An inside look at how a team of tightfisted money managers watches over Norway’s Petroleum Fund, the world’s fastest-growing major pool of assets.
By Andrew Capon
March 2003
Institutional Investor Magazine
Thorstein Veblen, economist and son of Norway, first coined the phrase “conspicuous consumption” in 1899. When it comes to managing their oil wealth, Norwegians nowadays practice something closer to conspicuous frugality.
Until government-owned energy company Statoil pumped its first barrel from the North Sea in the 1970s, Norway was Scandinavia’s poorest economy, with just a handful of developed manufacturing industries. Now it is the world’s third-largest oil exporter after Saudi Arabia and Russia, producing 3.1 million barrels a day. Statoil pours tens of billions of dollars a year into the government’s coffers. Oil and gas together contribute 23 percent of gross domestic product and 32 percent of state revenues. Budget deficits are a dim memory, and the United Nations last year ranked Norway tops among all countries for quality of life.
Unlike some governments, which have wasted their oil bonanzas on white elephant infrastructure projects or lost them through corruption, Norway has been thrifty. In 1990 Parliament created the Statens Petroleumsfond, or Government Petroleum Fund, an endowment designed to transform today’s oil gushers into tomorrow’s financial security. Statoil pays the government taxes and royalties based on how much oil it drills every year; whatever is left over after the government has met its spending budget goes into the Petroleum Fund. The fund took in some $40 billion in 2001; last year, because the federal budget doubled, the fund got $20 billion.
It has quickly become quite a safety net. Since it received its first transfer of government money, $310 million in 1996, the fund has grown into Europe’s second-biggest pool of assets, behind Dutch pension fund ABP. Its $88 billion translates to about $195,000 for every man, woman and child in Norway. Based on long-term Finance Ministry projections of oil production and prices, plus planned government spending, the Petroleum Fund is expected to reach $250 billion by 2010.
The fund was set up with two clear objectives. It’s supposed to provide for Norwegian citizens’ financial future and also to mitigate the oil boom’s potential negative impact on the domestic economy -- from inflation to the decline of other industries -- by investing exclusively in capital markets outside Norway. Running the money is the job of Norges Bank Investment Management, a little-known offshoot of Norway’s central bank led by self-effacing Knut Kjaer, a 46-year-old economist and former insurance executive. Kjaer reports to central bank governor Svein Gjedrem, and his operation takes its cues from the Ministry of Finance, which sets broad asset allocation guidelines.
Low-key but rigorous in its standards, NBIM manages the bulk of its money in-house -- much of it through indexed accounts -- with a staff of 116, of whom 55 are investment professionals. About $19 billion is run by 32 external portfolio managers, across 22 mandate types, from 14 different firms, including Morgan Stanley Asset Management (on the fixed-income side) and Deutsche Asset Management and Schroder Investment Management (on the equity side).
Not surprisingly, money managers are competing fiercely for pieces of the Petroleum Fund, especially as NBIM often awards multiple mandates. The Norwegians are tough bosses: External managers must run a gauntlet of appraisal procedures before they get a foot in the door, and subsequent monitoring is relentless. NBIM keeps overall management costs at a strict 10 basis points of assets, and its size gives it considerable buying power. “Our mission is clear,” says Kjaer. “We are focused on providing cost-effective exposure to global markets and creating above-benchmark performance, using both internal and external management.”
Market professionals say Kjaer has done a superb job of bringing top-drawer investment skills to a still-fledgling public sector fund. Restrained and conservative, he is exactly the type of man to whom you would entrust your savings, say those who know him. And NBIM has delivered creditable results in volatile markets that have battered many of its peers. Last year the Petroleum Fund lost 4.7 percent, while the average U.K. pooled multiasset fund in the Mellon/Russell Caps universe declined 18.1 percent and the Second Swedish National Pension Fund was down 15.3 percent. The Netherlands’ ABP fell 7.2 percent. For the fifth consecutive year, NBIM outperformed its benchmark -- a hybrid based on the FTSE world index for equities and the Lehman Brothers aggregate index for bonds -- this time by 25 basis points.
Yet as the fund has grown so has public scrutiny -- and skepticism. Critics charge that the Petroleum Fund isn’t meeting its broader goals of protecting wealth and guarding the economy from inflation. The problem is that although NBIM manages the fund like a pension plan, it was never earmarked for anything specific, such as retirement benefits -- Norway still has a pay-as-you-go social security system. People feel cheated when so much money is sloshing around with no clear purpose. Special-interest groups from every point on the political spectrum have begun clamoring for payouts. Some economists, meanwhile, think that the fund should be turned into a true pension plan and at least partially privatized, with some of its assets diverted into individual retirement savings accounts that citizens would invest on their own.
Rising oil prices -- Brent crude is now about $32 per barrel -- swell cash flows to the fund, and Norwegians have a heady sense of how wealthy they are. Last year the daily newspaper Dagbladet calculated that the fund would buy 3,000 beers for each of Norway’s 4.5 million citizens. “Literally every day you hear politicians and commentators say that Norway is one of the richest countries in the world,” says Arne Jon Isachsen, an economics professor at the Norwegian School of Management in Oslo. “If you hear that every day, it does something to you. It inflates expectations.”
Indeed, the center-right Christian Democratic government of Kjell Magne Bondevik was elected in 2001 partly because voters were fed up with a Labor government that they considered to be miserly, keeping income taxes as high as 50 percent while running a budget surplus and sucking national wealth into the already huge Petroleum Fund. Immediately after the election, which took place on September 10, Norway’s new Defense minister, Kristin Krohn Devold, declared that she wanted to tap into the Petroleum Fund to buy new fighter planes for the Air Force. The government did not oblige.
Every day a new contingent pleads for money from the Petroleum Fund. The left-wing Venstre party wants oil revenues to be used to help clean up waste in the Norwegian Sea from the U.K.'s Sellafield nuclear plant. The Labor Union party thinks they should go toward holding down unemployment, through tax breaks and R&D subsidies for manufacturing companies. Early this year the Norwegian Red Cross called for some government oil money to be diverted into a humanitarian relief fund for Iraq, in anticipation of a war. And Carl Hagen, leader of the populist right-wing Progress Party, fulminates that the Petroleum Fund continues to grow “while school walls crumble, care for the elderly deteriorates, the health care system flags and taxation bursts through the roof.”
Others say that the Petroleum Fund isn’t providing a bulwark against the excesses of oil riches. Even after a central bank cut in January, interest rates remain at 6 percent, more than double the euro-zone average of 2.75 percent. The krone has zoomed to about 7 per U.S. dollar -- up more than 25 percent against the greenback in the past 12 months and more than 20 percent against the euro. It’s expected to rise a further 15 percent this year. Labor costs are stubbornly high, driven in part by the fast-growing public sector, while private sector unemployment is rising. Inflation, at 1.8 percent, is expected to rise this year because of lower interest rates.
“We have the short-term distortions for everyone to see, with high interest rates and a rapidly appreciating currency,” says economics professor Isachsen, author of the 2002 book What Does Oil Money Do to Us? and a proponent of turning the fund into a mechanism for privatizing Norwegians’ pensions. “If the Petroleum Fund was designed to stop that, it hasn’t worked.”
NBIM hasn’t escaped the controversies surrounding the Petroleum Fund. Like many managers of huge asset pools, it is under pressure from some politicians and special-interest groups to adhere to standards of “ethical investing” -- to avoid, say, securities issued by companies that make pornography or use sweatshop labor. Parliament set up an independent commission last fall to consider such ethical strictures. It’s scheduled to deliver its first report in June, and by spring 2004 new legislation could govern how NBIM can invest the Petroleum Fund. The commission’s head, University of Oslo law professor Hans Petter Graver, admits that new constraints could affect NBIM’s performance.
Some economists fear that the Petroleum Fund’s vagueness of purpose leaves room for potential misuses in the future. “The money should be out of the reach of the policymakers forever,” declares Kjell Roland, head of Oslo-based economic consulting firm ECON, which Kjaer helped found in 1986. “With every political debate, the money is sitting there, and people think it can be used to solve short-term problems. It is very hard to muster support for anything that would boost the private sector and wealth creation.”
Government officials are modest yet direct in refuting their critics. Central bank governor Gjedrem says that the current interest rate and currency spikes are simply the result of high world oil prices. These are short-term, cyclical conditions, he says, not evidence that Norway’s economy is doomed to boom and bust. “Our situation would have been much worse without the correcting influence of the fund,” he argues. “If the money had been invested in our economy, the pressure on the krone would have been higher than it is today.”
Gjedrem also dismisses the notion that NBIM is vulnerable to political pressure. Despite the Finance Ministry’s oversight, he says, there’s a “Chinese wall” between the government’s long-term policies regarding disbursement of the Petroleum Fund and NBIM’s day-to-day asset management decisions. “Our main responsibility is to ensure that the fund is managed in a professional way,” he says. “The responsibility for strategy belongs to the Ministry of Finance. I think the division of labor is very clear.”
The central banker adds that questions of ethical investment guidelines frequently come up for private sector funds, too. “I don’t think this is by any means an exclusively Norwegian issue,” he says.
Even the Petroleum Fund’s most outspoken critics find little fault with the way Kjaer runs NBIM. “The fund and NBIM are separate issues,” says Isachsen. “I don’t know anyone in Norway who has anything but praise for what NBIM has done and how it manages the money. Knut Kjaer is a man of outstanding personal qualities, and I cannot think of anyone whom I would trust more to look after this money.”
WHEN OSLO CAME UP WITH the idea of investing the entire Petroleum Fund outside Norway, it had a compelling rationale. Government economists wanted to save their country from “Dutch disease,” a short-lived financial bubble (in the Netherlands’ case, created in the 1960s when offshore gas fields were exploited) that leads to inflation, currency appreciation and a steep decline in manufacturing.
Norway’s political leaders were determined not to let that happen to their country. Says central bank governor Gjedrem: “The oil is a blessing, but there are also risks associated with it. These advantages and risks need to be finely balanced. The Petroleum Fund is a mechanism for doing that.”
Other oil producers have set up endowments, such as the Alaska Permanent Fund and the Alberta Heritage Fund, to soak up money streams. The Alaska fund pays an annual dividend to residents, in part to compensate for the hardships of working in the remote state -- and there’s no danger that the spending will be inflationary, because it’s absorbed by the huge U.S. economy. But Norway faces special dangers because its economy is tiny. “We looked closely at other oil funds, such as the Alaska fund,” says Yngvar Tveit, deputy director general of the Finance Ministry’s economic policy department. “But in terms of formulating policy for NBIM, we looked more closely at how large pension funds, such as ABP, operate.” Because of its size, Norway has to manage its money with an eye to geographic diversification.
When the fund was first set up in 1996, it was seeded with the previous year’s surplus of $310 million -- less than the country’s foreign exchange reserves. In fact, both pools of money were managed by a group within Norges Bank called the market operation department. Like many similar forex reserve operations in central banks across the world, the group knew how to manage currencies and government bonds but had little experience with other types of investments.
So in the spring of 1997, the central bank hired Kjaer away from Storebrand, Norway’s largest insurer, where he was head of strategy. His marching orders: to create a professional money management operation, essentially from scratch. Time was short. The Finance Ministry had decided that from 1998 onward the Petroleum Fund could invest in stocks, and it knew that inflows to the fund would begin soaring in 1999, because the ruling Labor Party was running a tight budget. (In fact, they grew even more than expected: Brent crude prices rocketed from a low of $9.72 per barrel in December 1998 to $24.75 a year later.)
Kjaer’s No. 1 priority, therefore, was putting strong equity managers in place. Finding qualified Norwegians was tough; the country has no history of private pension management, and insurers are the only institutional pools of money. So Kjaer tapped Storebrand’s head of equities, Yngve Slyngstad, to head NBIM’s equity operations and help locate talent. They recruited several managers from outside the country: Stephen Hirsch, an American from Minneapolis-based institutional fund manager Clifton Group, filled the key position of head of equity trading in Oslo. Robert Cook, a Briton who had run the back office for U.K. unit trusts at PDFM (now a division of UBS Global Asset Management), became head of investment support.
In January 1998 Norges Bank Investment Management was officially born. By the end of the year, Kjaer’s team had grown to 71, bolstered by a handful of seasoned professionals as well as some freshly minted graduates from Scandinavia’s best colleges. Of the senior staff, only information technology chief Ilse Bache came from the central bank’s original market operation division, although NBIM still occupies part of the central bank’s building, a neo-Gothic hulk of pink granite near the old fort of Oslo.
The sense of commitment to public service at NBIM remains tangible. Many Norwegian staffers who joined from the private sector took pay cuts. Employees are united in a culture of restraint unusual in the glad-handing world of many fund managers. External managers report that NBIM staffers refuse even modest entertainment and small gifts, spurning freebie lunches and returning bottles of claret delivered at Christmas.
These sober individuals faced unique challenges in 1998. They knew a flood of money was about to hit the fund, and they had ten years’ worth of budget and oil production projections that told them it would keep growing. In addition, they had to follow Finance Ministry constraints on risk, cost and asset allocation. The ministry requires that NBIM invest between 30 and 50 percent of the Petroleum Fund in equities, with a regional distribution of 40 to 60 percent in Europe, 10 to 30 percent in Asia-Pacific and 20 to 40 percent in the Americas. The equity benchmark is the FTSE world index. At 40 percent, NBIM’s equity allocation currently is in the middle of its target range.
The remainder of the fund is in fixed income. In 2002 the Finance Ministry changed the benchmark from the Salomon Brothers government bond index to the Lehman global aggregate, following advice from Norges Bank and NBIM, whose economists noted that government bonds are becoming a smaller part of the investable bond universe. The benchmark change resulted in some E20 billion worth of bond trading last year.
Although roughly one fifth of the overall fund is outsourced, 40 percent of NBIM’s equity portfolio is managed externally. “We are happy to buy skills that we do not have internally,” says Kjaer. “Our No. 1 rule is cost-efficiency. We don’t do fund management or anything else in-house for the sake of it. We will outsource whatever we can if that is the most cost-efficient thing to do.”
Winning NBIM’s business is far from easy, however. Kjaer boasts that it has the most rigorous system for appraising and monitoring fund managers of any endowment in the world. Its standard manager-evaluation form has more than 140 different criteria. NBIM’s executives follow up the questions with exhaustive due diligence.
“We want to first understand the investment process and then get beyond it,” says equity chief Slyngstad. “We want our portfolio managers to analyze the portfolios of external managers, but we also want our analysts to assess their analysts, our traders to assess theirs. We look at everything from the front office to the engine room of a firm.”
Getting hired is just the first hurdle. From then on, an NBIM portfolio manager monitors every trade. There are weekly, monthly and quarterly reviews of each portfolio, using an array of quantitative performance and analytic tools. At the end of each year, instead of giving a cozy performance review, NBIM repeats most of the original due diligence process. Turnover is relatively high. State Street Global Advisors lost its 1998 mandate to manage indexed equities at the end of 1999. Mellon Capital, hired in 2000 to manage a tactical asset allocation portfolio, was fired before the end of 2001. Although Gartmore Group still manages European active equities, it was fired from a U.K. index mandate. Kjaer and Slyngstad even sacked their alma mater, Storebrand, from a European equity portfolio.
“I’d say NBIM is tough but very fair,” says one fund manager. “There are no surprises. Agendas are agreed in advance of meetings, and the staff there will listen to a cogent explanation.” Tough but fair also sums up NBIM’s attitude toward fees, says another source. “Of course it uses its buying power. You’d expect that, but it isn’t unreasonable.”
Although external managers run just 22 percent of the Petroleum Fund’s total assets, they account for 65 percent of NBIM’s costs. Still, Kjaer has to stick to his expense ratio of 10 basis points of assets, which WM Co., a pension consulting firm in Edinburgh, says is broadly in line with costs at U.K. pension funds with mostly internal management. The Norwegian Finance Ministry uses a Toronto-based firm, Cost Effectiveness Measurement, to monitor NBIM’s expenses and benchmark them against its peers.
Internally, NBIM makes an effort not to treat third-party fund managers as second-class citizens. “Organizationally, we try to think of internal and external management as producing a single return,” says Kjaer. “The heads of equities and fixed income are paid on the overall performance of their divisions, regardless of where that performance comes from. We are careful to incentivize them to ensure the best management skill, be it internal or external, runs our portfolios.”
NBIM’s operational structure impresses outsiders. One fan is Jean Frijns, chief investment officer of ABP Investments, who also balances internal and external management. “NBIM has been established in a very professional way,” says Frijns. “It is always quite stimulating to discuss policy issues with them.”
Kjaer’s guiding principle is to diversify as much as possible. To that end, all of NBIM’s portfolios -- equity and fixed income, internal and external -- are divided into beta and alpha mandates, and asset allocation is separate from risk allocation (defined in terms of tracking error). Beta portfolios are designed to generate the return of a market or asset class with very broad diversification and limited tracking error. Alpha portfolios are more tightly defined and have a bigger tracking-error allocation.
Today, all equity beta mandates are run internally. In 2001, Slyngstad says, he saw a money-saving opportunity when the FTSE world index moved to free-float weighting. The beta portfolios had been managed by Barclays Global Investors and Deutsche Asset Management, which fully replicated their FTSE benchmarks. Trading into new positions to match the new index would have been costly, so Slyngstad decided to switch NBIM’s beta portfolios to enhanced-index strategies. “We think enhanced indexing both saves money on transaction costs and offers the opportunity for small excess returns,” he says. At the same time, he decided it made more sense to run these products in-house.
In its active, externally managed equity portfolios, NBIM has some traditional regional mandates (for example, Europe, Asia and the U.K.). But it’s increasingly allocating assets among global and regional sectors. “I think it is the best way to divide the investment universe,” says Slyngstad. “I don’t believe growth and value are meaningful definitions.”
Late last year, NBIM awarded a $200 million mandate to Boston-based Wellington Management Co. to run a global portfolio of utilities and water companies. Other new business in 2002 went to Lincoln Capital Management, Merrill Lynch Investment Managers and State Street, all hired to run enhanced-index mortgage-backed securities. NBIM has outstanding requests for proposals for $500 million in consumer noncyclicals and $750 million for consumer cyclicals. It’s also hunting for a U.S. small-cap manager to oversee between $500 million and $700 million.
To supervise its far-flung portfolios more effectively, NBIM has established two overseas offices. One, in lower Manhattan, manages $17.5 billion in U.S. fixed income; opened in 1999, it now has a staff of eight, including an American. In 2000 NBIM opened an office in London to manage U.K. and European equities. Its cosmopolitan staff of ten includes a Spaniard from BBVC, a Brit from ABN Amro, an Aussie from Queensland Investment Corp. and a Frenchwoman from Axa Investment Managers -- all experienced professionals.
Few companies take road shows to Oslo, so Kjaer likes having a presence in the main centers of international finance. He also likes to have some staff close to external fund managers, to keep tabs on them. “We have found the number of mergers and acquisitions in this business and the way fund managers move around difficult to keep up with,” he says. “In Oslo we get the official line. The true picture is sometimes different.”
NBIM’s fixed-income operation is similarly structured, but only 10 percent is managed externally. Managers run both alpha and beta portfolios, of which the biggest is a relative-value alpha strategy, accounting for roughly half of total fixed-income investments. The relative value portfolio is in turn divided into four trading books with low correlations: global (ex-U.S.) credit and government bonds, both run from Oslo; and U.S. government or agency bonds and corporates, both run from New York. There are 105 individual bond positions across the four books, with little overlap. “We think [low correlation] is the best way to add value,” says fixed-income chief Dag Lotveit. “It is superficially attractive to take big tactical positions in markets, but we are not a hedge fund, and there is no evidence that this kind of management can consistently generate positive returns.” Lotveit’s team generated 45 basis points of excess return in 2002, well above its 25-point target.
Despite the professionalism of Kjaer and his team, NBIM’s net annual return of 2.6 percent since 1998 lags behind those of true pension funds, which have much bigger equity allocations. During that period ABP returned 3.4 percent and the average U.S. public pension fund returned 3.2 percent.
Nevertheless, the controversy swirling around the Petroleum Fund concerns how its bounty should be spent, not how it should be managed. Until the government clarifies the fund’s purpose, NBIM’s somewhat incestuous governance structure will remain suspect. The Finance Ministry, the central bank and Parliament all have a say in how Norway’s oil wealth is distributed. That makes many economists skittish. They believe that political pressure to disburse the money will become irresistible and that the Petroleum Fund will wind up fueling a state-dominated, inflation-prone economy.
“The way [the fund] is organized strengthens the public sector versus the private sector,” says ECON’s Roland. “We now have the biggest share of public employees in the workforce of any OECD country. Sweden used to be on top, but they have put in place reforms of the public sector. We haven’t done that.”
Isachsen of the Norwegian School of Management, although an old friend and great admirer of Kjaer, agrees that as long as the Petroleum Fund remains under state control, it could potentially do more harm than good. His solution: Use the money to finance a transition from Norway’s current pay-as-you-go pension system to a funded system. As it happens, the country’s current pension liability is $85 billion -- a sum the Petroleum Fund could easily cover, with money left over to kick-start private plans. By using the fund to pay off current liabilities and set up new, private accounts for individuals, the government could avoid the intragenerational inequality that normally accompanies a switch from unfunded to funded pensions, in which the unlucky transitional group winds up simultaneously paying for its parents’ retirement and its own.
Isachsen says that for now, no one in office is paying much attention to his calls for turning the Petroleum Fund into a private pension plan. At best, he says, he is raising politicians’ consciousness that handouts from the fund to fix short-term problems would be destructive. “The goal is to make people interested in not throwing the money away,” he says. But as Norway grows richer and richer, that kind of conspicuous frugality gets harder to defend.
