What goes into the investment strategy of the world’s largest sovereign wealth fund – Norway’s so-called “Petroleum Fund”?
That was the focus of a recent speech by Egil Matsen, one of the keynote speakers at Nordea’s 8th Annual AAA Seminar held in Oslo on 14 June. Matsen is Deputy Governor at Norges Bank with responsibilities for Norges Bank Investment Management, which manages the oil fund known as the Government Pension Fund Global.
The seminar – hosted by Nordea Markets – kicked off with a friendly battle between Nordea’s chief economists from Denmark, Sweden, Finland and Norway, about the macro outlook for the Nordic region, where the debate naturally included what the Petroleum Fund means for the Norwegian economy and what will happen in the future.
With the room filled with about 100 leading investors and issuers in the AAA-space from across the Nordics, Matsen later shared insights about the investment strategy for the fund, including asset allocation, international diversification and the role of bonds in a portfolio with 70% allocation to equities.
After a brief introduction on governance, investment strategy and return and risk of the fund, Matsen focused mainly on the role of fixed income in the fund, given the audience of investors and issuers.
From natural resources to financial wealth
Introducing the mechanism, which has transformed natural resources to financial wealth over the last 10 years, the numbers show remarkable development. The petroleum fund is referred to as Norway’s “piggy bank”, and its strategic management model, with oil revenues, active investments and transfers to finance non-oil budget deficits, creates a good balance and positive returns.
The question is: How does it work?
The Ministry of Finance has the overall responsibility for the fund’s management (under the Norwegian parliament). Norges Bank has been tasked with the management of the fund, and its Executive Board has delegated the operational day-to-day management to Norges Bank Investment Management. A detailed mandate from the Ministry explains what to invest and not invest in, the risk limits, benchmark index and ethical guidelines. Norges Bank reports back to the Ministry of Finance and parliament on a regular basis.
The management objective is to achieve the highest possible return in the long term. Norges Bank’s job is to invest the actual money and to advise about how the management mandate should evolve over time. The mandate contains tight limits on how much Norges Bank can deviate from the government’s benchmark index.
The benchmark index has two roles: to indicate risk tolerance and provide a yardstick for the risk and return for the actual portfolio.
The current benchmark index consists of stocks and bonds only. The equities allocation is on its way to 70% in the benchmark index this year, which suggests that the owners are prepared to handle risks.
However, the current public discussion on the investment strategy centres mainly on two issues:
- Should the fund be allowed to invest in privately held assets such as infrastructure and private equity?
- Are the investments responsible or not?
|In global investments – the assets are divided between 72 countries and 49 currencies – mainly in these regions|
|Asia and Oceania||20%|
|Rest of the world||3%|
Return and risk
Despite downturns in 2002 and 2008, the fund has generated positive returns since 1998 – up to 6.6 % the past 10 years. Politicians did not panic in the downturn periods, but it was challenging to maintain a forward focus, said Matsen, even though much of the volatility was calculated and expected.
The role of fixed income in the fund
The most important parts of the funds financial strategy are at times under discussion and have often changed, but the strategy is evolving gradually.
Norges Bank has currently advised the Ministry of Finance to rethink its strategy. Given the event’s audience, Matsen presented the bank’s main advice on what the role of fixed income should be in the oil fund.
In general, fixed income should:
- Reduce volatility
- Provide liquidity
- Earn risk premiums
Fixed income – the current benchmark index. This model is divided in two:
- Government and related, GDP-weighted – 70% and
- Corporate sector, market-weighted – 30%
The bond parts are then broken down to nominal government bonds, bonds issued by international organisations and inflation-linked bonds on one hand and corporate bonds and covered bonds on the other hand.
70% equities – what is next for the fixed income strategy?
Should the high equities allocation, at 70%, have implications for the fixed income strategy, the government asked? Norges Bank thinks so and has advised the Ministry of Finance – owner of the fund – to develop its strategy along three following dimensions:
- Duration management
- Currencies in the benchmark index
- The role of corporate bonds
Duration in the bond portfolio, together with correlation between bonds and equity returns, matters a lot for the volatility of the full portfolio, Norges Bank has advised the Ministry of Finance.
Simulations and measurements have shown that the longer the duration of your bond portfolio, the more exposed your portfolio is to changes in the equity-fixed income correlation. What is important to Norges Bank is that duration can be managed – correlation cannot.
Norges Bank’s advice is to take control of the duration and not let it drift further.
Currencies in the benchmark index
Currency is partly a matter of liquidity but also a part of risk and returns.
Matsen presented the currency breakdown for government bonds in the current benchmark index, with USD at the top and Korean Won (KRW) as the largest emerging markets currency.
Norges Bank has proposed that the owner decides on a fixed list of currencies that will help reduce fluctuations in the fund’s return and ensure sufficient liquidity. For an investor with 70 percent invested in a geographically diversified equity portfolio, analyses show that there is little reduction in risk to be achieved by also diversifying the bond investments across a large number of currencies. A longer list of currencies would make the index slightly less liquid, said Matsen.
The role of corporate bonds and the credit premium
Matsen pointed out that there has been deterioration in credit quality in the last few years, at least according to the rating agencies.
The benchmark index does not take this into account in the sense that 70% government bonds and 30% corporate bonds is an allocation according to issuer, not credit quality. This is something to think about as it could have implications for strategy, said Matsen.
Norges Bank has also advised to look at the contribution of corporate bonds to portfolio volatility when you already have 70% equities.
Other than the equity share, the exposure to interest-rate risk is the decision that has meant the most for the fund’s risk and return. Bond investments should also provide exposure to risk premiums in the bond market. Besides interest-rate risk, bond investments have mainly exposed the fund to the credit premium, through investments in corporate bonds, and the carry premium, through investments in government bonds issued in high-yield currencies. Exposure of this kind has had an impact on the fund’s historical risk and return to a far lesser extent than the choice of equity share and exposure to interest-rate risk. The credit premium and the carry premium also have some similarities with the equity premium. The Bank has therefore proposed removing government bonds in emerging-market currencies and corporate bonds from the benchmark index, but retaining the option of investing parts of the fund in these bonds.
Matsen presented Norges Bank’s proposal for a possible new framework for fixed income with this model:
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