Rebalancing regime for the Government Petroleum Fund

22 August 2001

The following letter was submitted to the Ministry of Finance on 22 August 2001

Introduction

In a discussion of a rebalancing regime for the Petroleum Fund, it is important to distinguish between the strategic benchmark and the actual benchmark. The strategic benchmark for the Petroleum Fund is defined by the weightings set by the Ministry of Finance for the regions (Europe/North America/Asia-Oceania equal to 50/30/20) and the asset classes (equities/fixed-income instruments equal to 40/60). These weightings are referred to as strategic weightings. The actual benchmark, against which management performance is measured, is based on the strategic weightings.However, during the period between two rebalancing operations, the weightings in the actual benchmark are influenced by the relative price changes of the various asset classes/regions. This means, for example, that if equity prices advance sharply in a period, the equity portion in the actual benchmark will be higher than 40 per cent. Rebalancing brings the weightings in the actual benchmark back to the strategic weightings. With the exception of deviations due to active management, management of the Petroleum Fund follows the actual benchmark. This means that when the weightings in the actual benchmark are changed (rebalancing), the same changes will normally be made in the Petroleum Fund. Hence, rebalancing entails transaction costs linked to necessary buying and selling. This gives rise to a dilemma: if rebalancing takes place too seldom, the portfolio will drift away from the strategic weightings, while frequent rebalancing will lead to high transaction costs. A rebalancing strategy must therefore be devised that weighs up these two considerations.

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