’s ordinary portfolio. Actual and benchmark portfolios, second quarter 2001. Per cent
| |
Measured in terms of the benchmark portfolio’s currency basket |
Measured in NOK |
|
| |
Actual portfolio |
Benchmark portfolio |
Actual portfolio |
Benchmark portfolio |
Difference* |
|
First quarter |
-2.77 |
-2.61 |
-4.18 |
-4.03 |
-0.16 |
|
April |
2.23 |
2.11 |
2.80 |
2.69 |
0.11 |
|
May |
-0.32 |
-0.38 |
1.36 |
1.30 |
0.06 |
|
June |
-0.80 |
-0.77 |
-2.12 |
-2.09 |
-0.03 |
|
Second quarter |
1.09 |
0.95 |
2.00 |
1.85 |
0.14 |
|
So far this year |
-1.71 |
-1.69 |
-2.27 |
-2.25 |
-0.02 |
* The return differential is calculated as an arithmetic difference, ie in percentage points.
Table 3 shows that the Petroleum Fund’s ordinary portfolio (excluding the Environmental Portfolio) had the same return for the quarter as the whole Fund (including the Environmental Portfolio). In April the return was positive, while returns in both May and June were negative. Table 4 shows the returns on the equity and bond portions of the ordinary portfolio separately. In terms of the currency basket, the equity portfolio had a positive return of 3.20 per cent for the quarter, while the return on the fixed income portfolio was negative at -0.31 per cent.
Table 4 also shows return figures measured in USD, which appreciated against both the currency basket and NOK in the second quarter. Measured in USD, the Fund’s return was therefore negative, at -0.48 per cent. If we instead measure against the euro or a currency basket based on import weights, we find positive returns of 3.93 and 3.19 per cent, respectively, for the period.
Table 4: Return on the Petroleum Fund’s ordinary portfolio in the second quarter of 2001 measured against various benchmark currencies. Per cent
|
|
Equity portfolio |
Fixed income portfolio |
Total portfolio |
|
Benchmark portfolio’s currency basket |
3.20 |
-0.31 |
1.09 |
|
Import-weighted currency basket |
5.46 |
1.68 |
3.19 |
|
USD |
1.71 |
-1.93 |
-0.48 |
|
Euro |
6.21 |
2.41 |
3.93 |
|
NOK |
4.24 |
0.51 |
2.00 |
In the second quarter the ordinary portfolio outperformed the benchmark portfolio by 0.14 per cent, The excess return is largely due to the fact that actual dividend payments in the second quarter were higher than dividend payments in the benchmark return, which is based on the assumption of an even distribution of dividends over the year. This seasonal effect made a positive contribution in the second quarter, but will make a correspondingly negative contribution in the other quarters combined.
The excess return due to internal and external equity management also contributed to the outperformance in the second quarter.
Table 5: The return on the Environmental Portfolio in the second quarter of 2001. Per cent
| |
Measured in terms of the benchmark portfolio’s currency basket |
Measured in NOK |
|
|
|
Actual portfolio |
Benchmark portfolio |
Actual portfolio |
Benchmark portfolio |
Difference |
|
First quarter |
-13.17 |
-12.98 |
-13.69 |
-13.50 |
-0.19 |
|
Second quarter |
2.97 |
2.87 |
4.16 |
4.06 |
0.10 |
|
Memo: Ordinary benchmark with country weights as in the Environmental Portfolio |
|
2.79 |
|
3.94 |
|
|
So far this year |
-10.59 |
-10.48 |
-10.10 |
-9.99 |
-0.11 |
Table 5 shows that in the second quarter the Environmental Portfolio had a return of 2.97 per cent measured in terms of the currency basket and 4.16 per cent measured in NOK. The return was 0.10 percentage point higher than the return on the benchmark portfolio. The accumulated underperformance of –0.11 percentage point so far this year is largely due to transaction costs in connection with the establishment of the portfolio in the first quarter.
In addition to ordinary returns, revenues from various types of securities lending are included in the figures in Tables 3-5. Lending from the equity portfolio takes place through J.P. Morgan Chase & Co., which is the Petroleum Fund’s global custodian for equities. Securities from the fixed income portfolio are lent out both internally and through some of the external fixed income custodians. Table 6 shows that second quarter revenues from this type of activity amounted to an annualised 7.5 basis points (0.075 percentage point) of the total portfolio. This is equivalent to about NOK 83 million in the second quarter and NOK 128 million so far this year.
Table 6: Income from securities lending in the second quarter of 2001
|
|
Q1 |
Q2 |
So far this year |
|
|
Basis points* |
Basis points* |
Basis points* |
1000s of NOK |
|
Equity lending |
2.32 |
4.48 |
3.40 |
70 667 |
|
Lending of fixed income instruments |
2.47 |
3.16 |
2.81 |
57 818 |
|
Total lending income |
4.79 |
7.64 |
6.21 |
128 485 |
* The figures are in basis points (hundredths of a percentage point) of the total portfolio, and are annualised.
Some costs are charged directly to the Petroleum Fund’s portfolio, and thus contribute negatively when the above return figures are calculated, whereas they are not included in the calculation of the benchmark return. These include brokers’ costs in connection with equity transactions and turnover taxes in some equity markets. Another source of negative return differential is that in some countries tax is paid on dividends from the Petroleum Fund’s investments, while the calculated return on the benchmark portfolio presupposes a tax status that does not imply a tax burden. Costs of this type will normally result in a passively managed portfolio achieving a lower return than the benchmark portfolio.
See also a separate article on this subject on Norges Bank’s website.
The market risk associated with the Petroleum Fund is constantly monitored by both the departments responsible for the investments and a department with special supervisory responsibility. Various types of model are used in the work to analyse risk exposure. The guidelines from the Ministry of Finance place a limit on relative market risk, with reference to the BARRA model, and this is the measure reported here. The BARRA model provides an estimate of market volatility based on historical experience. At the end of each month, a new month is added to the underlying data, while the weighting of earlier months is reduced. This may cause changes in estimates of expected tracking error even though no change has taken place in the extent of active management.
Chart 6 shows expected tracking error for the entire ordinary portfolio, and for the equity and fixed income portfolios individually, so far this year. There is an appreciably higher relative risk associated with the equities portfolio than with the fixed income portfolio, reflecting both greater volatility in the equity markets and a higher degree of active management of the equities portfolio. At the end of the second quarter, the expected tracking error for the fixed income portfolio was just under 30 basis points. The tracking error for the equity portfolio remained stable at between 60 and 70 basis points throughout the quarter. Taking account of the risk in tactical asset allocation, the relative market risk associated with the total ordinary portfolio was 29 basis points at the end of June. The Ministry of Finance has imposed an upper limit of 150 basis points.
The relative market risk figures for the Environmental Fund at the end of June was 24 basis points, measured as expected tracking error in relation to the benchmark for this portfolio. The Ministry of Finance has imposed an upper limit of 100 basis points.
Chart 6: Expected tracking error for the ordinary portfolio at the end of each month in the second quarter of 2001. In basis points (hundredths of a percentage point)
| Expected tracking error
The Ministry of Finance uses the risk measure expected tracking error to manage the market risk of the Petroleum Fund. This measure is defined as the expected value of the standard deviation of the difference between the annual return on actual investments and the return on the benchmark portfolio. When deviations from the benchmark portfolio are restricted by setting an upper limit to expected tracking error, there is a high probability that the actual return will vary within a range around the return on the benchmark portfolio. The lower the limit placed on the tracking error, the narrower this range will be. An expected tracking error of 1.5 percentage points or 150 basis points means that the actual return on a portfolio that remains unchanged over time will deviate by less than 1.5 percentage points from the return on the benchmark in two out of three years. |
Table 7 shows the composition of the fixed income portfolio according to credit ratings by Moody's and Standard & Poor's respectively. In the table, government bonds and government-guaranteed bonds without credit ratings have been assigned the credit rating of the issuing country. For example, US government bonds have been assigned the rating Aaa/AAA, while government-guaranteed issues from the city of Yokohama, denominated in USD, have been rated AA/ Aa, which is the rating given to the Japanese state for bonds in a foreign currency. We see from the table that the rating of 0.01 per cent of the fixed income portfolio is lower than the limit for purchase imposed on the Petroleum Fund by the guidelines. These are fixed income instruments that have been downgraded since they were purchased, and they will therefore be sold.
Table 7: The fixed income portfolio as at 30 June 2001, by credit rating. Percentages of market value
|
Moody’s |
Standard & Poor’s |
|
Rating |
Percentage of total |
Rating |
Percentage of total |
|
Aaa |
55.46 |
AAA |
56.48 |
|
AA- |
43.12 |
AA |
42.14 |
|
A |
1.37 |
A |
1.34 |
|
Baa |
0.04 |
BBB |
0 |
|
Lower |
0.01 |
Lower |
0 |
|
No rating |
0 |
No rating |
0.05 |
|
Total |
100 |
Total |
100 |
Table 8 provides an overview of the risk limits stipulated in the Ministry of Finance's Regulation on the Management of the Government Petroleum Fund and guidelines for the ordinary portfolio, and of actual exposure during the quarter. The figures show that management of the Fund has been in compliance with the limits defined in the regulation, and there have been no infringements of the guidelines for the Environmental Portfolio.
Table 8 provides figures for interest rate risk in the fixed income portfolio. The Petroleum Fund’s market risk is restricted by the limit on expected tracking error, by limits on the distribution of assets by asset class and region, and by a special limit on interest rate risk. According to the Petroleum Fund Regulation issued by the Ministry of Finance, the average modified duration of the fixed income portfolio is to be between 3 and 7. Modified duration is a measure of how sensitive the value of the portfolio is to changes in the interest rate, and indicates the percentage decline in the value of the portfolio should yields for all maturities rise by 1 percentage point.
Table 8: Risk exposure limits as defined in the regulation and guidelines
|
Section |
Risk |
Limits |
Actual |
|
|
|
31.03.01 |
30.04.01 |
31.05.01 |
30.06.01 |
|
Section 4 |
Market risk |
Maximum tracking error 1.5 percentage points |
0.37% |
0.33 % |
0.37 % |
0.29% |
|
Section 5 |
Asset distribution |
Bonds 50-70% |
60.01% |
58.14 % |
58.48 % |
60.01 % |
|
|
Equities 30-50% |
39.99% |
41.86 % |
41.52 % |
39.99 % |
|
Section 6 |
Currency distribution |
Europe 40-60% |
50.94% |
49.69 % |
48.68 % |
50.02 % |
|
The Americas 20-40% |
29.69% |
30.05 % |
30.73 % |
30.10 % |
|
|
Asia/Oceania 10-30% |
19.37% |
20.26 % |
20.59 % |
19.88 % |
|
Section 6 |
Emerging markets |
Maximum 5 per cent of the equity portfolio |
1.21% |
1.30 % |
1.30 % |
1.33 % |
|
Section 7 |
Interest rate risk |
Modified duration 3-7 |
5.64 |
5.35 |
5.39 |
5.47 |
|
Section 8 |
Credit risk* |
Max 20% in bank deposits |
8.01% |
5.97 % |
8.99 % |
6.64 % |
|
Section 10 |
Maximum ownership |
Max. 3% of a company |
1.02% |
1.13 % |
1.13 % |
1.10 % |
* In addition to ordinary bank deposits, reinvested cash collateral from securities lending is included in the table.
6. Management costs
Table 9 provides an overview of the costs of managing the Government Petroleum Fund in the first half of 2001. The costs consist partly of fees to external managers and custodian institutions, and partly of Norges Bank’s internal operating costs. In addition to the Petroleum Fund, Norges Bank Investment Management manages the Government Petroleum Insurance Fund and the bulk of Norges Bank’s foreign exchange reserves. The total internal costs are distributed among the three funds by means of a set of internal prices. The internal costs pertain not only to Norges Bank Investment Management, but also to all support functions in other parts of Norges Bank. The internal costs are calculated according to the guidelines applying to business operations in Norges Bank.
Table 9: Management costs in the first half of the year. In thousands of NOK and basis points of the average portfolio
|
|
2001 |
2000 |
|
|
NOK 1000 |
Basis points |
Basis points |
|
Fee to external equity managers, excluding performance-related fees |
37 209 |
|
|
|
Costs of equity custodian and settlement |
20 879 |
|
|
|
Internal costs, equity management |
29 630 |
|
|
|
Total equity management |
87 718 |
11.5 |
13.0 |
|
Performance-related fees to external equity managers |
24 207 |
|
|
|
Fees to external fixed-income managers, excluding performance-related fees |
9 273 |
|
|
|
Custodian costs fixed income |
8 421 |
|
|
|
Internal costs, fixed income management |
26 184 |
|
|
|
Total fixed income management |
43 878 |
3.9 |
4.4 |
|
Performance-related fees to external fixed-income managers |
696 |
|
|
|
Fees to external managers, tactical asset allocation
Custodian costs, tactical asset allocation
Internal costs, tactical asset allocation |
3 572
469
5 761 |
|
|
|
Total, tactical asset allocation |
9 802 |
- |
- |
|
|
|
|
|
|
Total management costs, excluding performance-related fees |
141 397 |
7.3 |
7.9 |
|
Total management costs |
166 300 |
8.6 |
10.9 |
Annualised, the costs in the table are equivalent to 0.115 per cent of the average equity portfolio, and 0.039 per cent of the average portfolio of fixed income instruments. A price of this type is of little relevance to tactical allocation, as management is based mainly on the equity and fixed-income portfolios, and in such a way that managers’ own portfolios are small in relation to the risk taken.
In addition to the above costs come performance-based fees to external managers of NOK 24.2 million (0.032 per cent of the average equity portfolio) and performance-based fees to external fixed income managers of NOK 0.7 million (0.001 per cent of the average fixed income portfolio). The amounts are determined by the managers’ total excess returns over the past four quarters. Equity costs including these performance-related fees constitute 0.146 per cent and fixed income costs 0.039 per cent of average portfolios.
Table 10: Costs of internal and external management in the first half of 2001
|
|
Average market value (in millions of NOK) |
Management costs (in thousands of NOK) |
|
Internal management |
257 847 |
51 921 |
|
External management |
147 851 |
114 379 |
For the whole portfolio, including tactical allocation, annualised management costs excluding performance-based fees amount to 0.073 per cent of the average market value for the quarter. Table 10 shows that about two third of the costs accrued in external management.
The Management Agreement between the Ministry of Finance and Norges Bank lays down the principles for the remuneration Norges Bank is to receive for managing the Petroleum Fund’s portfolios. The point of departure is that the remuneration is to cover the costs incurred by the Bank. Remuneration for 2001 comprises 0.072 per cent of the Petroleum Fund’s average market value through the year. In addition to this remuneration, fees paid to external managers for the excess return achieved are to be recovered from the Ministry. Agreements on performance-based fees have been made with the majority of external active managers, and approved in each individual case by the Ministry of Finance.
Table 11 shows the mix of different instruments as presented in Norges Bank’s accounts at the ends of the last five quarters. Table 12 shows the book return, which in the second quarter was NOK -8 810.5 million prior to the deduction of Norges Bank’s management fee.
The accounting figures are based on holdings including unsettled trades (with the exception of cash). The figures indicate market values based on verified price information. Investments in foreign currency are converted to NOK at market rates as at 29 June 2000 quoted on WM/Reuters London. The value of the Petroleum Fund’s portfolio recorded in the accounts differs from the market value in Table 2 above because remuneration for management is not deducted in the table, and because different assessment principles are used for some items (cf. the appendix on methodology for calculating returns). Work is in progress to eliminate such differences. Similarly, there are small differences in the return figures.
Off the balance sheet, financial futures with a total market value of NOK 83 802.8 million had been purchased and financial futures with a market value of NOK 57 917.2 million had been sold at 29 June 2000. Interest rate swaps with a total market value of NOK 22 090.2 million were purchased and swaps for NOK 21 950.5 million were sold. Foreign exchange with a total contract value of NOK 18 926.1 million had also been bought and sold forward.
Income and costs in foreign currency are converted into NOK according to the exchange rate on the transaction date, and are recognised as they are earned or accrued, according to the accruals principle (see Table 12).
Table 11: The Petroleum Fund's international portfolio distributed by instrument. In thousands of NOK
|
30.06.00 |
30.09.00 |
31.12.00 |
31.03.01 |
30.06.01 |
|
|
|
|
|
|
|
Deposits in foreign banks |
11 544 250 |
29 920 603 |
34 358 399 |
44 482 450 |
34 887 205 |
|
Money market placings in foreign financial institutions against collateral in the form of securities |
42 765 478 |
66 003 651 |
79 461 351 |
111 282 119 |
106 908 470 |
|
Loans from foreign financial institutions against collateral in the form of securities |
-46 062 732 |
-78 294 783 |
-123 522 619 |
-132 289 675 |
-103 543 138 |
|
Foreign interest-bearing securities |
184 352 284 |
212 970 380 |
245 789 902 |
260 290 423 |
297 907 551 |
|
Foreign equities |
112 034 379 |
126 407 521 |
150 175 494 |
141 639 807 |
186 712 315 |
|
Forward contract adjustments |
-26 767 |
-32 535 |
193 609 |
-121 631 |
-37 496 |
|
Claims on or debt to Norges Bank |
6 244 |
- |
- |
-361 256 |
- |
|
Total portfolio before remuneration for management |
304 613 136 |
356 974 837 |
386 456 136 |
424 922 237 |
522 834 907 |
|
|
|
|
|
|
|
Accrued management remuneration |
-111 875 |
-238 715 |
-330 018 |
-80 338 |
-159 459 |
|
|
|
|
|
|
|
Total portfolio, recorded value |
304 501 261 |
356 736 122 |
386 126 118 |
424 841 899 |
522 675 448 |
Table 12: Book return on the Petroleum Fund’s international portfolio as at 30 June. In thousands of NOK
|
Book return |
30.06.00 |
30.09.00 |
31.12.00 |
31.03.01 |
30.06.2001 |
|
|
|
|
|
|
|
Interest income |
4 211 425 |
6 784 066 |
9 719 526 |
3 108 050 |
6 754 056 |
|
Dividends |
862 442 |
1 247 786 |
1 552 377 |
524 548 |
1 579 770 |
|
Exchange rate adjustment |
6 437 912 |
12 173 320 |
7 907 405 |
-6 373 350 |
-2 554 261 |
|
Unrealised securities loss/gain |
-1 082 664 |
-2 628 242 |
-6 318 289 |
-14 851 795 |
-13 870 491 |
|
Realised securities gain |
2 083 473 |
2 338 275 |
1 661 195 |
1 054 981 |
-284 868 |
|
Brokers’ commissions |
-3 155 |
-10 792 |
-22 221 |
-11 947 |
-26 080 |
|
Result forward exchange trading |
-760 |
-1 375 |
-1 741 |
1 452 |
-6 077 |
|
Gains/losses futures |
-173 218 |
-205 884 |
-319 798 |
-270 486 |
-402 570 |
|
|
|
|
|
|
|
Book return on investments |
12 335 455 |
19 697 154 |
14 178 454 |
-16 818 547 |
-8 810 521 |
|
Accrued management remuneration |
-111 875 |
-238 715 |
-330 018 |
-80 338 |
-159 459 |
|
|
|
|
|
|
|
Net return market value |
12 223 580 |
19 458 439 |
13 848 436 |
-16 898 885 |
-8 969 980 |
APPENDIX: Methodology for calculating returns
Returns are calculated according to the market value principle, ie the portfolios are valued at the relevant market prices at the beginning and end of the period. Interest expenses and revenues, dividends, changes in holdings and changes in securities prices are included and accounted for on an accruals basis when calculating returns. The trade date is used for recognising income and expenses for agreed, unsettled transactions. The return is compared with the return on the benchmark portfolio. The difference between the returns on the actual and benchmark portfolios is measured as an arithmetic differential.
The time-weighted method should be used for calculating the return on a portfolio with incoming and outgoing payments. This method requires that the market value of the portfolio be calculated at the time of each incoming or outgoing payment, and the return found as the change in market value between one point in time and the next. Thus an index for the market value is arrived at for each point in time compared to the previous point in time for cash flow. By multiplying these index figures for the individual periods, the return for the total period is arrived at. Thus cash flow elements will only contribute to the return from the time of the incoming or outgoing payment1.
To date, Norges Bank has performed a verification of market values only at month-end, and has therefore does not calculate a time-weighted return at any other point during the month. Instead, a money-weighted method (modified Dietz method) is used, whereby the monthly percentage return is calculated by distributing the various cash flows between incoming and outgoing value, and the return is found by dividing the portfolio’s adjusted outgoing value by the adjusted incoming value.
The modified Dietz method can be described by means of the following formula: 
The geometrical return is used for long periods, such as quarterly and annual return and return so far this year. In other words, the return indices for the individual periods are multiplied together. Thus the return is a time-weighted return on the returns for the individual months.
The return is calculated in both NOK and local currency. The total return in NOK is found by totalling the market values in NOK of all currencies and distributing total cash flows in NOK, as expressed in the formula above. WM/Reuters exchange rates are used for converting local currencies to NOK. The NOK return on the benchmark portfolio is calculated as the difference between the returns in NOK and in local currency, measured in terms of the currency distribution of the benchmark portfolio. This indicates how much the Norwegian krone has appreciated or depreciated in relation to the currency distribution of the benchmark portfolio.
Return calculations are carried out in separate models, which are reconciled with the accounting system. There are thus deviations in the return calculated using these models and the accounts figures as a result of the application of different assessment principles. Deviations will be due to differences in the treatment of accrued interest and of not yet repaid withholding tax. In the accounts, allocations are also made to cover Norges Bank’s management fee.
The benchmark portfolio
The benchmark portfolio for the Petroleum Fund excluding the Environmental Portfolio consists of an equity benchmark and a fixed income benchmark, which are based on internationally recognised market indices. At the beginning of each quarter, 60% of the benchmark portfolio is to consist of bonds and 40% of equities. During the quarter, the distribution between the two asset classes varies, depending on market developments.
The equity benchmark:
The equity benchmark portfolio is based on the FTSE All-World Index. It is distributed between Europe, North America and Asia and Oceania. At the beginning of each quarter the portions allocated to the regions are to be 50%, 30% and 20% respectively. Equity investments in each region are distributed among the approved countries according to market values measured by the FTSE indices. During the quarter, both country and regional weights change, depending on market developments.
The principles on which the compositions of the FTSE indices are based are described in "Ground Rules for the Management of the FTSE All-World Index, Version 1.7 June 2001".
The fixed income benchmark:
The fixed income benchmark portfolio is based on Schroder Salomon Smith Barney’s World Government Bond Indexes (WGBI). It is distributed between Europe, North America and Asia and Oceania. At the beginning of each quarter the portions allocated to the regions are to be 50%, 30% and 20% respectively. Within each region the country weights are determined on the basis of the IMF’s GDP weights and average exchange rates for the year for which the GDP figures are specified. During the quarter, both country and regional weights change depending on market developments. The principles for the composition of this index are found in "Salomon Smith Barney Global Index Catalog, February 2001".