The Norwegian Government Pension Fund

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  • 1. Norges Bank Investment Management The Norwegian Government Pension Fund & NBIM Presentation to Central Bank of Chile, Santiago, 3 October 2007 Knut N. Kjaer Norges Bank Investment Management KNK NBIM Santiago October 2007 1
  • 2. Norges Bank Investment Management Agenda • Introduction, background • From oil to equities • Fund management model • Strategic asset allocation • Experiences 1998 – 2007 (testing the strategy in practice) • NBIM tasks and organization • Achieving excess return by active management • Performance 1998 – 2007:2 • NBIM critical success factors • Ethical investments • Discussion points NBIM KNK Santiago October 2007 2
  • 3. Norges Bank Investment Management Historical Context • ”One may disregard the possibility of discovering coal, oil or sulphur on the Norwegian Continental Shelf” (Letter from the Geological Survey of Norway to the Ministry of Foreign Affairs, 1958) • 1962: Phillips Petroleum applies for exclusive exploration and production rights (Not granted) • 1969: First petroleum discovery (Ekofisk Field) (Production started in 1971) NBIM KNK Santiago October 2007 3
  • 4. Norges Bank Investment Management Historical Context 1990 The Norwegian Government Petroleum Fund established by law 1996 Initial capital transfer (May) 1998 Equities added to the investment universe 2002 Non-government bonds added to the investment universe 2004 Ethical investment guidelines issued 2006 The Government Pension Fund established • Part of a broad-based national pension reform • Continuation of the Petroleum Fund and the National Insurance Scheme Fund – no change in organisational set-up or activities – two separate funds • The Government Pension Fund – Global continues to be managed by Norges Bank NBIM KNK Santiago October 2007 4
  • 5. Norges Bank Investment Management The Ranking of Oil Producers 2006 (mill b/d) Production Net export Saudi Arabia 10.23 Saudi Arabia Russia 9.65 Russia USA 7.32 Iran Iran 4.27 UAE Mexico 3.70 Norway China 3.68 Nigeria Canada 3.21 Venezuela UAE 3.03 Kuwait Venezuela 2.84 Mexico Norway 2.77 Libya 0 2 4 6 8 10 12 0 2 4 6 8 10 Source: Facts – The Norwegian Petroleum Sector 2007, Ministry of Petroleum and Energy NBIM KNK Santiago October 2007 5
  • 6. Norges Bank Investment Management Macroeconomic indicators for the petroleum sector Source: Facts – The Norwegian Petroleum Sector 2007, Ministry of Petroleum and Energy NBIM KNK Santiago October 2007 6
  • 7. Norges Bank Investment Management The net government cash flow from petroleum activities Source: Facts – The Norwegian Petroleum Sector 2007, Ministry of Petroleum and Energy NBIM KNK Santiago October 2007 7
  • 8. Norges Bank Investment Management Transfers to the Pension Fund The Governments Net Cash Flow from Petroleum 60.0 50.0 Transfers to the Petroleum Fund 40.0 Financing the budget deficits USD bn 30.0 20.0 10.0 0.0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 NBIM KNK Santiago October 2007 8
  • 9. Norges Bank Investment Management The National Challenges % 25 GDP of Petroleum revenues Pensions 20 15 10 5 0 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 • Ensure a fair distribution of oil wealth across generations – as oil wealth is transformed to financial wealth do not spend the principal, only the expected real return • Avoid pronounced cyclical fluctuations in the mainland economy due to variations in oil revenues – invest in financial assets abroad only NBIM KNK Santiago October 2007 9
  • 10. Norges Bank Investment Management An international Perspective on Our Business Bn. USD 350 300 250 Bn. USD 200 150 100 50 0 NBIM, Norw ay ABP, Netherlands CalPERS, USA AP-fondene, Sw eden PGGM, Netherlands Pension Fund Global Other Funds Source: Funds’ web pages, Investments&Pensions, the Economist / Latest available information NBIM KNK Santiago October 2007 10
  • 11. Norges Bank Investment Management Sovereign Wealth Funds – Largest Funds Ranked by Assets Fund name Country Assets (USD) Adia UAE 875 GIC Singapore 330 Funds of various types Saudi Arabia 300 Government Pension Fund - Global Norway 300 State FX Investment Corp and Hueijing Co. China 300 Temasek Holdings Singapore 100 Kuwait Investment Authority Kuwait 70 Australian Future Fund Australia 40 Permanent Reserve Fund Alaska, USA 35 Stabilisation Fund Russland 32 Brunei Investment Authority Brunei 30 Korea Investment Corporation Sør Korea 20 Khazanah Nasional BHD Malaysia 18 National Stabilisation Fund Taiwan 15 Alberta Heritage TF Canada 13 Oil Stabilisation Fund Iran 11 Source: Morgan Stanley estimates NBIM KNK Santiago October 2007 11
  • 12. Norges Bank Investment Management Projected Growth of the Government Pension Fund - Global 500 450 400 350 300 Bn. USD 250 200 150 100 50 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Revised National Budget 2007, May 2007 NBIM KNK Santiago October 2007 12
  • 13. Norges Bank Investment Management From Oil to Equities Basics behind the Norwegian Government Petroleum/Pension Fund KNK NBIM Santiago October 2007 13
  • 14. Norges Bank Investment Management Mission for the Petroleum/Pension Fund • Safeguard the petroleum wealth for future generations (also stabilizing the economy) Function • Diversifying from one asset (petroleum) to a portfolio of international securities reduces the risk and increases expected return NBIM KNK Santiago October 2007 14
  • 15. Norges Bank Investment Management Strategy: Transition From Petroleum • The Oil Fund’s key function is to diversify the Petroleum Wealth into a broad portfolio of international securities • The transition takes down the expected risk significantly and increases the expected return • The Fund makes the income stream from the non-renewable resources permanent • The intention is to spend only the (expected) real return at the annual public budgets, thus preserving the capital of the fund for all future generations NBIM KNK Santiago October 2007 15
  • 16. Norges Bank Investment Management Petroleum Wealth - Autumn 2006 600 500 400 USD Bn 300 200 100 0 Petroleum In Oil fund Equities Bonds Ground Petroleum in the ground: Net present value of the government’s future cash flows from oil activities. Estimated at NOK 3660 billion at constant 2007 values (Source: National Budget 2007) NBIM KNK Santiago October 2007 16
  • 17. Norges Bank Investment Management Petroleum Wealth - Value at Risk 200 180 160 140 120 USD Bn 100 80 60 40 20 0 Petroleum In Oil fund Equities Bonds Ground Value at Risk is defined as one standard deviation in this context. The actual values will fluctuate outside the bands in one out of three years NBIM KNK Santiago October 2007 17
  • 18. Norges Bank Investment Management Real Global Market Returns 1900 – 2006 1000 Money Market 427 Bonds 100 Equities Oil 10 6 3 1 2 0.1 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Source: Dimson, Marsh & Staunton, Triumph of the Optimists, 2002, with updates NBIM KNK Santiago October 2007 18
  • 19. Norges Bank Investment Management Portfolios of Equities, Oil and Bonds 7.00 % 6.00 % 100% equities 5.00 % Real Return 4.00 % 3.00 % 2.00 % 1.00 % 100% oil 100% bonds 0.00 % 0.00 % 5.00 % 10.00 15.00 20.00 25.00 30.00 35.00 % % % % % % Standard deviation NBIM KNK Santiago October 2007 19
  • 20. Norges Bank Investment Management From petroleum to financial wealth Per cent of total national wealth 7 6 5 4 Petroleum wealth 3 Financial wealth 2 1 0 1999 2030 NBIM KNK Santiago October 2007 20
  • 21. Norges Bank Investment Management The Fund Management Model, Governance Structure NBIM KNK Santiago October 2007 21
  • 22. Norges Bank Investment Management Accountable to the People of Norway • The Parliament has the ultimate responsibility towards the owners (the Norwegian population) and sets the risk appetite. • The key decision is the strategic allocation to equities and to other asset classes (Defines risk tolerance rather than return requirements) • The Parliament also sets ethical guidelines • The operational management is delegated to Norges Bank (the central bank) NBIM KNK Santiago October 2007 22
  • 23. Norges Bank Investment Management Norway’s SWF – Key Features Accountability • The main decisions on objectives, risk tolerance and ethical criteria’s lays with the Parliament • Clear investment strategy and principles • Clear division of responsibility between the owner (Parliament, MoF) and the manager (Norges Bank) Transparency • All principles, guidelines, risk and performance data are made public. • All holdings disclosed in the annual reports NBIM KNK Santiago October 2007 23
  • 24. Norges Bank Investment Management The Role of the Ministry of Finance • Propose risk tolerance, strategic allocation and key guidelines to the Parliament. • Define the benchmark portfolio • Set limits on active risk • Monitor the performance of Norges Bank • MoF use consultants and a strategic council to get second opinions on performance and strategy • A ethical council give the MoF advice on exclusion of companies (based on the ethical guidelines) • Reports to the Parliament NBIM KNK Santiago October 2007 24
  • 25. Norges Bank Investment Management The Role of Norges Bank • cost-effective transitions and market exposure • active management to achieve excess return • risk control and reporting • exercise ownership rights / Corporate governance • provide professional advice on investment strategy NBIM KNK Santiago October 2007 25
  • 26. Norges Bank Investment Management Pension Fund Global / Governance Structure Founded on Act, regulations and separate contracts Legislator Norwegian Parliament Office of the Auditor General Pension Fund Performance reports and strategic changes Act reported in National Budgets and National Accounts Principal Ministry of Finance Advisory / consultancy agreements Advisors Norges Regulations Management - Strategy Council Bank Audit - Council of Ethics agreement - Mercer - Norges Bank Performance Manager Norges Bank Investment reports Management / NBIM NBIM KNK Santiago October 2007 26
  • 27. Norges Bank Investment Management Transparency • Performance, risk and costs are reported by NBIM every quarter. Focus on contribution to value added in operational management • Quarterly reports published on web-site • Press conference on a quarterly basis • Annual report listing all investments, both equities and fixed income NBIM KNK Santiago October 2007 27
  • 28. Norges Bank Investment Management Transparency: Reporting The annual report disclose all holdings of securities and gives detailed descriptions on absolute and relative performance, risk and costs NBIM KNK Santiago October 2007 28
  • 29. Norges Bank Investment Management NBIM's Web pages www.nbim.no NBIM KNK Santiago October 2007 29
  • 30. Norges Bank Investment Management Transparency: Ministry of Finance NBIM KNK Santiago October 2007 30
  • 31. Norges Bank Investment Management Building Blocks of Setting Strategic Asset Allocation (SAA) KNK NBIM Santiago October 2007 31
  • 32. Norges Bank Investment Management • Governance. Asset owner responsibilities • Ability to cope with volatility in returns • Financial theory • Historical data • Simulation models • Information, stakeholder dialogue NBIM KNK Santiago October 2007 32
  • 33. Norges Bank Investment Management The Two Components of Financial Return β Market exposure The asset owner’s choice of long term strategic allocation. Based on robust assumptions. Does not rely upon information privileges α Excess return by active management.The managers exploiting of information privileges This presentation is based on the realistic assumption that alpha plays a less significant role in the long term returns for most funds NBIM KNK Santiago October 2007 33
  • 34. Norges Bank Investment Management Governance • The SAA defines most of the funds expected risk and return and must be understood and owned by the ultimate asset owner • Norway: The Parliament represents the 4.6 million stakeholders and decides the SAA. • NBIM give advice through the Ministry of Finance. They also use an Advisory Council and second opinion advisors NBIM KNK Santiago October 2007 34
  • 35. Norges Bank Investment Management Ability to Cope With Volatility in Returns • Norwegian Oil Fund: Future governments can easily cope with fluctuations in return. With no defined liability side – the key decision criteria is to set the risk as high as possible, but not so high that the strategy is adjusted in market draw downs • Pension funds: The true long term benchmark is the pension liabilities • Given diversified portfolio, all limits on expected volatility impose costs NBIM KNK Santiago October 2007 35
  • 36. Norges Bank Investment Management Capital Asset Pricing Model (CAPM) • Assumes efficient markets • In equilibrium, all investors hold a diversified portfolio of all assets (the market portfolio) and a part in a risk free portfolio (dependent on the risk aversion) • Not possible to enhance return without increasing the risk • All investments give the same risk adjusted return (in optimum) NBIM KNK Santiago October 2007 36
  • 37. Norges Bank Investment Management Expected Return Againts Expected Risk Expected return Expected Rates of Return for Various Asset Classes 11% S&P 500 SPEC EQ CORE EQ 10% VENT CAP YLD EQ 9% GROWTH EQ 8% EXT MAT FI INT'L EQ 7% S/L IND FI INT'L FI VALUE EQ 6% ACT FI REAL ESTATE 5% DEF FI 4% CORE FI INT FI 3% CASH Risk (standard deviation) 2% 0% 5% 10% 15% 20% 25% 30% 35% Source: Bridgewater Associates NBIM KNK Santiago October 2007 37
  • 38. Norges Bank Investment Management Source: Bridgewater NBIM KNK Santiago October 2007 38
  • 39. Norges Bank Investment Management Key Question: Risk Preferences • Buy the global market portfolio • If risk is too high, blend the market portfolio with a risk free portfolio. If too low, leverage up. And if you are to big to do that, increase the equity portion • There is no way to get higher returns without being willing to increase risk NBIM KNK Santiago October 2007 39
  • 40. Norges Bank Investment Management Basically Two Options • Lender (Bonds) Lending to governments and companies. The cash flow is fixed. Lenders are contractually protected by collateral in the company’s assets, but have normally no ownership rights • Owner (Equities) Equity is unsecured capital. Owners get the residual after the contract counterparties (suppliers, customers, employees, lenders) have got their share, but have the ownership rights (corporate governance) The cash flow is variable. NBIM KNK Santiago October 2007 40
  • 41. Norges Bank Investment Management Capital Market Return Data From 17 Countries, 1900 to 2006 • Many empirical studies has been based only on short time series and/or data from a few countries • Most of the research on equity premiums has been based on American data. USA has been a remarkably successful economy. • Survivorship bias overstates capital market return • Dimson, Mars & Staunton (DMS) at the London Business School present very relevant data in the book ”Triumph of the Optimists” - covering return in 16 (17) countries from 1900 to 2000 (2006) • The next charts are based on this data, delivered by Morningstar NBIM KNK Santiago October 2007 41
  • 42. Norges Bank Investment Management Year-To-Year Fluctuations in Return G lo b a l E q u ity M a rk e t N o m in a l R e tu rn 80 60 40 Percent 20 0 Standard -2 0 deviation global equities: -4 0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 16.6% G lo b a l B o n d M a rk e t N o m in a l R e tu rn 80 60 Standard deviation 40 global bonds: Percent 20 8.6% 0 Money -2 0 Market: 2.8 % -4 0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 NBIM KNK Santiago October 2007 42
  • 43. Norges Bank Investment Management Global Equity Real Return, 5 and 10 Year Horizons 25.00 20.00 15.00 10.00 Percent 5.00 0.00 -5.00 5 Years -10.00 10 Years -15.00 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 NBIM KNK Santiago October 2007 43
  • 44. Norges Bank Investment Management Global Equity Risk Premiums, 5 and 10 Year Horizons 25.00 5 Years 20.00 10 Years 15.00 10.00 Percent 5.00 0.00 -5.00 -10.00 -15.00 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 NBIM KNK Santiago October 2007 44
  • 45. Norges Bank Investment Management Global Capital Market Return 1900-2006 1000 Money Market 427 Bonds 100 Equities 6 10 3 1 0.1 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Excess return equities over money market: 4.8% annually NBIM KNK Santiago October 2007 45
  • 46. Norges Bank Investment Management Global Capital Market & Copper Return 1900-2006 1000 Money Market 427 Bonds 100 Equities Copper 6 10 3 1 1 0.1 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Excess return equities over money market: 4.8% annually NBIM KNK Santiago October 2007 46
  • 47. Norges Bank Investment Management NBIM KNK Santiago October 2007 47
  • 48. Norges Bank Investment Management Model simulations NBIM KNK Santiago October 2007 48
  • 49. Norges Bank Investment Management Is the Past a Good Predictor for Future Equity Risk Premiums? Points made by DMS: • No reason to expect persistent multiple expansion in the future (?), lower ERP with 0.7 pp • Today’s dividend yield lower than historical average, lower ERP with 0.5 - 1 pp (?) NBIM KNK Santiago October 2007 49
  • 50. Norges Bank Investment Management Report no 24 to the Storting / Main points • Equity share to increase from 40 to 60 per cent • Inclusion of small cap equities in the benchmark • Approved country / currency list is abolished • Exclusion mechanism for countries (Burma) • (For private companies there is an exclusion mechanism) • Positive assessment on real estate, but no implementation commitment NBIM KNK Santiago October 2007 50
  • 51. Norges Bank Investment Management Pension Fund Global – Guidelines • The Ministry of Finance has decided on the following guidelines: • Asset allocation until June 2007 (60% Fixed Income / 40% Equities) • Exchange listing (for EQ) • Maximum ownership share in any one company is 5% • Risk limit (1.5% expected tracking error) • No investments in Norwegian companies or in NOK • A benchmark portfolio for bonds and equities is created based on well-defined market indices NBIM KNK Santiago October 2007 51
  • 52. Norges Bank Investment Management Benchmark for the Pension Fund-Global FI - Americas Strategic benchmark: 21 % EQ - Europe 20 % 60 40 % Fixed FI - Asia / Pacific Income 3% 40 60 % Equities “Smart” rebalancing: EQ - Asia / Pacific 6% • Monthly inflows • Asset class / region with largest negative EQ - Americas / Africa FI - Europe 36 % deviation from 14 % benchmark Equity index: Fixed income index: FTSE All World Index Lehman Brothers Global Aggregate Large & Mid Cap Government / Agency / Corporate / Securitized 9 2 421 equities 9 205 bonds NBIM KNK Santiago October 2007 52
  • 53. Norges Bank Investment Management Experiences 1998 - 2007 The Oil Fund increased the equity portion from 0 to 40% in 1998 .. and met from 2000 the worst decline in global equity markets since the 1930’s… KNK NBIM Santiago October 2007 53
  • 54. NBIM KNK 4. 80 90 100 110 120 130 140 150 160 170 kv . 19 97 1. kv . 19 98 2. kv . 19 98 3. kv . 19 98 4. kv . 19 98 Index, 1997:12 = 100 1. kv . 19 99 2. kv . 19 99 3. kv . Santiago October 2007 19 99 4. kv . 19 99 1. kv . 20 00 2. kv . 20 00 3. kv . 20 00 4. kv . 20 00 1. kv . 20 01 2. kv . 20 01 3. kv . Market Return 1998 - 2002 20 01 4. kv . 20 01 1. kv . 20 02 2. kv . 20 02 3. kv . Equities 20 02 4. Bonds kv . 20 02 Total Norges Bank Investment Management 54
  • 55. Norges Bank Investment Management ”They make Norway more poor” ”Catastrophic numbers for the oil fund” Aftenposten November 2002 NBIM KNK Santiago October 2007 55
  • 56. Norges Bank Investment Management Puts all assets into equities after having lost NOK 40 bn in the 3rd quarter. Have bought equities for NOK 75 bn since June Dagens Næringsliv November 2002 NBIM KNK Santiago October 2007 56
  • 57. Norges Bank Investment Management VG 27/11 2002 Klassekampen 11/10 2002 NBIM KNK Santiago October 2007 57
  • 58. NBIM KNK 4. kv . 80 100 120 140 160 180 200 220 1. 19 kv 97 .1 2. 9 kv 98 . 3. 199 kv . 8 4. 199 kv . 8 1. 199 kv . 8 2. 199 kv 9 . 3. 199 kv . 9 4. 199 kv . 9 1. 199 kv Index, 1997:12 = 100 . 9 2. 200 kv . 0 3. 200 kv . 0 4. 200 kv . 0 1. 200 kv . 0 Santiago October 2007 2. 200 kv . 1 3. 200 kv . 1 4. 200 kv . 1 1. 200 kv .2 1 2. 00 kv . 2 3. 200 kv 2 . 4. 200 kv . 2 1. 200 kv . 2 2. 200 kv . 3 3. 200 kv Bonds . 3 4. 200 kv . 3 1. 200 kv 3 .2 2. 00 kv 4 .2 3. 00 kv 4 . 4. 200 kv .2 4 1. 0 0 kv . 4 2. 200 kv 5 . 3. 200 kv .2 5 4. 00 kv 5 Market Return 1998 – 2007 Q2 . 1. 200 kv 5 .2 2. 00 kv 6 .2 3. 00 kv 6 .2 4. 00 kv 6 .2 1. 00 kv 6 .2 Equities 2. 00 kv 7 .2 00 7 Total Norges Bank Investment Management 58
  • 59. Norges Bank Investment Management Key Learning Norwegian Oil Fund • The costs of not rebalancing in 2001 – 2002 and even worse, start selling equities, would have been enormous • Even with negative press articles and some critical politician- and quasi investors comments, there where no real danger of changes in long term strategy • Why? – Strategy understood and owned by Parliament – Active and realistic information policy since 1998 (and we where not forced to change strategy by regulators…) NBIM KNK Santiago October 2007 59
  • 60. Norges Bank Investment Management Average Annual Net Real Return Since 31 December 1996 10 % Net Real Return on Actual • Average annual net 9% real return (adjusted Portfolio Net Real Return on Benchmark 8% for management costs and inflation) is 7% 4.57% 6% 5% 4% • Annual real return on 3% the benchmark is 2% 4.09% (β) 1% 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 • α 0.51% annually Information Ratio 1.34 NBIM KNK Santiago October 2007 60
  • 61. Norges Bank Investment Management NBIM’s Tasks and Organization KNK NBIM Santiago October 2007 61
  • 62. Norges Bank Investment Management Norges Bank Investment Management (NBIM) • NBIM was established in 1998 as a separate wing of Norges Bank. NBIM is organised as a business unit. Offices in Oslo, London and New York • Funds managed by NBIM as of 30 June 2007 (billion USD): The Pension Fund - Global 328 The Foreign Exchange Reserves 38 The Petroleum Insurance Fund 3 Total 369 NBIM KNK Santiago October 2007 62
  • 63. Norges Bank Investment Management NBIM’s Main Tasks • Cost efficient market exposure (β) and investment of new funds • Create excess return against the benchmark (α) by active management • Safeguard long-term financial interests by active corporate governance (as a minority shareholder) • Advice the Board and MoF on strategy • Risk management, control and reporting NBIM KNK Santiago October 2007 63
  • 64. Norges Bank Investment Management NBIM / Organisation chart Executive Director Executive Director Knut N. Kjær Knut N. Kjær Fixed Income Fixed Income Equity Equity Investments Operations Chief Financial Officer Chief Financial Officer Investments Operations Investments Operations Investments Operations Espen Klitzing Espen Klitzing Dag Løtveit Dag Løtveit Bjørn Egge Bjørn Egge Yngve Slyngstad Yngve Slyngstad Stephen A. Hirsch Stephen A. Hirsch Risk, Performance & Accounting Espen Klitzing (Trond Grande from autumn 2007) Corporate Governance Real Estate Project Henrik P. Syse Paul Golding IT Infrastructure Ilse Bache Offices in Oslo, London and New York Legal / Finance / HR Marius N. Haug Employees as of 30 June 2007: 148 Bjørn Taraldsen Kristin S. Kleven KNK NBIM Santiago October 2007 64
  • 65. Norges Bank Investment Management Delegation, Line Management, Measurement, Control Owner The relationship between the Owner of Parliament/Ministry of Finance the Fund and the Fund’s Manager is Manager clearly defined all the way down to the Norges Bank level of each trading decision Equities Fixed Income All trading is executed within precisely defined risk limits Internal management External management Performance measurement and Beta Alpha investment guideline compliance are monitored regularly Relative Value Global Value Portfolio trading decisions are delegated to more than 70 external portfolio Strat.1 Strat 2 Strat 3 Strat 4 mandates and to 15 internal investment teams (and within these teams to Pos 1 Pos 2 Pos 3 Pos 4 Pos 5 Pos n individuals) More than 30.000 positions An important precondition for management, measurement and control: More than 10.000 prices updated daily Benchmark portfolios NBIM KNK Santiago October 2007 65
  • 66. Norges Bank Investment Management Achieving Excess Return by Active Management KNK NBIM Santiago October 2007 66
  • 67. Norges Bank Investment Management Challenges in Alpha Management • Create excess return against the benchmark • targeting 0.25% over rolling 3 year horizons • with costs less than 0.1% ex performance fees • and annual inflow at USD 20 – 50 bn / year Excess Return, Basis Points 140 120 100 80 60 40 20 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 NBIM KNK Santiago October 2007 67
  • 68. Norges Bank Investment Management The Principles behind Our Active Management • Very high respect for the market. Applying financial theory. Humility and discipline • Active management only where there may be some less market efficiency and where we find/develop managers with unique expertise • Specialization. More than 100 sub-portfolios • Extensive delegation. No committee structure • Incentives linked to performance NBIM KNK Santiago October 2007 68
  • 69. Norges Bank Investment Management "Financial Market Theory for Cautious Investors"* "The possibility of achieving an above average return lies in being able to identify cases of incomplete market equilibrium. To be able to detect what is abnormal, it is necessary to know what is normal."* * Jan Mossin, Markedseffisiens (Market efficiency), TANO, 1986 NBIM KNK Santiago October 2007 69
  • 70. Norges Bank Investment Management Textbook Approach to Active Portfolio Management • Active management is a process. Active management begins with raw information, refines into forecasts, and then optimally and efficiently constructs portfolios balancing those forecasts of return against risk • Active management is forecasting, and a key to active management performance is superior information • Active managers should forecast as often as possible (the fundamental law) • Mathematics cannot overcome ignorance/lack of information R.C. Grinold & R.N. Kahn, Active Portfolio Management, 1994, 1999 NBIM KNK Santiago October 2007 70
  • 71. Norges Bank Investment Management ”The Fundamental Law of Active Management” • Information Ratio = Return / Risk IR = IC⋅ BR Information Coefficient (IC) = corr[α, θ] α = expected (ex ante) return θ = actual (ex post) return corr[α, θ] = correlation between α and θ BReadth (BR) = number of independent positions • The Challenge: Improve IC (hit ratio) • and/or increase breadth by taking many independent positions and trade often NBIM KNK Santiago October 2007 71
  • 72. Norges Bank Investment Management Move to More Scalable Alpha-Strategies May Imply Lower Information Ratio • NBIM prefers relative value and fundamental strategies • Our IR is now 1.34 However, we may be forced to move to more factor based strategies Management strategy Tactical Factor-based Fundamental Relative allocation strategies strategies value Analytical ability + + ++ +++ Number of independent positions - - +++ ++ Implementation costs +++ + ++ + Experience - ++ +++ Expenses Low Moderate High High Expected information ratio Low Moderate High High NBIM KNK http://www.norges-bank.no/english/petroleum_fund/articles/2004/highest_excess_return/ 72 Santiago October 2007
  • 73. Norges Bank Investment Management Neccessary Conditions for Creating Alpha • Talented people • Motivated and challenged in a rational, efficient and supportive structure NBIM KNK Santiago October 2007 73
  • 74. Norges Bank Investment Management Rational and Supportive Structure • Clear investment philosophy • Various investment strategies • Specialization • Large number of independent positions • Good access to information • Alpha separated from Beta • Low costs in trading and transitions NBIM KNK Santiago October 2007 74
  • 75. Norges Bank Investment Management Specialization and Independence • Specialization, focus Very clearly defined mandates. Specialist expertise to provide the competitive edge needed in a near efficient market • Independence, low correlation Different types of investment strategies in various units; a large number of individual investments. No committee decisions; no predefined processes NBIM KNK Santiago October 2007 75
  • 76. Norges Bank Investment Management Talented People • NBIM learning from external and internal management: Alpha creation is mostly about the quality of the people. Only special talents create alpha. • The key issues is then: How to recruit, develop, motivate and retain talents? NBIM KNK Santiago October 2007 76
  • 77. Norges Bank Investment Management Empowerment and Ownership • Individual investment mandates and considerable freedom to develop own investment style, methodology and tools • Individual incentive structure • clearly defined and measured • ‘managing own money’ • Ownership in all other processes • operations included in the business units • division of responsibilities, defined work task • Independence in team structure • optimal size for flexibility and communication • accountability and visibility without ‘atomization’ • blending competition and support • avoiding ‘group think’ NBIM KNK Santiago October 2007 77
  • 78. Norges Bank Investment Management Internal and External Management Internal External 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Portfolio Active ris k Cos ts 51 external fund managers are responsible for appr. 60 percent of the active risk. (86 different mandates) NBIM KNK Santiago October 2007 78
  • 79. Norges Bank Investment Management Annualised contribution to gross excess return the last three years (from Q3 2004 to Q2 2007) External Internal Total Excess return within management management each asset class Equity management 0.15 0.25 0.40 1.04 Fixed income management 0.05 0.15 0.20 0.30 Total 0.20 0.40 0.60 NBIM KNK Santiago October 2007 79
  • 80. Norges Bank Investment Management Information ratio last three years (from Q3 2004 to Q2 2007) External Internal Total management management Equity management 0.59 1.43 1.21 Fixed income management 2.10 2.25 2.78 Total 0.78 2.45 1.75 The IR is a measure of risk-adjusted return, and is an indicator of the degree of skill in investment management. It is calculated as the ratio between excess return and the actual relative market risk to which the portfolio has been exposed. The IR reveals the level of excess return generated for each unit of risk NBIM KNK Santiago October 2007 80
  • 81. Norges Bank Investment Management Excess return over the last three years 0.8 % 0.8 % 0.7 % 0.7 % 0.6 % 0.6 % 0.5 % 0.5 % 0.4 % 0.4 % 0.3 % 0.3 % 0.2 % 0.2 % 0.1 % 0.1 % 0.0 % 0.0 % -0.1 % -0.1 % -0.2 % -0.2 % 4 4 04 5 05 05 05 05 05 06 06 06 06 06 06 07 07 07 li 0 pt 0 ov an 0 rs ai Juli ept ov an ar Mai Jul ep ov Jan ar Mai Ju Se N J Ma M S N J M S N M NBIM KNK Santiago October 2007 81
  • 82. Norges Bank Investment Management Excess return since 1998 1.0 % 0.8 % 0.6 % 0.4 % 0.2 % 0.0 % -0.2 % -0.4 % 98 98 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Average annual excess return since 1998: 0.50pp Aggregate excess return: NOK 36.2bn Information ratio: 1.34 (a measure of quality in active management) NBIM KNK Santiago October 2007 82
  • 83. Norges Bank Investment Management Excess Return and Contribution to Total Risk From Active Management Excess return and return on the Risk contribution due to benchmark portfolio active management Benchmark Excess return Risk due to active management Benchmark risk • Active management has increased the return with no increased risk NBIM KNK Santiago October 2007 83
  • 84. Norges Bank Investment Management NBIM Critical Success Factors • Time is spent on professional challenges – not marketing • Empowerment of individuals (mandates and resources) • Delegated power matters more than placement in org charts • No committee governance with unclear responsibilities • Meritocracy – rewards and positions are based on performance • Ability to change leadership and structure when performance or new challenges requires it • Incentive level and structure is competitive and fosters the targeted risk-taking and behavior NBIM KNK Santiago October 2007 84
  • 85. Norges Bank Investment Management NBIM’s Salary and Incentive System Objectives: • Play an important role in NBIM’s strategy to achieve the excess return targets • Reward outstanding performance • Facilitate desired turnover Main features: • Fixed salary • Performance-based salary • Quantitative and qualitative criteria • Compensation benchmarked to other local competitors • Focus on transparent, non-discriminating and non-inflating system • Certain common evaluation criteria across the org. (e.g core values) =>Fair, efficient and cost effective system NBIM KNK Santiago October 2007 85
  • 86. Norges Bank Investment Management The Ethical Dimension KNK NBIM Santiago October 2007 86
  • 87. Norges Bank Investment Management Background: Ethics in the Norwegian Pension Fund • Financial return is a key ethical concern in itself. The fund safeguards the oil wealth for future generations • The return shall, however, not be achieved in ways that conflict with the overlapping consensus of the Norwegian citizens • The ownership power shall be used to enhance ethics and sustainability, when this is in the interest of the long-term financial return of the portfolio NBIM KNK Santiago October 2007 87
  • 88. Norges Bank Investment Management Ethical Guidelines / Corporate Governance • The government has issued Ethical Guidelines for the Pension Fund Global. Based on three pillars: • Exercise of ownership rights • Negative screening • Exclusion of companies • NBIM shall exercise ownership rights • The Executive Board has established principles for corporate governance and the protection of financial assets • The Council on Ethics shall advise the Ministry of Finance on negative screening and exclusion of companies NBIM KNK Santiago October 2007 88
  • 89. Norges Bank Investment Management Companies excluded by the Ministry of Finance Date Company Reason 26.04.2002 Singapore Technologies, Singapore Land mines 31.05.2005 Kerr-McGee, USA (*) Western Sahara 31.08.2005 Alliant Techsystems, USA L-3 Communications, USA Components for cluster EADS (Airbus), The Lockheed, USA bombs Netherlands (**) Raytheon, USA General Dynamics, USA Thales, France 31.12.2005 BAE Systems, UK Northrop Grumman, USA Nuclear weapons Boeing, USA Safran, France Finmeccanica, Italy United Technolog., USA Honeywell, USA 31.05.2006 Wal-Mart Stores Inc., USA (1) Violation of human / labour Wal-Mart de Mexico (1) rights (1) Freeport McMoRan, USA (2) Environmental damage (2) 30.11.2006 Poongsan Corporation, South Korea Components for cluster bombs (*) KerrMcGee (now merged into Anadarko Petroleum) was included again from 30 June 2006 (**) EADS has stated that the company no longer invests in the production of cluster munitions. The company is, however, involved in the production of nuclear weapons and on this basis the Ministry reaffirmed the exclusion on 10 May 2006 NBIM KNK Santiago October 2007 89
  • 90. Norges Bank Investment Management Corporate Governance in more than 3000 Companies • The principles are based on internationally recognized guidelines, such as – OECD Corporate Governance Guidelines – OECD Guidelines for Multinational Enterprises – UN Global Compact Norges Bank’s principles approved by the Executive Board December 2004 NBIM KNK Santiago October 2007 90
  • 91. Norges Bank Investment Management Ethics Focus of Financial Investors • In addition to focus on board performance & elections, incentive systems for top management, basic mission and business strategy, and capital structure, a long-term investor must also look to: • The values & norms of the portfolio companies: - Human rights policies - Anti-corruption work and respect for laws and regulations - Environment / climate - Social responsibility: e.g., child labour, children’s rights NBIM KNK Santiago October 2007 91
  • 92. Norges Bank Investment Management Externalities and Financial Returns Are Woven Together in the Long Term • Many companies cannot realistically contribute to serious externalities over long time, without risking return capabilities: Pollution, climate change, social unrest, disorder in economic and contractual structures, etc. • Still, the individual companies and most investors don’t see and take into account the consequences of collective (in)action: Therefore, a need for national and international regulations. Investors and companies cannot do this alone. NBIM KNK Santiago October 2007 92
  • 93. Norges Bank Investment Management Our Position • Our time horizon nearly infinite (future-generation endowment) • We own broad stakes in the global capital market • Our return depends on the sustainability of the markets • Can’t avoid this by selling stocks • We have to influence the companies NBIM KNK Santiago October 2007 93
  • 94. Norges Bank Investment Management How to Get Such Influence While Being Only a 0.5 % Owner? • Long-term perspective in the engagement with companies: Contribute to the understanding of long-term consequences of company actions or no-actions, and get acknowledgment of ethical, legal and environmental obligations • Build alliances and networks with other investors • We can only mobilize other investors if we succeed in arguing for long-term financial benefits and act as a serious investor (and not as politicians) • (The financial investor’s toolbox is different from the government’s!) NBIM KNK Santiago October 2007 94
  • 95. Norges Bank Investment Management Our Strategic Priorities (1) Ownership rights and Corporate Governance: a precondition for corporate responsibility. Examples: • The right to vote • The right to nominate and elect board members • The right to sell • The right to open, timely information NBIM KNK Santiago October 2007 95
  • 96. Norges Bank Investment Management Our Strategic Priorities (2) Externalities: Future social and environmental sustainability • Children’s rights within the value chains of multinational companies, particularly related to limiting child labour and measures to protect children’s health; • Companies’ lobbying towards national and supranational authorities on issues related to long- term environmental change – including the risk of pronounced climate change Responsible investors can make a difference on such issues through consistent engagement NBIM KNK Santiago October 2007 96
  • 97. Norges Bank Investment Management Discussion points Can a public entity achieve excellence and high performance? Some key learning from Norges Bank / NBIM KNK NBIM Santiago October 2007 97
  • 98. Norges Bank Investment Management • The owner of a fund must set clear objectives, the preferred risk/return balance and the strategic asset allocation • For a public fund – these key decisions must be taken by the political authorities. The main decision – how much risk is to be taken – should not be delegated • But the operational management must be carried out by investment professionals. To avoid a mixture of politics with investments, the mandates to the manager(s) must be defined very clearly NBIM KNK Santiago October 2007 98
  • 99. Norges Bank Investment Management • A public fund management organization can and should be run like a private company: Key focus on the value added, a line structure where every financial position has an ”owner” and a compensation system that rewards people according to results • Transparency on objectives and performance is a necessary condition for building a professional business culture NBIM KNK Santiago October 2007 99