Building a Fund from $30 bn to $324 bn While Keeping the Alpha Capability

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1 Exploring Capacity Issues: Building a Fund from $30 bn to $324 bn While Keeping the Alpha Capability The Q-Group Spring 2007 Seminar, Georgia, 28 March Knut N. Kjaer, CEO Norges Bank Investment Management 1

2 Agenda Background and Facts Transition in Two Dimensions: Strategic: From Oil to International Securities Financial: From Cash to Equities The Alpha Challenge Results Discussion The Advantage of Size Capacity Constraints KNK

3 Background and Facts 3

4 The Ranking of Oil Producers 2005 (mill b/d) Norges Bank Investment Management Production Net export Saudi Arabia Russia USA Iran Mexico Saudi Arabia Russia Norway Iran Kuwait China 3.63 Venezuela 2.12 Canada 3.03 Nigeria 2.09 Norway 2.97 UEA 2.09 Venezuela 2.64 Mexico 1.66 Kuwait 2.51 Libya 1.38 Source: Fact sheet 2006 KNK

5 The Norwegian Oil Fund and NBIM Norway is the world s 3 rd largest exporter of oil Since the late 1990 s the bulk of oil revenue has been saved to the Oil Fund for future generations NBIM was established in 1998 and manages the Oil Fund and the bulk of the Central Bank s currency reserves The Ministry of Finance owns the Fund and sets the benchmark Asset under management in NBIM increased from USD 30 bn at inception in 1998 to USD 324 bn at year end 2006 KNK

6 Projected Growth of the Government Pension Fund - Global Bn. USD Source: National Budget 2007, October 2006 KNK

7 A Possible Scenario Ownership in Equity Markets 1.40 % Percent of FTSE Market Cap 1.20 % 1.00 % 0.80 % 0.60 % 0.40 % 0.20 % Europe America Asia Total 0.00 % KNK

8 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 31 Dec 2006 (billion USD): The Pension Fund - Global 286 The Foreign Exchange Reserves 36 The Petroleum Insurance Fund 2 Total 324 KNK

9 NBIM / Organisation Chart Executive Director Knut N. Kjær Corporate Governance Henrik P. Syse Fixed Income Investments Operations Dag Løtveit Bjørn Egge Equity Investments Operations Yngve Slyngstad Stephen A. Hirsch Risk, Performance & Accounting Ilse Bache IT Infrastructure Ilse Bache Offices in Oslo, London and New York Number of Employees as of : 132 Legal / Finance / HR Marius N. Haug Bjørn Taraldsen Kristin S. Kleven KNK

10 Benchmark for the Pension Fund-Global EQ - Europe 20 % EQ - Asia / Pacific 6 % EQ - Americas / Africa 14 % FI - Americas 21 % FI - Europe 36 % FI - Asia / Pacific 3 % Strategic benchmark: 60 % Fixed Income 40 % Equities Smart rebalancing: Monthly inflows Asset class / region with largest negative deviation from benchmark Equity index: FTSE All World Index Large & Mid Cap Approx equities Fixed income index: Lehman Brothers Global Aggregate Government / Agency / Corporate / Securitized Approx bonds KNK

11 Transition in Two Dimensions: Strategic: Oil to International Financial Securities Financial: Cash to Equities and Fixed Income Securities 11

12 Petroleum Wealth - Autumn USD Bn Petroleum In Ground Oil fund Equities Bonds 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) KNK

13 Petroleum Wealth - Value at Risk USD Bn Petroleum In Ground Oil fund Equities Bonds 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 KNK

14 Real Global Market Returns Equities Bonds Money market Oil Source: Dimson, Marsh & Staunton, Triumph of the Optimists, 2002, with updates 376 KNK

15 Portfolios of Oil and Equities Norges Bank Investment Management 7.00 % 6.00 % 100% equities Real Return 5.00 % 4.00 % 3.00 % 2.00 % 1.00 % 100% oil 0.00 % 0.00 % 5.00 % % % % % % % Standard deviation KNK

16 Portfolios of Equities, Oil and Bonds 7.00 % Real Return 6.00 % 5.00 % 4.00 % 3.00 % 2.00 % 100% equities 1.00 % 100% bonds 100% oil 0.00 % 0.00 % 5.00 % % % % % % % Standard deviation KNK

17 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 KNK

18 Implementation:Transition From Cash Inflow LHS Inflow as % of MV at the beg. of year RHS Inflow in USD (bill) Inflow in % of MV KNK

19 Trading Efficiency Norges Bank Investment Management Given the expected large inflows and expected large size, NBIM knew early on that efficient trading was critical to success If trading was not efficient, NBIM would easily spend any alpha generated and more System advances over the last 9 years along with management willing to focus on trading has enabled NBIM to build the infrastructure and gain the expertise to compete in a competitive part of the marketplace Data is the key to improving trading efficiency. Tracking all data components of the trading cycle is extremely difficult but more than pays for the effort KNK

20 Total Equity Trade Volume USD Billions Sep98 Dec98 Mar99 Jun99 Sep99 Dec99 Mar00 Jun00 Sep00 Dec00 Mar01 Jun01 Sep01 Dec01 Mar02 Jun02 Sep02 Dec02 Mar03 Jun03 Sep03 Dec03 Mar04 Jun04 Sep04 Dec04 Mar05 Jun05 Sep05 Dec05 Mar06 Jun06 Sep06 Dec06 Singlestock (phys) Program Futures Equity Swaps FX Equity trading volume tripled from the end of 2004 to the summer of 2006 and is expected to increase for the foreseeable future KNK

21 How is Volume Distributed (%) Norges Bank Investment Management 100 % 80 % 60 % 40 % Electronic Agency Natural Capital 20 % 0 % Jan04 Mar04 May04 Jul04 Sep04 Nov04 Jan05 Mar05 May05 Jul05 Sep05 Nov05 Jan06 Mar06 Mai06 Jul06 Sep06 Nov06 Natural flows and capital are the sweet spots for broker interaction. This is an area of focus for us. Tracking costs told us that agency is not optimal relative to other alternatives. KNK

22 Electronic Trading Volumes Billions % 60 % 50 % Jan04 Mar04 May04 Jul04 Sep04 Nov04 Jan05 Mar05 May05 Jul05 Sep05 Nov05 Jan06 Mar06 May06 Jul06 Sep06 Nov06 40 % 30 % 20 % 10 % 0 % -10 % Value Percent Being nimble is important in the fast changing trading environment. We see electronic trading as an important tool required to improve efficiency and lower total trading costs. KNK

23 Volume By Instrument 2006 Billions Physical Swap Elec. Phys Elec. Swap Swaps have there place in an investment strategy, but are expensive to trade given constraints in execution. Tracking costs enabled us to see the costs confirming what the traders were telling us. KNK

24 Cutting the Trading Cost Basis points Total Single Stock Trading Cost Tax&Charges Commission Shortfall Diligent management enabled a significant decrease in trading costs despite strong growth in volume and average ticket size KNK

25 Trading - Conclusions Actively managing and monitoring all trading costs is important Lowering commissions is only a small start The ability to influence the trading mix has changed dramatically over the last 5 years giving the buyside the tools to actively manage total trading costs The key to lowering trading costs is Data and access to Data. Good Data is important not only for improving trading costs but should also be extended to improving portfolio management decisions KNK

26 The α Challenge 26

27 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 bn / year Excess Return, Basis Points KNK

28 Move to More Scalable Alpha-Strategies May Imply Lower Information Ratio NBIM prefers relative value and fundamental strategies Our IR is now 1.22 However, we may be forced to move to more factor based strategies Management strategy Tactical allocation Factor-based strategies Fundamental strategies Relative value Analytical ability Number of independent positions Implementation costs Experience Expenses Low Moderate High High Expected information ratio Low Moderate High High KNK

29 The Principles behind Our Active Management Norges Bank Investment 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 KNK

30 "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 KNK

31 Textbook Approach to Active Portfolio Management Norges Bank Investment 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 KNK

32 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) Norges Bank Investment Management and/or increase breadth by taking many independent positions and trade often KNK

33 Neccessary Conditions for Creating Alpa Talented people Motivated and challenged in a rational, efficient and supportive structure KNK

34 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 KNK

35 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 KNK

36 Example: Risk Allocation Fixed Income 14 % 6 % 18 % Correlation matrics, profit units Average % 0 % F.I. Ext. mgrs RV GV QP EI Cred AO EI cred b cred a rv gv qp ao ext a EI 1 cred b cred a rv gv qp ao ext a % 22 % 21 % 49 % Oslo cre Oslo gov NY c re NY gov 43 % RV 14 % 0 %1 %1 %1 %1 0 %%1 %1 %2 % 3 %1 2 %1 %2 0 %1 %1 1 % 2 %1 %1 1 %%2 % % 2 % % 1 % 3 % % % % %1 % % % 0 1 % 0 1 % Pos. 2 % 2 % 1 1 % 2 % 10 2 % 1 % 2 % 1 % 2 % % % 1 % 2 % 1 % 10 1 % 2 % % 1 % 0 % 0 % 1 1 % 1 % 1 1 %1 %1 % 1 % 1 %1 % 0 % KNK

37 Talented People NBIM learning from external and internal management: Alpha creation is mostly about the property of the people. Only special talents create alpha. The key issues is then: How to recruit, develop, motivate and retain talents KNK

38 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 KNK

39 Performance KNK

40 Average Annual Net Real Return Since 31/ % 9.0 % 8.0 % 7.0 % 6.0 % 5.0 % 4.0 % 3.0 % 2.0 % Net Real Return on Actual Portfolio Net Real Return on Benchmark Average annual net real return (adjusted for management costs and inflation) is 4.58 % Annual real return on the benchmark is 4.12 % 1.0 % 0.0 % KNK

41 Excess Return Last Three Years Norges Bank Investment Management Monthly excess return Three years rolling excess return 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 % Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 KNK

42 Annualised Contributions to Gross Excess Return Percentage Points External management Internal management Total Excess return in each asset class Equity management Fixed income management Total KNK

43 Information Ratios External Internal Total management management Equity management Fixed income management Total The IR is a measure of risk-adjusted return and is an indicator of skills in investment management. It is calculated as the ratio of excess return to the actual relative market risk to which the portfolio has been exposed. The IR indicates how much excess return is achieved for each unit of risk. KNK

44 Quarterly Excess Return Since % 0.8 % 0.6 % 0.4 % 0.2 % 0.0 % -0.2 % -0.4 % Q1 98 Q3 98 Q1 99 Q3 99 Q1 00 Q3 00 Q1 01 Q3 01 Q1 02 Q3 02 Q1 03 Q3 03 Q1 04 Q3 04 Q1 05 Q3 05 Q1 06 Q3 06 Average annual excess return since 1998: 0.48 percentage points Cumulative excess return NOK 28,9 bill. Information ratio 1.22 KNK

45 Excess Return and Contribution to Total Risk From Active Management Excess return and return on the benchmark portfolio Risk contribution due to active management Benchmark Excess return Risk due to active management Benchmark risk Active management has increased the return with no increased risk KNK

46 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 KNK

47 Discussion The Advantage of Size Capacity Constraints 47

48 The Advantage of Size Norges Bank Investment Management Economies of scale in beta management and transition Easy to scale from a system and -competence base with fixed costs. Can afford large investments in systems Low commissions. Our flow has value Low trading costs gives more opportunity for applying quant strategies Size and organizational skills gives power to demand and build new products with service providers, like: Custodians, prime brokers, prime custody, backoffice Size advantage in securities lending 24/7 systems and organization KNK

49 The Advantage of Size (2) Norges Bank Investment Management Access to company information; scale advantage in some research, easier access to the global talent pool Some lower fees in external management Top credit rating; balance sheet advantages Some studies indicates a positive relation between alpha and size (next two slides) KNK

50 Large funds did better than small funds. On average, the Net Value Added was higher by 28 bps for a $1 billion fund compared with a $100 million fund. Net Value Added versus Size (log10) All Funds Log (Size) Coefficient 0.28% "t" statistic 4.3 "T" statistic values in excess of the absolute values of 2.0, 1.6 and 1.3 are significant at the 95%, 90% and 80% confidence levels, respectively. Size predicted Net Value Added since larger funds have lower costs and have higher weightings in specialised, high performing asset classes. The belief is supported by the fact that the size factor was reduced significantly when the following factors were added: Total Cost, US Small Cap Stock, and Private Equity. Net Value Added vs. % Private Equity, % US Small Cap Stock, Total Cost (bps) and Size (log10) All Funds Coefficient "t" statistic Private Equity 4.933% 2.8 US Small Cap Stock 2.700% 3.1 Total Cost % -1.4 Log (Size) 0.155% 1.9 KNK

51 Big is Better? KNK

52 Capacity Constraints Market impact. (Trading costs may eat to much of the alpha return. But as explained, we try to build trading into an advantage) May have constraints in external active management Lack of scalability in some of the internal alpha strategies. May be difficult to keep the return targets? May a fat and complacent organization follow with increased size? KNK

53 Discussion Yes, it is possible to become to big, but we are still not there When there is one owner of the assets; by splitting in different portfolios, there is a risk for ending up with costly index management (overlap that average out active positions) Better way of splitting up: Keep the beta and transition machines, set up different & focused alpha satellites Avoiding being fat & complacent: Line structure with real delegation, results having effect on compensation and position for everybody, outsourcing of all activities that are not in the core business, individual measurement KNK

NBIM Quarterly Performance Report Second quarter 2007

NBIM Quarterly Performance Report Second quarter 2007 Government Pension Fund Global Norges Bank s foreign exchange reserves Investment portfolio Buffer portfolio Government Petroleum Insurance Fund Norges