The Government Petroleum Fund 2004

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Key figures 1997-2004

In 2004 the return on the Petroleum Fund was 8.9 per cent, measured in international currency. The returns on the equity and fixed income portfolios were 13.0 per cent and 6.1 per cent, respectively. The return on the Fund was 3.9 per cent measured in NOK. The difference between the return measured in international currency and measured in NOK is due to movements in the krone exchange rate, which have no effect on the long-term international purchasing power of the Petroleum Fund.

The average annual return since 1997 has been 5.8 per cent, measured in international currency. The cumulative return amounts to NOK 182 billion. After deductions for inflation and management costs, the annual net real return was 4.0 per cent.

In 2004, Norges Bank achieved an excess return of 0.53 percentage point compared with the return on the benchmark portfolio defined by the Ministry of Finance. Since 1988, the first whole year the Petroleum Fund invested in equities, the average annual excess return has been 0.45 percentage point. The corresponding NOK amount for the entire period is 14.2 billion.

The Ministry of Finance has given Norges Bank a framework for exercising active management with a view to achieving an excess return. Since 1998 the market risk of the actual portfolio has been only marginally higher than the market risk of the benchmark. Thus the cost of active management has been low in terms of higher risk and has been somewhat higher than if the portfolio had been managed passively close to the benchmark. The real value added through active management, taking into account these costs, is estimated at an average of 0.40 percentage point annually.

The information ratio is one measure of skills in asset management. It is calculated as the ratio of the annual excess return to the excess risk taken in relation to the benchmark (tracking error). In other words, the information ratio shows how much excess return is achieved for each unit of risk. Since 1998 the information ratio has averaged 1.15.

The market value of the Petroleum Fund at end-2004 was NOK 1 016 billion. During 2004, the Ministry of Finance transferred NOK 138 billion to the Fund. A total of NOK 934 billion has been transferred since 1996.

Return 1997-2004

The return on the Petroleum Fund is shown in Table 1. Since 1997, the annual nominal return on the Petroleum Fund, measured in international currency, has averaged 5.76 per cent. The return has been positive in six of these years and negative in two. In 1997, the Fund was only invested in interest-bearing government securities. Since 1998 the portfolio has included both equities and fixed income instruments. The nominal annual returns on the equity and fixed income portfolios for the years 1997 - 2004 have averaged 3.64 and 6.46 per cent, respectively. The real return is the nominal return less price inflation. The real annual return for the whole Fund since 1997 has been 4.09 per cent. Average management costs have amounted to 0.08 per cent of total assets. The annual net real return less management costs has been 4.01 per cent since 1997. Chart 1 shows developments in the average annual net real return and the real return without the contribution from active management since 1997.

Table 1: Annual nominal and real return measured in terms of the Fund's currency basket 1997 - 2004. Per cent

* Including the separate Environmental Fund, which was established in 2001 and discontinued in 2004.
** Weighted average of consumer price inflation in the countries included in the Fund’s benchmark portfolio during the year in question.
*** Costs include fees to external managers for excess return achieved. Costs in 1997 are estimated but not calculated exactly.

Chart 2 illustrates the annual percentage return on the equity and fixed income portfolios since 1998, measured in terms of the Fund's currency basket. A positive return on the equity portfolio was recorded for four of these years, and a positive return for fixed income investments for all years except 1999.

Chart 1: Average annual net real return since 1997. Per cent

Chart 3 shows the return since 1998 as an absolute amount, in NOK and in terms of the Fund's currency basket. At the end of 2004, the cumulative return for the whole period was NOK 182 billion measured in terms of the currency basket, and NOK 85 billion measured in NOK. When the krone appreciates relative to the investment currencies, the return is lower measured in NOK than in foreign currency. For the three years 2001, 2002 and 2004 combined, a stronger krone exchange rate contributed to reducing the value of the Fund by just over NOK 166 billion. Over the entire period from 1998, a stronger krone reduced the NOK value of the Fund by approximately NOK 101 billion. This has no effect on the international purchasing power of the Fund.

Chart 2: Annual return on the equity and fixed income portfolios, measured in terms of the Fund's currency basket 1998 - 2004. Per cent

Chart 4 shows movements in the value of NOK 100 that was invested in equities and NOK 100 invested in fixed income instruments at the end of 1997. The values are measured in terms of the Fund's currency basket.

Chart 3: Cumulative return. In billions of NOK and in terms of the Fund's currency basket. 1998-2004

While returns on the fixed income portfolio have been fairly stable, the returns on the equity portfolio have fluctuated substantially. At the end of 2004, the value of the equities would have been NOK 128, reflecting a 28 per cent increase during this period. The value of the fixed income investment would have been NOK 151, corresponding to a 51 per cent increase. The cumulative return since 1998 on a combined portfolio composed of the same equities and fixed income instruments as the Petroleum Fund would have been 43 per cent.

Chart 4: Index for the cumulative return on the asset classes in the Petroleum Fund 1998-2004. The Fund's currency basket at 31 December 1997=100

Transfers of new capital 1995-2004

The Ministry of Finance first transferred capital to the Government Petroleum Fund in May 1996 when the central government accounts for 1995 showed a surplus of NOK 2 billion. Since then, the central government accounts have shown a surplus each year and capital equivalent to the surplus projected by the Ministry of Finance has been transferred to the Fund. When the central government accounts are final, several months into the following year, the next year's transfers to the Fund are adjusted through corrections for the discrepancy between the amount transferred during the year and the final allocation to the Petroleum Fund.

Table 2 shows that the final allocation in the central government accounts as from 1996 has varied from about NOK 26 billion for 1999 to more than NOK 250 billion for 2001. Actual transfers in 2004 amounted to NOK 138 billion. A total of NOK 934 billion has been transferred to the Petroleum Fund for the years 1995-2004.

Table 2: Transfers to the Government Petroleum Fund 1995-2004. In millions of NOK

* Less management remuneration to Norges Bank
** Preliminary estimate

The table also shows the share of the central government's net cash flow from petroleum activities that has been transferred to the Petroleum Fund. In 2000 and 2001, almost the entire cash flow was transferred to the Fund, while in the years 2002-2004 the share transferred to the Fund represented about 2/3 of the cash flow.

Norges Bank's contribution to fund performance

The Ministry of Finance has defined a benchmark for the management of the Petroleum Fund. This benchmark expresses the overriding investment strategy for the Fund and makes it possible to measure Norges Bank's performance as asset manager. Norges Bank contributes to the Fund's return by selecting an actual portfolio which differs from the benchmark. A simple measure of Norges Bank's contribution to the return is the difference between the actual return and the benchmark return. The first line in Table 3 shows that the excess return each year has been positive, averaging 0.45 percentage point each year since 1998. This is equivalent to a total of NOK 14.2 billion for the period.

Line 2 in Table 3 shows net value added through active management. This is an expression of the value added as a result of Norges Bank's management compared with an alternative where the entire portfolio follows the benchmark portfolio very closely and is managed at the lowest possible cost (index management). The calculation of net value added takes into account that even with pure index management, there are some transaction and management costs. On the other hand, deductions are made both for extra management costs related to active management and for income from securities lending which would also have been generated by passive management. These calculations are discussed in more detail in section 2.2 of the Annual Report.

Table 3: Norges Bank's contribution to the return on the Petroleum Fund. Percentage points

*In previous years, some adjustments have made when calculating the excess return. Adjustment relate to costs associated with investment of new capital, extraordinary costs associated with the Ministry of Finance’s changes in the benchmark and taxes on dividends. An account of these adjustments is provided in previous annual reports. Since 1 January 2004, the index supplier has adjusted the return on the benchmark to take account of Norges Bank’s tax position with respect to share dividends. Adjustment has not been made for 2004 for other costs associated with the phasing in of new capital and changes in the benchmark.
**Excess return less active management costs and income from securities lending, but including estimated transaction costs due to ordinary indexing and the phasing in of new capital (see page 14) . The estimate for phasing in new capital does not take into account any market effect.

Norges Bank's net contribution to value added by active management was 0.49 percentage point in 2004. The average net contribution to the excess return over the period 1998-2004 was 0.40 percentage point. This is equivalent to NOK 12.7 billion.

Chart 5: Index for cumulative actual return and benchmark return (left-hand scale) and quarterly excess return in percentage points (right-hand scale) 1998-2004

Chart 5 shows the excess return for each quarter from 1998 onwards. Norges Bank has outperformed the benchmark in 20 of the 28 quarters since the Petroleum Fund first invested in equities. The chart also shows the cumulative actual return and the cumulative benchmark return. The difference between the two return series over the entire period adds up to a gross excess return of 4.24 percentage points.

Chart 6: Relationship between excess return and return on the benchmark portfolio 1998-2004. Per cent

Chart 6 shows the relationship between the excess return for each month and the return on the benchmark in the same month for the period from 1998 to 2004. This chart does not reveal any definite pattern. This indicates that the excess return achieved by Norges Bank is independent of the return on the benchmark portfolio defined by the Ministry of Finance.

Chart 7: Expected and actual tracking error at the end of each month. 1999-2004. Percentage points

In order to evaluate the quality of Norges Bank's active management, it is also important to take into account the market risk Norges Bank has taken to achieve the excess return. Chart 7 shows developments in tracking error (see box in section 5 of the annual report) between the actual portfolio and the benchmark portfolio since 1999.

Two different measures of risk are used in the chart. Expected tracking error is calculated in advance on the basis of market volatility during the last few years. This risk measure has shown relatively small variations over time and during the entire period has been well below 1.5 percentage points, which is the upper limit set by the Ministry of Finance for Norges Bank's risk-taking in connection with the management of the Fund. The actual tracking error is calculated retrospectively on the basis of the variation in the actual return differential in the last 12-month period. The two measures indicate very different levels of risk-taking in 2000, when equity markets fluctuated widely, but show roughly the same level of risk-taking for the last four years.

The information ratio is one measure of skills in asset management. It is calculated as the ratio of annual gross excess return to market risk, measured as relative tracking error. In other words, the information ratio shows how much excess return is achieved for each unit of risk. For the period 1998-2004, the average information ratio for the Petroleum Fund is 1.15. A separate feature article published in 2004 provides a detailed review of the results of active management in this period. Table 4 provides a historical overview of the information ratio for the portfolio as a whole and by asset class.

Table 4: Information ratios

Chart 8 shows how much of the overall return since 1999 is due to the contribution from active management (excess return). The contribution is 9.4 per cent of the total return.

Chart 8: Excess return and the return on the benchmark portfolio and risk due to active management

The chart also illustrates how much of the total risk can be attributed to active management. The share is 0.7 per cent. In other words, there has been only a very low cost in the form of increased total risk associated with active management.

Internal and external management

Chart 9 shows some key figures for the relationship between internal and external management of the Petroleum Fund in the last two years. On average, about 78 per cent of the Fund was managed internally in Norges Bank in 2004. The costs of internal management amounted to about 38 per cent of total management costs. Internal management accounted for about 37 per cent of the overall risk associated with active management. There is no absolutely correct method of calculating the distribution of active risk. The distribution in the chart is based on summation of the value at risk (VaR) of each mandate, disregarding the correlation between mandates.

Chart 9: Distribution of portfolio, management costs and active risk between internal and external management in 2003-2004. Per cent

The share of external management, measured by volume, decreased marginally from 2003 to 2004, while external management accounted for a somewhat higher share of overall risk than in 2003. External management is more expensive than internal management, partly because active management is appreciably more expensive than indexing. Another important explanation is that due to economies of scale internal management of large portfolios may be less expensive than buying external management services in the market. Norges Bank's strategy is to allow external managers with specialised expertise to take responsibility for a large portion of the overall active risk-taking, while the Bank, through internal management, tries to take advantage of the economies of scale inherent in the Fund's size as well as to engage in active management in some areas.

Chart 10 shows that the number of external mandates increased substantially in 2004. At end-2004, 35 external managers had a total of 65 mandates.

Chart 10: Numbers of external managers and external management mandates

The size of the Petroleum Fund in an international perspective

At end-2004, the market value of the Petroleum Fund's international portfolio was NOK 1 016 billion. Since this is wealth, it would be misleading to compare the amount with, for example, annual government expenditure or GDP. We can, however, look at how much of the Petroleum Fund may be used annually, without reducing the real value of this wealth. If, as in the government's fiscal rule for the use of petroleum revenues, the long-term real return is estimated at 4 per cent, this is equivalent to about 6.6 per cent of central government spending for 2004.

The Petroleum Fund has become large, even compared with the largest funds internationally. In Chart 11 the Petroleum Fund is compared with the largest pension fund in the US, the two largest funds in Europe and the combined assets of the Swedish National Pension Funds (AP Funds). In 2004, the largest European Fund (ABP in the Netherlands) was still larger than the Petroleum Fund, while the largest fund in the US (CalPERS in California) was about the same size. However, the Petroleum Fund is not among the world's largest asset managers. A few managers handle over USD 1000 billion.

Chart 11: Size of large international funds 2004.

Source: The funds’ websites and Norges Bank

Chart 12 shows the Petroleum Fund's average ownership interest in listed companies in three geographic regions, calculated as a share of the market value of the companies in the FTSE index for the countries in which the Petroleum Fund is invested. At end-2004, the average ownership interest in European companies was just under 0.5 per cent.

Chart 12: The Petroleum Fund's ownership interests in equity markets, as a per cent of market capitalisation in the FTSE indices

Source: FTSE and Norges Bank

Table 5 shows the Fund's ownership interests in various fixed income markets in each of the three geographic regions, calculated as percentages of the securities in the Lehman Global Aggregate index in the currencies in which the Fund has been invested. In the government securities markets, the ownership interests are highest in Europe, where the Fund owned about 0.64 per cent of all outstanding securities at end-2004. The ownership interest in the US is 0.57 per cent.

Table 5: The Petroleum Fund's ownership interests in fixed income markets at 31 December in the years 1998-2004 as a percentage of market capitalisation in the Lehman indices