The return
Chart 95 Annualised mean relative return and tracking error in percent (left-hand axis) and
information ratio (right-hand axis). By asset manager ownership type
Chart 95 Mean relative return and tracking error (left-hand axis) in percent, annualized. Information ratio (right-hand axis). By size of asset manager.
Mean return Tracking error Information ratio
Chart 95 Annualised mean relative return and tracking error in percent (left-hand axis) and information ratio (right-hand axis). By size of asset manager
145 consequently delivered the most excess return
measured in kroner.
It is our experience that the smaller specialists usually deviate more from the benchmark than larger institutions. This is often due to the fact that the fewer assets they manage, the more freedom they have in investing in concentrated portfolios across the full market-cap spectrum.
Even when taking the increased small-cap exposure into consideration, we see that small and medium-sized firms have delivered better results for us, with a higher information ratio of 0.7 and 0.8 respectively than the larger institutions at 0.6.
Mandate age
Another question is whether the managers deliver a higher return at the start of the mandate or when the mandate is more mature.
To investigate this, we align the mandates to have the same inception date and calculate
average performance for each month. All mandates are part of the results for the return in month 1, while in month 120 only mandates with a performance record longer than this will be part of the sample. The monthly return numbers are then chain-linked to calculate cumulative performance. We find that we have a higher return in the first year of a mandate, but that performance continues after this at a high level.
After 13 years the series delivers a cumulative relative return of 66.6 percent or 1.7 percent per year.
We have found considerable dispersion in the first year, with some mandates doing
exceptionally well and others making a negative contribution. This dispersion reduces over time for more mature mandates, which is to be expected. Managers are allocated a smaller amount initially. As we get more or less confident, through analysis of transactions and more meetings with the managers, mandates are increased or terminated.
Chart 96Cumulative relative return by mandate age. Months since inception.Percent
Chart 96 Cumulative relative return by mandate age.
Percent Chart 98 Annual relative return by mandate age. Percent.
0.0
Chart 97 Annual relative return by mandate age.
Percent
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sub-strategies within each area – such as brazil and china in emerging markets – and to having multiple mandates within each sub-strategy.
Selecting managers with differentiated approaches to investing has been a focus since the start of the external mandates.
Finally, having multiple independent strategies has increased the total information ratio by 0.22.
Our experience is that while there is some positive correlation in excess return within a strategy, the correlation across strategies is lower. For instance, the correlation between the excess return in emerging markets mandates and developed small-cap mandates has been -0.1.
Information ratio
The information ratio for the time-weighted portfolio of all mandates since inception is 0.86 for the first 20 years. This is higher than the information ratio of 0.25 that we initially expected. The information ratio has been 1.15 for the emerging markets mandates, 0.49 for the regional mandates, 0.48 for the environmental mandates, 0.17 for the small-cap mandates and 0.03 for the sector mandates. The information ratio is calculated as excess performance divided by realised relative volatility.
The total information ratio of 0.86 can be broken down into several sub-components. First, the average equal-weighted information ratio across all mandates with more than 12 months’ history has been 0.22. This indicates that the general selection of managers has been successful, but that a lot of the value added has come from work post hire as well as in portfolio construction.
Investing with successful managers for longer time periods and pruning other managers have contributed 0.10 to the total information ratio.
We have substantially more data on existing live managers than potential managers and will use this to add to and prune mandates.
Higher allocation to managers who have subsequently performed better have added an additional 0.09 to the total information ratio.
This is an indication that we have been able to distinguish between expected future excess performance between managers.
Due to diversification across different mandates within a strategy, the aggregate portfolio has a lower relative volatility than the average manager. This intra-strategy diversification has increased the total information ratio by 0.23. The diversification is due both to having multiple
147
Chart 98 Information ratio for the combined portfolio of all mandates within a strategy. Mean and 95 percent confidence interval
-0.6
All mandates Regional Sector Emerging Small-cap Environmental
Chart 98 Information ratio for the combined portfolio of all mandates within a strategy. Mean and 95 percent confidence interval
-1.0
Interquartile range Median information ratio since inception Chart 100 Information ratio by mandate age Chart 100 Information ratio by mandate age
Chart 99 Information ratio for single mandates. Mean and middle 50 percent of the mandates within each strategy
-0.8
All mandates Regional Sector Emerging Small-cap Environmental
Chart 99 Information ratio for single mandates. Mean and middle 50 percent of the mandates within each strategy
Chart 101 Information ratio contribution
0.0
Chart 101 Contributions to information ratio
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Performance in different market cycles It is generally acknowledged that global factors are important drivers of stock market
performance. The problem is that they are hard to predict and hard to assess. In order to gain some insight into how these macro factors affect our excess returns, we have divided a range of macro indicators into non-overlapping time segments. These time segments are characterised as bear markets, neutral markets and bull markets. The macro environment we analyse is the performance of the global stock market, the US dollar against a basket of currencies, brent crude oil prices, and the relative performance of emerging markets versus developed markets.
For each of the different time periods and macro factors, we have measured the annualised relative performance of each portfolio. If macro environments systematically affect our relative performance, we would have seen significantly different levels of excess return in each of these market environments. The initial hypothesis is that the selected managers outperform independently of market cycles, i.e. that the managers outperform the market over time.
There have been different numbers of months of bear, neutral and bull markets for each of the five strategies, but except for the environmental mandates in a bear market, there are at least 22 months for each strategy with each cycle.
What we have seen is that, historically, our excess returns have been fairly independent of the global macro environment, regardless of how we measure these macro trends. These results are encouraging, as they indicate that the excess returns generated by the managers we have chosen have been positive, steady and largely independent of the macro environment since inception.
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Bear Bull Neutral Bear Bull Neutral Bear Bull Neutral Bear Bull Neutral Bull Neutral
Regional Sector Emerging Small-cap Environ-mental Mean
Chart 105 Excess return in different market cycles measured by increasing/decreasing levels of MSCI World Index
Chart 102 Excess return in different market cycles measured by increasing/decreasing levels of MSCI World Index
Bear Bull Neutral Bear Bull Neutral Bear Bull Neutral Bear Bull Neutral Bear Bull Neutral
Regional Sector Emerging Small-cap Environ-mental Mean
Chart 106 Excess return in market cycles determined by crude oil prices
Chart 103 Excess return in market cycles determined by crude oil prices
Bear Bull Bear Bull Bear Bull Bear Bull Bear Bull Regional Sector Emerging Small-cap
Environ-mental Mean
Chart 107 Excess return in periods when EM is outperforming (bull) and underperforming (bear) DM Chart 104 Excess return in periods when emerging
markets outperform (bull) and underperform (bear) developed markets
Bear Bull Neutral Bear Bull Neutral Bear Bull Neutral Bear Bull Neutral
US dollar Global equities Crude oil EM outperform Mean
Chart 108 Excess return across all mandates in various market cycles
Chart 105 Excess return across all mandates in various market cycles
150
Chart 109 External Active Equity. Share of months with excess return in rising and declining markets. Percent
0
(1999-2018) 1999-2003 2004-2008 2009-2013 2014-2018 Total Up-market months Down-market months
Chart 106 Share of months with excess return in rising and falling markets. Percent
0
Regional Sector Emerging Small-cap Environmental
Total Up-market
months Down-market months
Chart 110Share of months with excess return in rising and declining markets. Percent
Chart 107 Share of months with excess return in rising and falling markets. Percent
Performance in rising and falling markets Another way to examine whether managers’
performance is dependent on the general market is to look at each manager’s performance versus his or her own benchmark’s absolute
performance, and see whether excess returns occur more frequently when the manager’s market is positive or negative. We look at each month, for each mandate versus its benchmark, and calculate the percentage of times we have gained or lost in months when the market is rising or when the market is falling.
Over the full period 1999-2018, the external mandates delivered excess performance in 59 percent of months. Excess performance was
achieved in 63 percent of months when the benchmark was rising, and 55 percent of months when the benchmark was falling. On average, the regional and sector mandates’ main contributions to the positive performance were in up-market months, while the emerging markets, developed markets small-cap and environmental mandates’ main contributions were when their respective markets fell. Our emerging markets managers are conservative with regards to companies’ management quality and balance sheet strength. They have learned through cycles that it is important in these markets to have a focus on environmental, social and governance issues and quality of operations in order to generate a sustainable excess return.
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Chart 113 Relative return and fees. Million kroner
-10,000 -5,000 0 5,000 10,000 15,000
-10,000 -5,000 0 5,000 10,000 15,000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Fees Relative return
Chart 108 Relative return and fees. Million kroner
-15,000 -5,000 5,000 15,000 25,000 35,000 45,000 55,000 65,000
-15,000 -5,000 5,000 15,000 25,000 35,000 45,000 55,000 65,000
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Sector Emerging Regional
Small-cap Environmental
Chart 114 Cumulative excess return and fees in million NOK
Chart 109 Cumulative excess return and fees.
Million kroner Performance after fees
External managers are remunerated with fees for their services. We aim to buy the best possible product at the lowest possible price.
Since 1998, the number of mandates with some sort of performance-based fee structure has been stable at around 70-75 percent. We prefer this fee structure, as it aligns the asset manager’s interests better with our own. Fixed fees have mainly been used for mandates where
representative benchmarks are skewed towards a few companies, or where none of the existing benchmarks are applicable, such as in frontier markets and environment-related investments.
Norges bank Investment Management’s fee structure has evolved over time and will continue to evolve to meet the objective of maximising the return on invested fees.
152
Return on investment
When negotiating with potential external managers, the goal is to maximise our return on the fees we pay. We therefore aim not only to select the best manager, but also to minimise the fee paid for each krone of performance.
Initially, we expected on average to pay 0.40 percent in fees and generate 1 percent in excess return on the assets invested with external managers. That is, we expected to pay 40 percent of the excess return in fees. The reality is that we have paid 0.38 percent in fees, but have generated 2.1 percent in excess performance, which is far more than we expected. Since inception, the fund has retained 82 percent of the percentage excess return generated and 76 percent of the excess return generated in Norwegian kroner, which is way above the 60 percent we initially expected.
Today’s investment mandates are purely specialist mandates within narrow investment fields. These specialist mandates are more costly than the more generalist strategies of our early years. The higher fees are in part explained by capacity constraints in these strategies. Only a limited amount of investments can be made in such niche strategies, and competition is fierce for access to these specialist managers.
With a large proportion of external management fees dependent on excess return generated over time, total management costs are thus expected to be higher in years of good performance.
Since 1998, we have on average paid an annual fixed fee of 0.18 percent plus an annual performance-based fee of 0.20 percent.
0.0
1999-2018 1999-2003 2004-2008 2009-2013 2014-2018 Base Performance
Chart 111 Fees as share of assets. Percent Chart 110 Fees as share of assets. Percent
0
1999-2018 1999-2003 2004-2008 2009-2013 2014-2018 Base Performance
Chart 112 Fees as share of relative NOK performance. Percent Chart 111 Fees as share of relative return in kroner.
Percent
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Chart 115 Cumulative excess return and fees in billion NOK
Chart 112 Cumulative excess return and fees.
Billion kroner
-4,000 -2,000 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000
-4,000 -2,000 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Relative return Fees paid
Chart 116 Management fees and relative return by mandate vintage, in million kroner
Mandate vintage: managers selected that year Return and fees calulated from inception until 31.12.2018
Chart 113 Management fees and relative return by mandate vintage. Million kroner
Long-term
When we started out in 1998, the standard performance-based fee schedule was a variation on a 0.20 percent fixed fee and a 20 percent participation rate, with a 1 percent excess return hurdle rate and a 3 percent cap on the fees. The cap is the maximum amount we pay out in a single year to a single manager. The performance part of the fee schedule was based on a rolling 12-month period.
The fixed and performance fees were paid out every quarter except in the first year. No performance fee was paid out for the first three quarters of a mandate; instead, the accumulated performance fee for the entire first year was paid after 12 months of performance was
established. For a given year, that meant that the entire performance fee for performance
generated the year before was paid out the year
after. While this method decreased performance fees over time, it had the unfortunate effect of moving performance fee payments to a different year to the one in which the performance was generated.
As we evaluated the fee schedule, we increased the time period on which the performance fee was based to 36 months. The argument was that the expected annualised relative volatility over a three-year period was only 58 percent of the 12-month volatility. As our expected fee was based on an option-pricing model, lower volatility implied a lower expected fee. The next step in our fee modelling was to scale the participation rate, such that very low excess performance and very high excess performance were given a lower rate, while 2-5 percent excess performance was usually close to a 20 percent participation rate.
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by 2009, the average performance-based fee schedule had a fixed-fee component of 0.13 percent, while 15 percent of the mandates were based on rolling 12-month performance and 85 percent on 36-month performance. The fixed-fee element was based on a decreasing scale as the mandate size increased, and the performance fee component on a variable scale dependent on the excess performance.
A few situations arose as we moved from broader to more specialised mandates that made us re-think the fee schedule. First, we had excess returns on many portfolios. This led to high fees, as our fee schedule at that time was not suited to the highly volatile specialist mandates.
Second, the new mandates, such as china, Russia or health care, tended to have a higher fee than a US or developed Europe mandate.
Furthermore, we were not able to invest as much per specialist mandate as in more broadly diversified developed markets mandates. For example, an Indonesia mandate would never be as big as a developed Europe mandate. This affected average fees negatively, as our fees had a discount based on asset size. The larger the assets, the lower the percentage fee we paid.
Finally, until a 36-month history had been achieved, we measured performance since inception. As the standard deviation is higher over shorter measurement periods, the expected relative performance differential is larger when there is a short time period since a manager was funded. Several of the specialist mandates were quite new, with higher expected volatility and higher expected fees.
Under our new performance fee structure, we have solved this by retaining part of the performance fee earned by the manager in the initial years of a mandate. The way the schedule is structured, the fee not paid out is retained and released as the mandate matures, subject to continued performance. This structure adjusts for the asymmetry between manager and client by putting the retained fee on the line if the manager in the future destroys the value created. Once the mandate is mature, after five years, the pay-out rate rises to 100 percent.
The performance fee is furthermore linked to the whole history of the mandate. If a manager has a period with returns lower than the benchmark, the manager must earn back all of this underperformance before performance-based fees begin to accrue again. It is our intention to reward skill and consistency of excess return, not luck or simply higher market risk.
Finally, all the mandates have a cap on fees. This works similarly to the pay-out rate, in that the manager will have the fee above the cap paid out in subsequent years, unless performance since inception at that point is lower.
Alignment of interests
Many fee schedules promote asset gathering as opposed to value creation. Our current
performance fee schedule was introduced in 2011, and one of the main objectives was to align the interests of the manager with our interests as a client. An important aspect in this regard has been to design a fee schedule that optimises the incentive for managers to maximise return without undue risk. Our schedule allows us to pay performance fees only to managers that generate excess returns.
155 The underlying principle of the performance fee
structure is simple. We pay a performance fee on an annual basis based on the value added by the manager since inception. We define the value added as how much the manager has delivered in excess return measured in an agreed currency.
This value added is calculated on the basis of the difference between the return on the mandate and the return on a comparable benchmark plus the cost of risk capital. This cost of risk capital is there to reflect the uncertainty in determining whether positive returns close to zero are due to skill or luck. In addition, it creates an adjustment for the asymmetry where managers receive part of the excess return but do not have to pay the client if they do not generate an excess return.
In order not to pay fees on the same
performance twice, given that we pay a fee each year for added value since inception, we subtract fees already paid to the manager at the time of the calculation. In the interim quarters, a minimum fee is paid, which we view as a pre-payment of future performance fees.
There are some key reasons why we prefer
There are some key reasons why we prefer