The Government Petroleum Fund Annual Report 2003

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The Government Petroleum Fund 1990-2003

Key figures

At the end of 2003, the market value of the Petroleum Fund’s assets was NOK 845 billion.

Chart 1 shows developments in the Fund’s market value from 1997 both in NOK and in terms of the currency basket which corresponds to the composition of the Fund’s benchmark portfolio. Developments in the two series of figures were quite similar up to and including 2001. In 2002, the Norwegian krone appreciated considerably against the currencies in which the Fund is invested. As a result, the increase in value measured in NOK was substantially lower. In 2003, a weaker krone exchange rate had the opposite effect. A change in the krone exchange rate affects the Fund’s value in NOK but not the Fund’s value for Norway measured in terms of the possibilities of purchasing foreign goods and services in the future. The return measured in terms of foreign currency therefore provides a more correct picture of developments in the Fund’s international purchasing power than figures that include the effects of a change in the krone exchange rate.

Chart 1: Market value of the Petroleum Fund 1997-2003. In billions of NOK and in terms of the Fund’s currency basket.

For 2003 as a whole, the return on the Petroleum Fund’s portfolio was 12.6 per cent measured in terms of the Fund’s currency basket.

The percentage return on the Petroleum Fund’s assets since 1997 is shown in Table 1. In 1997, the Fund was invested in interest-bearing government securities, whereas since 1998, the portfolio has consisted of both equities and fixed income instruments. For the period 1997-2003, the average annual nominal returns on both the equity and fixed income portfolios have been positive, at 2.2 and 6.5 per cent respectively. For the Fund as a whole, the average annual nominal return has been 5.3 per cent, which means an annual net real return of 3.7 per cent after deductions for price inflation and management costs. Average management costs have amounted to 0.08 per cent of total assets. This is low compared with similar funds in other countries.

Table 1: Annual nominal and real return on the Petroleum Fund in the period 1997-2003, measured in terms of the Fund’s currency basket. Per cent

* Including the Environmental Fund
** 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 shows the annual percentage return on the equity and fixed income portfolios since 1997, measured in terms of the Fund’s currency basket. In 1998, and especially in 1999 and 2003, the equity portfolio showed a high positive return, whereas the return was negative in 2000, 2001 and 2002. With the exception of 1999, returns on the fixed income portfolio have been positive.

Chart 2: Annual return from 1998 to 2003 on the equity and fixed income portfolios, measured in terms of the Fund’s currency basket. Per cent

Chart 3 shows the return since 1998 as an absolute amount, in NOK and in terms of the Fund’s currency basket. After negative returns in 2001 and 2002, the trend was reversed in 2003 to a substantial positive return. After 2003, the cumulative return is positive, measured both in NOK and in terms of the Fund’s currency basket. The cumulative return for the entire period is NOK 96.6 billion 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. 1998-2003

Chart 4 shows developments in the value of NOK 100 that was invested at the end of 1997 either in equities or in fixed income instruments. At the end of 2003, the value of the equities would have been NOK 114, reflecting a 14 per cent increase during this period. The value of the fixed income instruments would have been NOK 143, corresponding to a 43 per cent increase. The values have been measured in terms of the Fund’s currency basket. Whereas the return on the fixed income portfolio has been fairly steady, the return on equities has fluctuated widely. 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 32 per cent

Chart 4: Index for the cumulative return on the asset classes in the Petroleum Fund 1998-2003. The Fund’s currency basket at 31 December 1997=100

Transfers of new capital 1995-2003

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 have been 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 2003 amounted to NOK 104 billion. Between 1995 and 2003, a total of NOK 796 billion was transferred to the Petroleum Fund.

Table 2: Transfers to the Government Petroleum Fund 1995-2003. 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, nearly the entire cash flow was transferred to the Fund, whereas the share fell in 2002 and 2003.

Norges Bank’s contribution to the return

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 Fund manager. Norges Bank can contribute 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 as calculated by the index suppliers. The first line in Table 3 shows that the excess return each year has been positive, with an average of 0.36 percentage point each year since 1998.

The management of the Petroleum Fund involves some costs which comparable funds generally do not have. These are costs related both to the investment of large volumes of new capital and to substantial changes in the composition of the benchmark. In 2003, as in 2002, there have been substantial changes in the benchmark portfolio, as non-government-guaranteed securities have replaced a large portion of the government securities in Europe and the US. The Petroleum Fund pays tax on share dividends in a number of countries. It is normal practice to make adjustments for taxes when calculating the excess return. If adjustments are made for all of these cost components, we arrive at a figure for gross excess return. This figure is easier to compare with the excess return that is usually reported by other fund managers. The average gross excess return for the last six years is 0.43 percentage point (see line 2 in Table 3). This is equivalent to a total of NOK 9.4 billion for the period

Table 3: Norges Bank’s contribution to the return on the Petroleum Fund each year in the period 1998-2003 and on average for the six-year period.Percentage points

* Additions for costs related to investment of new capital, extraordinary costs related to the Ministry of Finance’s changes in the benchmark and taxes on dividends. Adjustment items have not been calculated for 1998 and 1999.
** Gross excess return less active management costs and securities lending revenues, but including transaction costs due to ordinary indexing.

Line 3 in Table 3 shows net value added by 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.

Norges Bank’s net contribution to value added by active management was 0.54 percentage point in 2003. The average net contribution to the excess return over the period 1998-2003 was 0.39 percentage point. This is equivalent to NOK 8.2 billion.

Chart 5 shows the gross excess return for each quarter from 1998 onwards. Norges Bank has outperformed the benchmark in 17 of the 24 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 3.24 percentage points.

Chart 5: Index for cumulative actual return and benchmark return (left-hand axis) and quarterly excess return in percentage points (right-hand axis). 1998-2003

In order to evaluate the quality of the active management, it is also important to take into account Norges Bank’s market risk in connection with achieving the excess return. Chart 6 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 three years.

Chart 6: Expected and actual tracking error at the end of each month. 1999-2003. Percentage points

The information ratio is a commonly used measure of the skill of an investment manager. It may be calculated as the ratio of the annual gross excess return to the actual tracking error. In other words, the information ratio shows how much excess return is achieved for each unit of risk. For the period 1998-2003, the average information ratio for the Petroleum Fund is 1.06. Norges Bank’s target is a ratio that is higher than 0.25.

Internal and external management

Chart 7 shows some key figures for the relationship between internal and external management of the Petroleum Fund in the last two years. On average, about 72 per cent of the Fund was managed internally in Norges Bank in 2003. The costs of internal management amounted to about 43 per cent of total management costs. Internal management accounted for about 42 per cent of the overall risk associated with active management.

Chart 7: Distribution of portfolio, management costs and active risk* between internal and external management in 2002-2003. Per cent

* 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.

The share of external management has increased somewhat in volume from 2002 to 2003, whereas the risk-taking in external and internal management remains unchanged. Nevertheless, external managers still account for more than half of the active risk-taking, while they manage 28 per cent of the capital. External management is more expensive than internal management, partly because active management is appreciably more expensive than indexing. Another important explanation is that internal management of large portfolios may be less expensive than buying external management services in the market owing to economies of scale. 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 8 shows that the number of external mandates has increased rapidly. At end-2003, 24 external managers had a total of 46 mandates.

Chart 8: Number of external managers and number of external management mandates at 31 December for the years 1998-200

The size of the Petroleum Fund in an international perspective

At end-2003, the market value of the Petroleum Fund’s assets was NOK 845 billion. Since this is wealth, it would be misleading to compare the amount with, for example, annual government expenditure or annual value added in Norway. We can, however, look at how much of the Petroleum Fund may be used annually, without reducing the real value of the Fund. 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 5 per cent of central government spending for 2003.

The Petroleum Fund has become a large fund, even compared with the largest international funds. In Chart 9, the Petroleum Fund is compared with the largest pension fund in the US and the two largest funds in Europe. At the end of 2003, both the largest European fund (ABP in the Netherlands) and the largest US fund (CalPERS in California), were still larger than the Petroleum Fund but the difference narrowed in 2003. On the other hand, the Petroleum Fund was about twice the size of the second largest pension fund in Europe (PGGM in the Netherlands). However, the Petroleum Fund is not among the world’s largest investment managers. Some funds managers handle around USD 1500 billion.

Chart 9: The size of the Government Petroleum Fund compared with other large international funds. Market values in billions of USD Sources: The Funds web-pages and Norges Bank

Chart 10 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-2003, the average ownership interest in European companies, where the share is highest, was less than 0.5 per cent.

Chart 10: Petroleum Fund’s ownership interests in equity markets, as a percentage of market capitalisation in the FTSE indices Sources: FTSE and Norges Bank

Table 4 shows the Fund’s ownership interests in various fixed income markets in each of the three geographic regions, calculated as portions of the securities in the Lehman Global Aggregate index in the currencies in which the Fund has been invested. In the government securities markets, ownership interests are highest in Europe where the Fund owned about 0.6 per cent of all outstanding securities at end-2003. The ownership interest in the US is 0.4 per cent. At year-end, the phasing in of non-government-guaranteed bonds was complete.

Table 4: Petroleum Fund’s ownership interests in fixed income markets at 31 December in the years 1998-2003 as a percentage of market capitalisation in the Lehman indices