Strategic allocation in the Petroleum Fund: an analysis of the basis for
28 August 2003
1. Introduction
The investment strategy of the Government Petroleum Fund consists of two parts. The first is the long-term strategy that is reflected in the benchmark portfolio. The second is active management, which results in deviations from the benchmark portfolio. The Ministry of Finance decides the long-term strategy and defines the benchmark portfolio. Norges Bank is responsible for implementing this strategy and for active management. In addition, the Bank provides advice to the Ministry concerning the choice of the long-term investment strategy for the Petroleum Fund.
In the management regime chosen for the Petroleum Fund, the total return of the Fund will essentially be determined by the strategic decisions on the composition of the benchmark portfolio. This is because the risk taken in active management is small in relation to the total risk in the benchmark portfolio. Empirical analyses show that more than 95% of the fluctuations in the Fund’s return can be ascribed to strategic choices, which is in line with the level found in most other funds.
The Petroleum Fund has a long investment horizon. Strategic decisions for the Fund are consequently decisions under uncertainty of, to some extent, a very long-term nature. It is therefore not very meaningful to evaluate the strategic decisions on the basis of performance in the short term. We must therefore largely rely on a qualitative evaluation of strategic choices, which entails an evaluation of the rationale and analyses that led to the decision. The purpose of this report is to present such an evaluation of the strategic choices for thePetroleum Fund.
The benchmark portfolio is governed by the Regulation on the Management of the Petroleum Fund. Section 2 of the report describes the benchmark portfolio of the Petroleum Fund, distributed by regions and industry sectors for equities and bonds respectively. The section also examines more closely the reasons for the Fund’s strategic allocation, as described for example in the Revised National Budget for 1997, and how the basis for the decision on strategic allocation can be analysed.
In this report, we will discuss two methods for estimating the long-term return in equity and bond markets. One method uses historical return rates for equity and bond markets, while the second method is based on valuation indicators for these markets.
Section 3 presents an analysis of the historical return in equity and bond markets using time series for the last 103 years for a number of countries. These analyses allow us to form a picture of how unusual the return in equity and bond markets has been in recent years. We also update some of the calculations underlying earlier strategic choices for the Fund in order to determine whether the basis for the choices has changed.
Section 4 reviews a set of standard valuation ratios for equities and bonds in order to shed light on how important price performance in recent years has been for the valuation in these markets. The purpose of this review is to determine whether existing valuation ratios for these markets can provide information on the future return on equities and bonds.
In section 5, the Petroleum Fund’s benchmark portfolio is compared with benchmark portfolios of selected funds in other countries.
The last section summarises the results in this report, focusing in particular on to what extent the basis for the strategic choices has changed.