Report

1. Mandate for management

Norges Bank manages the Government Petroleum Fund on behalf of the Ministry of Finance. The operational management is carried out by a separate unit in the Bank, Norges Bank Investment Management. The mandate for management was set out in a regulation issued by the Ministry of Finance. A management agree-ment has also been drawn up, which further specifies the relationship between the Ministry of Finance as dele-gating authority and Norges Bank as operational manager.

An important element of the mandate is a hypothet-ical benchmark portfolio of specific equities and bonds listed in countries where investment is permitted. The benchmark portfolio reflects the delegating authority’s investment strategy for the Petroleum Fund. It serves as an important basis for managing the risk of the opera-tional management, and for evaluating Norges Bank’s management performance. The Ministry of Finance has set limits for the deviation between the actual portfolio and the benchmark portfolio. Norges Bank submitted recommendations to the Ministry of Finance before the investment strategy was chosen.

In 1998 several important changes were made to the management strategy. First, equities were added to the benchmark portfolio in five monthly steps of 8 percen-tage points each, from 1 February to 1 June. Since then, equities have accounted for 40 per cent of the bench-mark portfolio. Second, the country weights for bonds in the benchmark portfolio were gradually changed in the same period, and the investment universe was expanded from 10 to 17 countries. The first five months of 1998 constituted a transitional period, during which extensive changes were made to the Fund’s benchmark portfolio at the end of each month.

A minor change was made when Portugal was in-cluded in the equity portion of the benchmark portfolio, as the 21st country, on 1 June, and in the bond portion, as the 18th country, on 1 July. The change reflected the inclusion of Portugal from those dates in the indices forming the basis for the benchmark portfolio: Financial Times/Standard & Poor’s equity index and Salomon Smith Barney’s bond index.

The selection of securities from each country included in these indices may change from month to month. In addition, country weights are changed quarterly. This means that the detailed benchmark portfolio is changed just as frequently. The responsibility for ensuring that the benchmark portfolio is correct is vested with Norges Banks’ Market Operations Department, and hence out-side the organisation responsible for operational mana-gement. The benchmark portfolio is discussed in more detail in feature article 2.

The Ministry of Finance has given Norges Bank the opportunity to deviate from the benchmark portfolio. Limits have been defined to restrict the degree of devi-ation permissible between the return on the actual port-folio and the return on the benchmark portfolio: the Ministry has stipulated that the expected tracking error is not to exceed 1.5 per cent. In practice, this restriction means that in two out of three years the diffe-rence between the return on the actual and benchmark portfolios will be less than 1.5 percentage points, if Norges Bank makes full use of the risk limit. The fea-ture article about the management of risk in the Petroleum Fund provides a further discussion of the concept ‘tracking error’.

Norges Bank can use the scope for deviating from the benchmark portfolio for two main purposes. First, such deviations can be made with a view to achieving a hig-her return than the benchmark portfolio. This is normal-ly called ‘active management’. Second, it will not be cost effective to allow the actual securities holdings to correspond precisely to the composition of the securities in the benchmark portfolio at all times.

In addition to imposing a limit on expected tracking error, the Ministry of Finance has set limits for interest rate risk, the share of the Fund that can be invested in equities and bonds, and the distribution of the Fund among the three main regions of Europe, the Americas and Asia/Oceania. A ceiling of 1 per cent has also been placed on maximum permissible ownership holdings in companies.

The Ministry of Finance is considering possible amendments to the guidelines. In the Revised National Budget for 1998, the Ministry writes:

As to guidelines on ethics and human rights, the Government has considered several alternatives. So far, no means have been identified for achieving the requirements that must apply with respect to clarity, consistency and feasibility, and which can thus be recommended to the Storting. The Government will continue working on a solution in which environmental considerations form the basis for investments, possibly by defining a smaller portion of the Fund’s portfolio that would be subject to special restrictions as regards investment within this sub-portfolio, on the basis of specified environmental criteria. Such criteria must be based on objective, easily identifiable factors..

2. Organisation of management in Norges Bank

On 1 January 1998, Norges Bank established a separate unit for investment management. Norges Bank Investment Management performs the operational management of the Government Petroleum Fund and the Government Petroleum Insurance Fund, and also the portion of foreign exchange reserves that is not ear-marked for short-term liquidity requirements. At the end of 1998, the value of the combined portfolios under management was NOK 287 billion.

The executive director of Norges Bank Investment Management reports to the governor of the central bank, but is not a full-fledged member of the Bank’s management group. Procedures have been established to ensure that the Investment Management entity does not gain access to certain types of confidential information that Norges Bank receives from other central banks and inter-national organisations.

The liquidity portfolio portion of Norges Bank’s foreign exchange reserves is managed by the Market Operations Department, which has executive respon-sibility for monetary policy. The Market Operations Department also has three different functions in relation to the operational management of the Government Petroleum Fund. First, the department has responsibility for formulating recommendations submitted by Norges Bank to the Ministry of Finance concerning the guide-lines for the Petroleum Fund. Second, the department is responsible for settlement functions for the internally managed sub-portfolios in the Petroleum Fund, and makes the final calculations of the return. Third, the department has a control function on behalf of the Central Bank Governor (see Section 7 below).

The supreme auditing of the Government Petroleum Fund has been assigned to the Office of the Auditor General. This office bases its audit on the work carried out by Norges Bank’s Auditing Department. The latter unit reports to Norges Bank’s Supervisory Council, which is appointed by the Storting. Norges Bank’s Auditing Department submits a statement to the Ministry of Finance on the Fund’s quarterly and annual reports. The day-to-day accounting functions of the Petroleum Fund are performed by Norges Bank, partly by the Market Operations Department and partly by the Budget and Accounting Department.

3. Fund management in 1998

At the end of 1997, the Fund amounted to NOK 113.4 billion. In 1998, NOK 11.8 billion was transferred to the Fund on 30 June, NOK 10 billion on 30 September and NOK 11 billion on 30 November. Total transfers in 1998 amounted to NOK 32.8 billion. From the second half of 1998, the general rule is that the Ministry of Finance will transfer capital to the Petroleum Fund on the last day of each quarter, but in the fourth quarter of 1998 an exception was made because of the work that had to be done in the New Year weekend following the introduction of the new European currency, the euro, on 1 January 1999.

3.1 Adaptation to the new benchmark portfolio

In the first five months of 1998 the management aimed primarily at adapting the actual portfolio to the exten-sive changes in the benchmark portfolio. This was an extensive operation, involving the establishment of a large equity portfolio financed by the sale of bonds, and the redistribution of large amounts within the bond portfolio. The main aim of activities during this phase was to adapt the portfolio as cost-effectively as possible, and with adequate control.

The equity portfolio was established according to a plan drawn up by Norges Bank in which an external equity manager, Barclays Global Investor (BGI) played an important part. BGI was one of four equity managers selected after an extensive process in the autumn of 1997. The three other external managers that were selected at the same time, State Street, Bankers Trust and Gartmore, assisted BGI, primarily by offering crossing opportunities in addition to those available at BGI. Crossing permits large equity portfolios to be purchased without using brokers and incurring broker-age fees. Another advantage of crossing may be that equity prices are influenced to a lesser extent than through trades using brokers. In the establishment phase, 82.6 per cent of the Petroleum Fund’s equity portfolio was acquired in this manner. See feature article 3 for further details.

Attempts were also made to curb the costs of equity purchases by spreading them over time. This reduced the influence of the purchases on the market, which could have led to a rise in the prices of the equities earmarked for purchase. Some of the equity exposure was initially achieved by buying futures contracts for equity indices, so that the timing of buying physical equities could be adapted more easily to the opportun-ities for crossing portfolios.

The capital for equity purchases was acquired through Norges Bank’s sale of part of the Petroleum Fund’s bond holdings. This was coordinated with a redistributi-on of the bond portfolio designed to minimise the num-ber of transactions. Among other things, emphasis was placed on avoiding unnecessary exchanges of currency.

3.2 Current management

The three external equity managers that were not direct-ly responsible for establishing portfolios, State Street, Bankers Trust and Gartmore, took over established port-folios in early March. Their mandate was to engage in index management, which means that the actual port-folio will contain virtually the same equity holdings as those in the benchmark portfolio. The actual return will therefore be very close to the return on the benchmark portfolio. This is a cost-effective form of management involving low management fees and few transactions. Transactions will only be required in connection with the small changes made each month in the equity indices the managers are required to follow.

From early June, when adaptation to a new bench-mark portfolio had taken place, BGI also switched to pure index management of the equity portfolio to be invested. Further capital was supplied to the four index managers in connection with transfers of new capital to the Petroleum Fund. The transfers were primarily made by having the managers take over portfolios of futures contracts. In 1998, they managed almost the entire equity portfolio. At year-end the equity index portfolios had a market value of NOK 60.8 billion.

In February 1998 mandates were announced for active equity management. Around 260 proposals for this type of management were submitted, and an extensive evaluation process was initiated. The first mandates were awarded in November, and three of these managers received portfolios in connection with the transfer of new capital to the Petroleum Fund on 30 November. At year-end these three managers had equity portfolios with a combined market value of NOK 6.4 billion. The managers have had these mandates such a short time that it is difficult to comment on the experience gained in connection with this management.

In 1998, internal equity management in Norges Bank was limited to trading futures contracts for equity indices. In the second half of 1998, Norges Bank began preparing the ground for its own trading in physical equities, with the intention of making cost-effective purchases of equity portfolios which will later be taken over by external managers. A second objective is for the Bank to be able to actively adapt the portfolio to changes in the market indices included in the bench-mark portfolio. A third objective is for the Bank itself to engage in active management in some market segments.

The sale of bonds and other fixed income securities to permit the purchase of equities in the first five months of the year was coordinated with the accumulation of the equity portfolio. The sales were carried out by Norges Bank at the same time equity purchases were to be made. The fixed income portion of the portfolio was redistributed as an adaptation to the new benchmark portfolio. The new benchmark portfolio contains more countries than previously, is based on other indices, and has a longer duration (ie the portfolio is positioned farther out on the yield curve, with prices that are more sensitive to interest rate changes). The changes were thus substantial. These were also the principal activities of the Fixed Income Unit in the transitional phase up to June 1998.

The Petroleum Fund’s portfolio of fixed income securities was managed almost in its entirety internally in Norges Bank in 1998. The market value of the internal fixed income portfolio was NOK 101.6 billion at year-end. The portfolio consisted mainly of securities that are either issued by the governments of the 18 countries in the bond investment universe, or guaran-teed by those governments. The guarantees are nor-mally explicit, but in some cases they may be implicit, particularly as in the case of bonds issued by US federal credit institutions.

The guidelines for the Petroleum Fund also permit investment in bonds issued by enterprises or institutions with a particularly high credit rating. This was not done in 1998, but work to prepare for this type of manage-ment is under way.

The Petroleum Fund only had one external bond manager in 1998. A mandate for foreign exchange reserves previously awarded to the Dutch bank ABN Amro was transferred to the Petroleum Fund in May. The market value of the portfolio at year-end was NOK 0.8 billion.

In September 1998 mandates for active bond man-agement were announced. Around 80 proposals were received, and these are currently being evaluated. According to plan, the process will be completed in the first half of 1999, and the first managers are expected to receive capital in the second half of the year.

Table 1: Market value* of the Government Petroleum Fund in 1998. In millions of NOK

	31.12.97	31.3.98	30.6.98	30.9.98	31.12.98
Equities	0	32 101	55 147	52 198	69 532
Bonds	113 401	88 421	80 622	88 520	102 300
Total	113 401	120 522	135 769	140 718	171 832

*The market value is based on the trading date, and not the value date. The above figures are therefore not identical to those presented in Norges Bank’s accounts. The figures include the portfolio reflecting the Fund’s krone account with Norges Bank, but do not cover possible differences between the transfers to this account and the government’s final annual surplus.

4. The return on the Fund

1998 was a turbulent year for international equity and bond markets. The first half of the year saw a sharp rise in prices in European and US equity markets, while a fall in interest rates generated a slight rise in bond prices. Japan also experienced a drop in interest rates, but the equity market showed no overall gains in the first half of the year. The economic crisis that began in Asia in the autumn of 1997 gathered momentum, and the Russian economic situation became increasingly difficult.

One consequence of this was a fairly sharp fall in equity prices worldwide in the third quarter. This decline was particularly marked in Europe, which had recorded the strongest rise in the first half of the year. As a result of the decline in equity prices, Japan’s equity index fell to more than 10 per cent below the level at the end of 1997. Interest rates dropped further in all main markets.

In the fourth quarter, equity markets in both the US and Europe recouped all or part of the losses in the third quarter and, viewed as a whole, the return on these markets was very high in 1998. The equity market in Japan also picked up, but the return on Japanese equity investments for 1998 as a whole was clearly negative. Interest rates were fairly stable in Germany and the US, but rose sharply in Japan in response to the gradual erosion of confidence in the Japanese economy. At the end of the year, the yield on 10-year Japanese govern-ment bonds was higher than at the beginning of the year.

A more thorough review of market developments in 1998 is presented in feature article 1.

In 1998 the Petroleum Fund recorded a return of 9.25 per cent, measured in terms of the currency basket defined by the country weights in the benchmark port-folio. If the equity and bond portions of the Petroleum Fund are considered separately, the return figures were 12.86 and 9.31 per cent for the equity and bond port-folios respectively. These figures are presented in Table 2, along with the return for each quarter in 1998. The returns on both equity and bond portfolios were negative in the third quarter, but the total return in the first and fourth quarters was solid. The return on equities was particularly high in both quarters.

The benchmark portfolio’s currency basket is partly weighted according to the importance of the individual countries in the world economy, and hence the supply of imports available to Norway, and partly according to current import weights. Thus, these weights differ from the actual import weights. It may therefore also be of interest to look at the return on an import-weighted currency basket. Table 2 shows that the return has been slightly higher when measured in this manner.

In the course of 1998 the Norwegian krone depre-ciated by nearly 10 per cent, measured in terms of the Fund’s currency basket. As a result, the return on the Petroleum Fund, measured in NOK, amounted to a full 19.75 per cent. The return in Norwegian currency is the official one, since the Fund’s accounts are kept in NOK. However, the extra return resulting from the depreciat-ion of the krone does not improve the Fund’s internat-ional purchasing power. A better indication of changes in the Fund’s purchasing power is obtained by com-puting the return either relative to the Fund’s currency basket or to an import-weighted currency basket.

The reference currency used has little effect on the difference between the actual return and the benchmark portfolio return. The differential measured against NOK was 0.20 percentage point. Calculated as a geometric difference instead of an arithmetic one, ie as a percen-tage of accumulated market value, the excess return was 0.16 per cent. This difference, calculated either way, represents an excess return that would not have arisen if the Fund’s portfolio had been identical to the bench-mark portfolio at all times.

The excess return in relation to the benchmark port-folio was highest in the first quarter. This was because most of the time the equity portion of the actual port-folio was larger than that of the benchmark portfolio. Since equity prices rose substantially in this quarter, the overweighting of equities was profitable. A similar situation occurred in the second quarter, but the gains in the form of an excess return were lower. In both quar-ters, the excess return was not a result of active manage-ment, but rather a side effect of a predetermined plan for reducing the possibility of market influence from equity purchases (see Section 3.1 above).

In the third quarter, the return on the actual portfolio was 0.23 percentage point lower than the return on the benchmark portfolio. One reason for this was a contin-ued overweighting of equities in July and August. With a decline in share prices, this was not profitable. Another reason was that the bond portion contained securities not included in the benchmark portfolio’s government bond indices. These non-government secu-rities have a small credit risk, and hence a higher yield than government paper. In the third quarter the yield spread between these securities and government paper increased substantially, resulting in a clear price loss in relation to government paper in the same currency.

Table 2: Return figures for each quarter and for the year 1998.

Return in the period	Equity portfolio		Bond portfolio		Total portfolio
	Actual	Benchmark	Actual	Benchmark	Actual	Benchmark
The Petroleum Fund’s currency basket
1st quarter	11,38*	11,78*	2,19	2,03	3,73	3,33
2nd quarter	2,14	1,89	1,86	1,90	2,07	2,03
3rd quarter	-15,57	-15,69	4,62	4,86	-3,58	-3,35
4th quarter	17,51	17,77	0,38	0,08	7,02	7,05
Year 1998	12,86	13,10	9,31	9,10	9,25	9,08
Import-weighted currency basket, 1998	13,26	13,50	12,16	11,95	11,58	11,40
USD, 1998	18,69	18,93	15,58	15,36	14,98	14,79
NOK, 1998	19,33	19,58	20,37	20,14	19,75	19,55
Excess return		-0,25		0,23		0,20

* The equity return for the first quarter includes February and March only. In January equities were not part of the benchmark portfolio.

In the fourth quarter there was little difference between the actual return and the return on the bench-mark portfolio. Some limited active positions were taken. These had a varying effect on the excess return, and in opposite directions, and the overall effect was limited.

The return figures include income from the lending of securities, specifically short-term lending to counter-parties that not only have high credit ratings but also supply full collateral for the value of the paper they borrow. Table 3 shows that total lending income amounted to NOK 45.1 million, or 0.03 per cent of the average value of the Petroleum Fund’s portfolio. This is income that the benchmark portfolio is not expected to generate.

Table 3: Income from the lending of securities in 1998

	Securities lending	Equities lending	Total
Income (NOK 1000)	14 538	30 560	45 098

The Government Petroleum Fund pays taxes on the return in some markets, and is fully exempt in others. In the benchmark portfolio, account is not taken of taxes, so that the return on the benchmark portfolio will be somewhat higher than the return achieved in practice through passive management. According to calculations made by Norges Bank, the return on the Petroleum Fund is 0.03 per cent lower than the return on the benchmark portfolio as a result of tax payments.

Methodology for calculating returns

The calculation of the final return figures is performed by the Market Operations Department, which is an entity separate from Norges Bank Investment Manage-ment. The returns are calculated according to the market value principle, ie the portfolios are valued at the rele-vant market prices at the end of the period. All return components, ie interest expenses and income, changes in holdings and changes in securities prices, are inclu-ded in the return and accounted for on an accruals basis. When calculating values and results, 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 relative geo-metric return is used.

The calculations of the return are carried out in separate models, which are not reconciled with the accounting system. In the calculations, market values on the trade date are used, and not the principle of lower of cost or market value, and the settlement date, as in the accounts. There may therefore be discrepancies in the returns calculated by two systems. Discrepancies may also be due to differences in the pricing of securities.

During the transitional period in connection with the adaptation to the new guidelines for the Government Petroleum Fund during the first half of 1998, frequent, large external cash flows took place between the asset classes equities and bonds and between the various currency portfolios within each asset class. The time-weighted return should be used when comparing the results against a benchmark portfolio, in order to elimi-nate the effect of incoming and outgoing payments to and from the portfolio. It is then necessary to calculate the market value of the portfolio at each cash flow date, and the return is found as the change in market value. A return index is thus derived for each cash flow date. The return for a period is found by multiplying the various return indices.

To date, Norges Bank has carried out quality assurance of market values only at month-end, and has therefore not been able to calculate a time-weighted return at any other point during the month.

Instead, a cash-weighted method has been used, whereby the monthly percentage return on the Government Petroleum Fund is calculated by distributing the various cash flows between the opening value and closing value, and the return is found by dividing the portfolio’s adjusted final value by the adjusted initial value.

The method used to calculate the monthly percentage return is summed up in the following formula:

der

y = return for period
V1 = the portfolio’s value at the start (including accrued interest)
V2 = the portfolio’s value at the end of the period (including accrued interest)
T = number of days in the period
i = day number in the period
d_i = total transaction amount on day i

The return for longer periods, such as the quarterly return and return to date this year, is found by multiplying the return indices for the months. In other words, it is a time-weighted product of the return for the individual months.

The return in both NOK and local currencies is calcu-lated by the method described above. 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. These exchange rates are fixed at 4 pm London time.

The total return in local currency is calculated by weighting the return for each currency by the share that currency constitutes of the total portfolio. The shares are regarded as the market values of the individual curren-cies as a percentage of the market value in NOK of the total portfolio at the start of the measurement period.

The currency return is calculated as the difference between the return in NOK and local currency. This has been found to be the most correct means of splitting the return between the currency return and the return on bonds/equities. This applied particularly during the transitional period, when there were many transfers between currencies and asset classes. The currency return can in turn be broken down into two components: one showing the return on currency achieved by the benchmark portfolio, and one corresponding to the return on currency the Fund has achieved by deviating from the currency distribution in the benchmark port-folio. By adding the latter portion of the return on currency to the return in local currency, one arrives at the return in local currency measured in the currency distribution of the benchmark portfolio.

Historical review

Capital was first transferred to the Government Petroleum Fund in 1996, when the central government accounts for 1995 showed a surplus. At the end of 1996 further capital was transferred, corresponding to the estimated central government surplus for that year. Capital was also transferred at the end of 1997. Table 4 shows the return for the three years that the Fund has been endowed with capital. The figure for 1996 is very small compared with figures for the past two years. Measured in NOK, the return in 1998 was markedly higher than in 1997, but mainly due to the depreciation of the krone in 1998.

Table 4: Historical return on the Government Petroleum Fund

	1996	1997	1998
Return measured against NOK	*3,15%	10,83%	19,75%
Excess return in relation to the benchmark portfolio		0,23%	0,20%
Transferred from the Ministry of Finance, in millions of NOK	46 194	64 019	32 873
Market value in millions of NOK, at 31 December	46 301	113 401	171 832

* The return for 1996 is for the period from the first transfer (NOK 1 981m in May) to the end of the year. The remainder of the 1996 transfer was made on 31 December.

5. Market risk

The Ministry of Finance has set a limit for the market risk associated with the actual portfolio, relative to the benchmark portfolio, by requiring that expected tracking error always be less than 1.5 per cent (see Section 1 above). This limit has not been exceeded. The limit was neared during the transitional period to June, when equity purchases for the actual portfolio were largely made a few days before the benchmark portfolio was modified. The figures at the end of each month of this period consequently show a high expected tracking error. But the tracking error compared with the benchmark portfolio for the next month was consi-stently low (see Chart 5).

Chart 5: Exepted each Friday in 1998, in basis points

Since the transition to the new benchmark portfolio, relative market risk has been low and relatively stable. The deviations made from the benchmark portfolio have never brought the expected tracking error above 1.0 per cent, and the usual level has been around 0.2 per cent.

6. Compliance with the regulations

In addition to the limit on market risk, the Ministry of Finance has set other limits on the investment of the Petroleum Fund’s capital. Table 6 provides a summary of these rules, and shows that in 1998 the Petroleum Fund has been managed such that there have been comfortable margins in relation to the stipulated limits.

Table 6: Risk exposure in relation to the limits in the regulation

Section	Risk	Limits	Actual 31.12.97	Actual 31.3.98	Actual 30.6.98	Actual 30.9.98	Actual 31.12.98
§ 4	Tracking error	Maximum 1,5%	0,12%**	1,20%	0,35%	0,50%	0,20%
§ 5*	Asset distribution	Fixed income 50-70%	100,0%	73,4%	59,4%	62,8%	59,6%
		Fixed income 30-50%	0,0%	26,6%	40,6%	37,2%	40,5%
§ 6*	Currency distribution	Europe 40-60%	57,7%	53,2%	50,4%	50,1%	50,1%
		America 20-40%	27,2%	29,2%	30,3%	29,8%	29,9%
		Asia / Oceania 10-30%	15,1%	17,6%	19,3%	20,1%	20,1%
§ 7	Interest- rate risk	Modified duration 3-7	3,43	4,06	5,13	5,29	5,14
§ 8	Credit risk	Max. 20% in bank	4,6%	3,6%	4,7%	5,0%	3,4%
§ 10	Largest holding	Max. 1% of a company	0,0%	0,07%	0,09%	0,11%	0,43%
	Largest amount in one company (NOK m)	No limit	0	131,6	581,3	485,6	831,2

* Sections 5 and 6 of the regulation entered into force on 1 June 1998.
** Calculated in relation to the benchmark portfolio for January 1998.

7. Control of management

The management of the Government Petroleum Fund is part of Norges Bank’s activity, and thus subject to the same control routines as the central bank’s other activi-ties. In addition, a number of control mechanisms apply specifically to the Petroleum Fund.

Norges Bank’s Executive Board has decided that the internal control requirements applying to other Norwegian financial institutions shall also apply to Norges Bank. This means that Norges Bank Investment Management is required to have its own routines to con-trol all aspects of its activities. This internal control is the most important and comprehensive form of control of investment management activities (see feature article 4).

The Central Bank Governor has the ultimate responsi-bility for the control of all the central bank’s activities. Several organisational measures have been implemen-ted to reinforce the Governor’s control of investment management. The Market Operations Department, which is not a part of Norges Bank Investment Management, is responsible for ensuring that Fund management proceeds according to satisfactory internal control procedures, and for making independent mea-surements of return and risk. A special advisory committee of persons from other parts of the central bank also assists the Governor in matters pertaining to investment management.

Norges Bank’s Auditing Department reports to the central bank’s Supervisory Council, which is appointed by the Storting. The Auditing Department has the same responsibility for auditing Investment Management as for other parts of the central bank’s activities, and has decided to give relatively high priority to this aspect of its responsibilities.

The Office of the Auditor General has the ultimate responsibility for supervising all government activities, including the management of the Government Petroleum Fund. To avoid duplication, an agreement has been entered into with Norges Bank’s Auditing Department, which stipulates that the Auditor General shall base its audit of the Petroleum Fund on the work carried out by the Auditing Department of Norges Bank.

As delegating authority for the management of the Government Petroleum Fund, the Ministry of Finance is continuously informed of the Bank’s management activities. The most important information is provided in quarterly reports, which are available to the public. In order to discharge its supervisory responsibilities, the Ministry has engaged the consulting company Bacon & Woodrow to evaluate management performance. Norges Bank’s Investment Management is obliged to give the Ministry’s consultants full access to its databases.

8. Management costs

The management agreement between the Ministry of Finance and Norges Bank (see documentation section) stipulates the principles and rates for remuneration to Norges Bank. In principle, costs incurred by Norges Bank in connection with the management of the Petroleum Fund are to be covered in full. The agreed rates for 1998 were 0.105 of the average value which may be invested in equity instruments according to the benchmark portfolio, and 0.065 per cent of the average value that can be invested in fixed income instruments. In the final calculation of the remuneration, a minor reduction was made because some of the cost compo-nents included in the calculation basis had actually been charged directly to the Petroleum Fund. Total remuneration for 1998 was NOK 77.4 million.

The actual costs incurred by Norges Bank consist partly of fees to external managers and to the custodian bank, and partly of the Bank’s internal operating costs. The external costs associated with the Petroleum Fund can easily be identified, whereas the internal costs will apply to all three funds under management. The internal costs applying to the Petroleum Fund are therefore calculated using a set of internal prices. The internal costs cover not only the units that contribute directly to the operational management, but also all support funct-ions. The internal costs are calculated according to the guidelines applying to business operations in Norges Bank.

Table 7 summarises the costs Norges Bank incurred in connection with the management of the Government Petroleum Fund in 1998. The table only presents current operating expenses, not write-offs of start-up costs and investments.

Table 7: Costs of managing the Government Petroleum Fund in 1998, including the costs of establishing the equity portfolio

	Thousands of NOK
Internal costs, equities	9 343
Fees, external equity managers	13 497
Costs, equity custodian	9 797
Total costs, equity management	32 637
Internal cost, fixed income management	29 012
Costs, external bond managers	874
Costs, fixed income custodian*	4 272
Total costs, fixed income management	34 158
Total management costs	66 795

*Including custodian costs that are charged directly to portfolios.

The average market value of the Fund, calculated on the basis of market values at the start of each quarter, was NOK 127.6 billion in 1998. Equities account for NOK 39.6 billion of this amount, and fixed income instruments for NOK 88.0 billion. Costs thus amounted to 0.082 per cent and 0.039 per cent of the average market value of the equity and bond portfolios respectively.

These are very low costs compared with those of other large international funds. It is difficult to find fully comparable funds, but the management costs of large pension funds in the US and Europe are normally over 0.10 per cent of the assets under management. The low cost level of the Petroleum Fund is partly attributable to the fact that the management model was not fully deve-loped in 1998, and that only a limited amount of active management has taken place with the aim of outperfor-ming the benchmark portfolio. In the longer term, a higher cost level can be justified if the increase in the return fully offsets the increase in costs.

9. Reporting of accounts

Pursuant to the Regulation on the Management of the Government Petroleum Fund, Norges Bank has in-vested the Fund’s krone deposits separately in assets denominated in foreign currency. Table 8 shows how the accounting value of the portfolio is distributed among instruments at 31 December 1998, as well as at the end of each quarter of the year. The accounting value recorded for the krone account, including the return for the period 1 January-31 December, 1998, amounted to NOK 167 643 767 103.99 at 31 December 1998. Investments made in foreign currency have been translated into NOK at the exchange rates prevailing on 31 December 1998 as listed on WM Reuters at 4 pm London time. The value of the foreign securities port-folio is set at the lower of average acquisition price or market value at 31 December 1998.

The valuation of the portfolio according to accoun-ting principles differs from the market values presented in this report. Market values have been used since the Petroleum Fund is composed exclusively of securities with daily quotations of market prices. The principle of market value provides a more secure basis for the correct valuation of this type of asset than the accoun-ting principle of lower value.

Table 8: The portfolio of the Government Petroleum Fund, sorted by instrument. In thousands of NOK

Instrument	31.12.97	31.3.98	30.6.98	30.9.98	31.12.98
Bank deposits/loans abroad	5 254 262	4 278 716	6 378 405	7 094 356	5 891 261
Foreign Treasury bills	164 822	-	123 783	333 606	492 384
Foreign bearer bonds	104 990 657	83 363 584	76 711 343	85 457 847	97 836 191
Equities abroad	-	28 583 192	46 292 677	45 949 356	64 245 807
Lending abroad	747 431	1 187 302	3 826 471	3 710 759	8 000 533
Accured interest	2 903 495	2 017 669	1 442 068	1 924 493	2 361 879
Accured dividends	-	68 909	91 283	150 686	98 578
Withholding tax	-	-	4 566	13 260	17 273
Forward conrtact adjustment	-	-	-1 739	-14 825	-7 610
Loans, foreign banks*	-747 431	-1 187 302	-2 213 499	-4 297 802	-11 215 049
Accured interest, loans	-273	-1 766	-5 136	-84	-118
Miscellaneous dept**	-	-	-	-49 153	-77 362
Total portfolio	113 312 963	118 310 304	132 650 222	140 272 499	167 643 767

* Collateral for securities on loan.
** Mainly remuneration erned by Norges Bank.

At 31 December 1998, the total market value of listed futures contracts purchased amounted to NOK 2 493.2 million. The total market value of futures sales contracts at 31 December 1998 amounted to NOK 3 531.5 million.

The total value of foreign currency bought forward at 31 December 1998 was NOK 3 135.3 million, and forward currency sales contracts amounted to NOK 3 135.3 million.

Pursuant to the Regulation, the return achieved by Norges Bank on foreign investments is transferred to the Government Petroleum Fund’s krone account. The return recorded on the krone account at 31 December 1998 is broken down in Table 9, which also shows comparable figures for 1997 and previous quarters of 1998.

The same accounting principles used for Norges Bank’s accounts have been used to calculate returns, ie income and expenses are translated into NOK according to the exchange rate at the time of transaction and recognised as they are earned or incurred according to the accruals principle. The return figures differ from those arrived at using the principle of market value, as applied earlier in this report. The use of the principle of lower value in the calculation of returns is arbitrary to some extent since the choice of the papers that are to be realised at various points in time may be somewhat random.

Table 9: The return on the portfolio of the Gov ernment Petroleum Fund in 1998. In thousands of NOK

Return	31.12.97	31.3.98	30.6.98	30.9.98	31.12.98
Interest income	3 342 455	1 657 894	2 932 567	4 156 859	5 566 546
Dividends	-	84 147	352 400	573 341	705 588
Exchange gains	1 688 979	2 776 568	3 751 569	3 291 827	13 149 314
Unrealised securities losses	36 660	-17 718	-18 393	-3 464 140	-60 969
Realised securities gains	- 204 500	343 110	457 719	568 552	857 559
Brokers’ commissions	-	-	-5 232	-7 302	-12 245
Result forward exchange trading	-	-	-140 298	-109 876	-4 158
Gains futures	10 332	153 341	134 232	166 806	1 369 864
Total return on investments	4 873 926	4 997 342	7 500 591	50 176 067	21 571 499
Accrued management remuneration	-	-	-	-53 200	-77 362
Net return	4 873 926	4 997 342	7 500 591	5 122 867	21 494 137

Auditor’s report

Statement to the Ministry of Finance

Annual Report of the Government Petroleum Fund for 1998

We have audited the annual report and accounts of the Government Petroleum Fund for 1998 which show a market value for the year of NOK 171.8 billion, an accounting profit of NOK 21.5 billion and an accounting value of NOK 167.7 billion. The Executive Board of Norges Bank is responsible for the annual report. Pursuant to the management agreement between the Ministry of Finance and Norges Bank, our responsibility is to examine the Fund`s annual report and determine whether the Fund is being managed in accordance with Act no. 36 of 22 June 1990 on the Government Petroleum Fund and the Regulation of 3 October 1997 relating to the Management of the Government Petroleum Fund. Our audit of the annual report comprises the report on the accounts presented in section 9 of the annual report. We have also made an assessment of information and figures provided in sections 1-8 of the annual report.

We have conducted our audit in accordance with generally accepted auditing standards and submit our certification in accordance with the accounting standard RS 800 of the Norwegian Institute of State-Authorised Public Accountants - «Auditors’ statements concerning audits for special purposes» We have performed those auditing procedures which we have considered necessary to confirm that the annual accounts are free of material misstatements or omissions. We have examined selected parts of the evidence supporting the accounts and information provided in the annual report. We have also assessed the accounting principles applied and the contents and presentation of the annual report. We have confirmed that the accounting information provided is consistent with the information on the Fund presented in the revised annual accounts for Norges Bank for 1998, which were adopted on 18 February 1999. To the extent required by generally accepted auditing standards, auditing instructions and agreements, we have reviewed Norges Bank’s asset management and the internal control of the Fund.

In our opinion, the annual report presents fairly the financial position of the Government Petroleum Fund at 31 December 1998 and the result of its operations for the financial year, in accordance with the annual accounts and accounting principles of Norges Bank. In our opinion, the management of the Fund in 1998 complies with the acts and regulations which are referred to in the first paragraph.

Oslo 24 February 1999
State Authorized Public Accountant

Svenn Erik Forsstrøm
State Authorized Public Accountant

Mats Leonhard Pedersen
Statsautorisert revisor