Choosing between internal and external management for the Government Petroleum Fund

Norges Bank submitted the following letter to the Ministry of Finance on 5 September 2000

5 September 2000

1. Introduction

With reference to a letter of 29 August 2000 from the Ministry of Finance, we submit in the following details of the strategy forming the basis for choosing between internal management of the Government Petroleum Fund by Norges Bank and delegation of this responsibility to external management organisations. The strategy is based on the objective of achieving the highest possible return within the guidelines and framework stipulated by the Ministry of Finance. Important criteria in this connection are that there shall be sound risk management, cost-effective management and an expected excess return in relation to the benchmark portfolio.

External managers were appointed for the first time in January 1998, when investment in the equity market commenced. The use of external managers was subsequently extended to fixed income management and tactical asset allocation. At the end of July 2000 there were a total of 14 external managers responsible for managing 43.1 per cent of the portfolio.

We refer also to the regular reports on management submitted to the Ministry of Finance. In the annual reports, in particular, a detailed account is provided of strategy and the options open.

2. Mandate for management

Pursuant to the Act on the Government Petroleum Fund, the Ministry of Finance is responsible for the management of the Fund. The Ministry has delegated the operational management to Norges Bank. The Ministry has defined a benchmark portfolio for this management, and placed limits on how far Norges Bank may deviate from this portfolio. Norges Bank's management mandate is set out in a regulation and written elaborations of this regulation, and in a special Management Agreement between the Ministry of Finance and Norges Bank.

The objective for Norges Bank's management of the Petroleum Fund is set out in the Regulation on Management of the Petroleum Fund.

"Norges Bank shall seek to achieve the highest possible return on investments denominated in foreign currency within the limits set out in the regulation and the guidelines issued pursuant to this regulation."

The guidelines pursuant to the regulation stipulate first and foremost which markets and instruments the Fund may be invested in, the limits for allocation between asset classes, allocation between regions, and interest rate risk. At the same time, a limit is stipulated for the maximum expected difference between the returns on the Fund and the benchmark portfolio, in that an upper limit is defined for expected tracking error.

Norges Bank's right to use external managers is laid down in the regulation and in the Management Agreement. The regulation stipulates requirements to the effect that such managers shall have adequate internal ethical guidelines for their activities. The Management Agreement states:

"Norges Bank may use external managers and other external service providers in the management of the Fund. Norges Bank is party to agreements with such service providers, and shall supervise their activity on behalf of the Fund."

The Management Agreement requires Norges Bank to inform the Ministry of Finance in advance of the basis for choosing the individual managers. The Ministry shall approve agreements that directly influence the remuneration paid by the Ministry of Finance to Norges Bank.

The agreement between the Ministry of Finance and Norges Bank is a business agreement that may be terminated with one year's notice by either party. The management responsibilities are defined so precisely that both the Ministry of Finance and the general public have a full overview of the results achieved by Norges Bank.

When evaluating Norges Bank's management, the Ministry of Finance will be able to monitor the difference between returns on the actual and benchmark portfolios, how much relative market risk the Bank has taken to achieve these results, and the costs incurred. Norges Bank's responsibility for performance applies to the entire management - including the part that has been delegated to external managers.

The management model chosen for the Petroleum Fund allows the Ministry of Finance to control all the main aspects of management. The formulation of the overall guidelines for the Fund is of far greater importance for the return than the results Norges Bank can achieve through active management within the stipulated risk limits. The rules and regulations and the agreement allow Norges Bank to decide how to use its freedom of manoeuvre to achieve the highest possible return.

Internal operational management takes place in a separate unit of the Bank, Norges Bank Investment Management. Monitoring of this management also takes place separately from the normal central bank functions. In addition to the Petroleum Fund, Norges Bank Investment Management manages the Government Petroleum Insurance Fund and the long-term portion of Norges Bank's foreign exchange reserves.

3. Management to date

Norges Bank commenced management of the Government Petroleum Fund's foreign exchange portfolio in June 1996, employing a management strategy very similar to that used for managing Norges Bank's foreign exchange reserves. The Fund was invested in government bonds and all management took place within Norges Bank.

In 1997, when it became clear that equities were to be included in the investment universe from January 1998, Norges Bank announced mandates for index management of equities. The mandates concerned replication of a broad market portfolio as cost-effectively as possible, and with marginal deviations from a representative market index. This was regarded as the safest approach while Norges Bank was developing its organisation and systems.

Indexing was regarded as a cost-effective means of assuring exposure to equity markets; at the same time, it was clear that because of its size, the Petroleum Fund would be compelled, under any circumstances, to invest large portions of its equity portfolio as index mandates. However, it was made permissible to invest parts of the portfolio more actively in order to achieve an excess return within the stipulated risk framework.

The first mandates for external active equity management were announced in February 1998. In September the same year, external active fixed-income mandates were also announced, and subsequently external active mandates in tactical asset allocation were announced and awarded. In tactical asset allocation, investments are moved between asset classes and markets.

In 1998, priority was given to establishing a sound system for monitoring the external index managers and a thorough selection process for external active managers. At the same time, preparations were made for commencing internal equity management. Internal active equity management commenced in summer 1999.

Throughout this period, the fixed-income portfolio was mainly managed internally. The management followed the benchmark portfolio very closely, but with definite elements of active management. While expertise in internal management of equities was being built up, internal fixed-income management and internal tactical asset allocation were being extended with a view to increasing the expected excess return.

At the end of July 2000, 93.4 per cent of the equity portfolio had been delegated to external managers and 8.8 percent of the fixed-income portfolio. The high proportion of internal fixed-income management must be viewed in the light of the fact that index management of this portfolio takes place internally.

Active external managers account for the bulk of the active management of the Petroleum Fund as a whole. The remuneration for external management is far greater than the costs associated with internal management. This is partly because active management is generally more cost-intensive, but is also due to the fact that economies of scale enable a large fund to operate cost-effectively with internal management.

Overview of external managers of the Government Petroleum Fund as at 31 July 2000

Mandate

Type

Fixed income management

Bridgewater Associates Inc, US

Global

Active

Morgan Stanley Dean Witter Investment Management, UK

Global

Active

Gjensidige NOR Kapitalforvaltning, Norway

Global

Active

Equity management

Capital International Limited

Japan

Active

Europe

Active

Fidelity Pensions Management

Japan

Active

Pacific

Active

Gartmore Investment Management

Europe

Active

Merill Lynch Investment Managers

UK

Active

Scudder Kemper Investments

Japan

Active

Storebrand Kapitalforvaltning, Norway

Europe

Active

Dresdner RCM Global Investors

Sector, North America

Active

ABN Amro Bank N.V.

Europe

Active

Gartmore Investment Management

UK

Index

Barclays Global Investors

Regional/Sector

Index

Deutsche Asset Management

Regional

Index

Tactical asset allocation

Mellon Bank, N.V.

Global

Active

4. Functions in the operational management of the Government Petroleum Fund

The operational management of the Government Petroleum Fund can be divided into three parts: portfolio administration and risk management, indexing and active management. Each of these must be conducted with a view to managing the Fund with the desired risk profile, in a cost-effective manner, and with the maximum possible expected return. Whereas portfolio administration and risk management very largely have to take place internally, indexing and active management can also proceed externally.

Portfolio administration and risk management

Portfolio administration and risk management constitute an important part of operational management. These are important responsibilities which Norges Bank must discharge, irrespective of the degree to which other aspects of management are delegated to external managers. The most important functions are:

  • Investing the foreign exchange that is transferred every quarter to the Petroleum Fund. Fixed-income and equity instruments are accumulated in a separate part of the foreign exchange reserves (called the Petroleum Buffer Portfolio) and managed with a view to keeping overall transaction costs to a minimum. To date, exposure in fixed-income instruments has mainly been associated with the purchase of bonds, and to some extent fixed-income futures, while all exposure in connection with flows of equity instruments has been associated with the purchase of equity futures.
  • Rebalancing of the Petroleum Fund takes place at the end of each quarter to bring the whole Petroleum Fund portfolio closely into line with the benchmark index's distribution by asset class. Quite substantial market transactions are required for the quarterly rebalancing. When there are large inflows of resources to the Petroleum Fund, much or all of the rebalancing will take place in connection with the transfer from the Petroleum Buffer Portfolio.
  • The Petroleum Fund is in a special situation because of the large inflow of new capital each quarter. Ensuring that these resources are invested in the market with a minimum of transaction costs constitutes an important aspect of Norges Bank's management. In the Bank's experience, greatest efficiency is achieved in the transfer of capital to external managers by the Bank itself controlling the types of transaction to be performed (crossing, programme trades or individual transactions of the least liquid securities). The Bank itself purchases the actual portfolios, which are subsequently transferred to the accounts for which the external operators are authorised. This process often involves the Bank investing resources temporarily in the futures markets, while waiting for opportunities to cross with other investors.
  • Norges Bank controls the risk in the Petroleum Fund on a day-to-day basis. Portfolios managed by external managers are also subject to daily monitoring. Deviations from the benchmark portfolio will constantly arise, even when the subportfolios closely approximate their respective benchmark portfolios. Risk management involves eliminating those deviations from the benchmark portfolio that are not deliberate ones aimed at achieving an excess return. Risk management of the equity portfolio involves the use of equity futures, but from the fourth quarter of 2000 it will be accomplished with greater precision trading in certain equities also commences. Both individual securities and futures are used in fixed-income trading.
  • Lending of securities is a source of income in both fixed-income and equity management. Lending from the fixed-income portfolio is administered internally, while the Petroleum Fund's global custodian administers equity lending. Other alternatives are under constant evaluation.

Taken as a whole, these activities entail very extensive internal management. The management tasks in question do not lend themselves to delegation to external managers. As an example of the scope of the task, it may be mentioned that this year Norges Bank will probably carry out transactions for more than NOK 120 billion in the international equity futures markets. This activity is largely associated with the operating tasks described above. It is independent of what proportion of the equities portfolio Norges Bank manages itself, and depends to only a small extent on the degree of active management aimed for.

Index management

The primary aim of index management is to minimise the differences in return between the actual portfolio and the benchmark portfolio. This is a cost-effective form of management, but does not offer much opportunity for outperforming the benchmark portfolio. If a pure indexing strategy is followed, the Petroleum Fund is unlikely to achieve exactly the same return as the benchmark portfolio, particularly owing to transaction costs and tax.

For many years, Norges Bank has been actively involved in the management of resources in the fixed-income and foreign exchange markets through its management of foreign exchange reserves. As a natural consequence, index management of the Petroleum Fund's fixed-income portfolio has taken place internally. Norges Bank did not have the same experience of, and infrastructure for, equity instruments, and therefore chose to use several external index managers for phasing equities into the Petroleum Fund. In other words, the choice was based primarily on operational limitations at the time.

There are a few, large operators in the index management market, who deliver standardised products at a low price. The objective for index managers is to achieve a return that is as close as possible to the return on the benchmark portfolio. However, it is possible to achieve a somewhat higher return by systematically exploiting various properties of the markets. Periods in which equities are added to or removed from indices may cause imbalances in the supply of and demand for some securities, and it may be possible to exploit these imbalances to improve the return under index management. Corporate actions such as share issues and mergers also provide opportunities for achieving a better spread in time of the purchase and sale of equities, and hence for achieving a better return than mechanical replication of an index would yield.

Norges Bank has looked for managers who can meet the need for such ‘active indexing'. This market is relatively undeveloped. The existing operators require a fee for these services that is appreciably higher than the costs of internal operations. Because of the size of the Petroleum Fund, it is financially sound to build up this expertise internally. In consequence, Norges Bank is engaged in developing an internal infrastructure that permits management of relatively large index portfolios, by establishing an external settlement function and a separate unit for effecting market transactions.

Active management

The guidelines give Norges Bank a certain latitude for deviating from the benchmark portfolio. The objective is partly to keep transaction costs to a minimum, and partly to utilise opportunities to outperform the benchmark portfolio.

In the annual report for 1999 on the management of the Petroleum Fund, Norges Bank's strategy for achieving the highest possible return is presented in a separate feature article. One important conclusion in the article is that diversification of active management is necessary for achieving an expected stable excess return over time:

"In setting out to achieve an excess return, a fundamental choice has been made in preferring to take many small positions against the benchmark index rather than a few large positions. Our strategy is that spreading our active management over many different types of positions (diversification of risk-taking) can result in a more robust excess return relative to general fluctuations in the market. Unless one is particularly skilled at forecasting market trends, a conscious strategy of spreading risk in position taking results in the best trade-off between excess return and risk."

Active risk can be taken by deviating from the benchmark portfolio with respect to allocation of assets between asset classes and geographical regions, or by selecting individual securities in the fixed-income or equity markets.

Three operational departments (Equity Management, Fixed-Income Management and Tactical Asset Allocation) are responsible for different parts of this management. Each of them has a defined responsibility for the performance of both internal and external management. The annual reports on the management of the Petroleum Fund contain breakdowns of the results of these six main sources of excess return (internal and external management in each of the three profit centres).

The purchase of active management services from external managers provides a management breadth which it would not be possible or financially sound to build up in Norges Bank. Internal active management will be focused on areas in which it is possible to develop sufficiently qualified expertise, and where it pays to do so.

Opportunities for achieving an excess return through active management vary over time and from market to market. The better developed the markets, the smaller the probability that it will be possible to achieve a consistently higher than average return in them. For this reason, Norges Bank has differentiated the extent of active management in the different markets.

Selection and monitoring of external active managers

Active management is only profitable if a return is achieved over time which is higher than the index return, and at the same time compensates for the extra costs of active management compared with index management. Experience shows that a minority of management organisations succeed in maintaining profitability, as defined above, consistently over time. Nor does a previous good performance provide any guarantee that future results will be satisfactory.

There are therefore very stringent requirements for the selection and monitoring of external managers in order to achieve profitability. Selection of managers can be regarded as investment decisions with clear similarities to investing in markets or individual instruments. The essential criterion for making the investment is expectations of future returns.

In order to be able to rank the various external management organisations, an understanding is required of what lies behind sound investment decisions, and how these can best be implemented in a low-risk, efficient manner. Good follow-up entails monitoring transactions, market developments, portfolio composition, risk management etc.

Diversification of active management is an important part of the investment strategy. The entire portfolio of external managers must be composed with overall risk management in mind. Little is achieved by adding managers who do much the same as other managers already in the portfolio. Nor does it make financial sense to use active managers who adhere closely to the given benchmark indices, since this portion of the portfolio could have been retained under index management and managed by others at a lower price. In consequence, Norges Bank is increasingly interested in using external managers who are specialists in particular areas, and less in using active managers with general mandates.

More of the external active management of the equities portfolio will be focused on special business areas. The portfolio will consist both of sector mandates across geographical areas, and regional mandates across sectors. The greater the complexity, the more stringent the requirements regarding internal expertise. Such a structure for external mandates also makes it more important that overall risk management can take place through purchase and sale of individual equities, and not only futures contracts. There will also be specialisation in active management of fixed-income instruments. The management guidelines allow for some of the portfolio to be invested in private fixed-income instruments with a high credit rating. For this management, Norges Bank will consider using external managers with specialist expertise in credit risk and other segments of fixed-income and foreign exchange management.

5. The relative amounts of external and internal management

The proportion of external to internal management is a matter of portfolio management and profitability. For a large fund like the Government Petroleum Fund, it is not a question of whether to choose external or internal management, but rather of finding the optimal proportions of these different types of management activity.

In general, the amount of capital being managed has a bearing on the ratio between external and internal management. For a large fund, it will be natural to increase the breadth of external active management by engaging several active managers, but this development could also encounter restrictions of a practical or management-related nature. On a practical level, there will be a limit to how many external managers it is possible to monitor in a satisfactory manner. With operational risk in mind, there will be limits to how large a portfolio it is appropriate to give the individual external manager. It is not desirable to be an overly dominant customer for any management organisation. Operating with a number of external active managers will also present a challenge with respect to optimal management, because the Fund risks seeing its returns converge towards an average (but with higher management costs than would be incurred with index management). It is therefore important to consider how the portfolio of each potential manager can be expected to influence the properties of the portfolio as a whole.

For a fund of a substantial size, it may be more cost-effective to conduct a large amount of the management internally. Capital management is an activity that offers economies of scale. A doubling of the management volume does not require double the resources in the various management, settlement and control functions. The cost benefits of internal management may apply to both index management and active management.

Norges Bank is currently indexing the fixed-income portfolio internally. The Bank is now laying the foundation for internal index management of equities because this provides opportunities for more cost-effective operations, improved risk control and a higher net return than that achieved on the standard product purchased in the market. It is also important to avoid becoming dependent on any of the few large operators in this market. In the period ahead, Norges Bank will combine internal index management of equities with delegation of substantial portfolios to external index managers.

In active management there is also a relationship between size and opportunities for profitable internal management. The size of the Petroleum Fund ensures ease of access to important sources of information. The extensive infrastructure required to manage the Petroleum Fund additionally provides a sound system platform and trading routines which can also be used in active management. On the other hand, the Bank's possibilities for internal active management may be limited by the supply of qualified expertise.

It will be neither possible nor desirable to build up an internal organisation that meets all the needs for special services that it may be relevant to acquire from external suppliers. Norges Bank's strategy is to develop its internal active management in selected areas, and to achieve the desired management breadth by purchasing management services from external specialists.

A large proportion of the active risk will therefore continue to be taken via external active managers. The choice and continuous monitoring of external managers are thus of great importance for achieving an excess return. This makes great demands of the expertise in Norges Bank's management organisation. Norges Bank is of the opinion that this expertise can best be built up and maintained in a broad professional environment that includes internal active management, with the proximity to the markets that this provides.

Norges Bank's strategy of combining external and internal management is in line with the practice of other large funds internationally. A common feature is that the extent of internal management increases with management volume.

Over time, it will be the profitability of the various management activities that determines the proportion of external to internal management. In its steering of capital management, Norges Bank assumes that both resources and possibilities for taking active risk will be shifted to the types of management that yield the best expected results, whether this be internal or external. In its annual reports, Norges Bank presents breakdowns of the return differentials for internal and external management of equities, fixed-income instruments and tactical asset allocation.

6. Conclusion

The Regulation on the Management of the Government Petroleum Fund and the Management Agreement between the Ministry of Finance and Norges Bank assign a clear responsibility for performance to Norges Bank. This responsibility concerns risk management and control, performance and management costs, and also applies to the portions of the portfolio that Norges Bank elects to delegate to external management organisations. The operational challenge for Norges Bank is to manage a portfolio of management mandates, internal and external, in a manner that assures sound risk management within a reasonable cost framework, and with expectations of a positive excess return.

At the end of July 2000, 14 external management organisations were managing a total of 43.1 per cent of the Petroleum Fund, measured as amounts being managed. They accounted for the bulk of active management and also for decidedly the largest portion of the costs associated directly with portfolio management.

As pointed out in the submission on the tracking error limit for the Petroleum Fund that was presented to the Ministry of Finance on 5 May 2000, achieving an excess return over time is a demanding task. This is reflected in the guidelines for management of the Petroleum Fund, which presuppose prudent conduct of active management. Managing a core portfolio of index mandates constitutes an important part of Norges Bank's strategy for achieving an excess return. This helps to keep overall management costs down, and to ensure that both internal and external active management are focused and not overlapping.

Another important part of the strategy to achieve an excess return is to diversify the active risk taken in management. This means that no single position must significantly affect the overall result. This strategy implies that in the future, too, Norges Bank will base active management largely on external resources. This provides opportunities for creating a generally broad-based management, but also means that only active managers who are focused and have specialist expertise will be used. This strategy is based on Norges Bank itself being responsible for overall management of risk associated with trading in fixed-income instruments, equities and futures.

It follows from Norges Bank's strategy for operational management that good results will be directly dependent on the Bank's ability and skill in selecting and monitoring external managers, and in terminating relations with managers when it is believed that there is no basis for an excess return in the future. Norges Bank will therefore place great emphasis on recruiting and developing qualified resources to monitor external managers.

Norges Bank has for many years possessed a high level of management expertise on the international government bond markets. Since the inclusion of equities in the Petroleum Fund as an asset class in 1998, the Bank has aimed to develop expertise to enable it to conduct its own equity management. Norges Bank considers that some internal management in all asset classes is necessary for the day-to-day operational and risk management of the Petroleum Fund. Moreover, because economies of scale can be realised, internal capital management in a large fund can be very cost-effective compared with purchasing external management services. Another, but not crucial consideration, is that monitoring of external managers can best be achieved in an environment with continuous access to market information, and which is also engaged in management where profitability is expressly required.

Norges Bank also aims to further develop its internal expertise in fixed-income management and tactical asset allocation. Iternal management is subject to the same requirements as external management with respect to risk management and an excess return after deduction of costs. In the active part of this internal management, Norges Bank will focus on those activities where there is the greatest probability that the Bank will consistently achieve an excess return.

Norges Bank has described here a number of factors that will influence the proportions of external and internal management. The basis is the Bank's strategy to achieve the highest possible return on the overall portfolio in a prudent manner. The strategy will be reviewed at regular intervals in the light of the actual results achieved. In its annual reports, Norges Bank publishes breakdowns of excess return according to source. This provides the Ministry of Finance and the general public with a constant overview of developments in the profitability of both internal and external management.

 

Svein Gjedrem

Knut N. Kjær