Treading with caution in the global market
When investing institutions look around the world at examples of best practice in portfolio management, they typically look at what is happening among the US pension and endowment funds. In 2003, when the New Zealand Superannuation Fund was starting up, they were no exception to this rule. Their early work most closely resembled the activities of the Yale and Harvard funds, and today their portfolio contains a wide variety of US-based managers.
The New Zealand Superannuation Fund was set up to fund partially the future cost of super, as the proportion of the population aged over 65 climbs. At present, one person in eight is over 65. This is forecast to rise to one in four by 2030. The fund is allocated on average $2bn a year. The assets and income of the fund are not able to be drawn on until after the year 2020, and then only to fund NZ superannuation payments. By then the fund is expected to total over $120bn.
According to the NZ Treasury's latest contribution rate model, capital contributions will cease in the mid 2020s and the Government will start to draw the equivalent of between 15-20% of the annual cost of superannuation.
The net fiscal impact of the fund is expected to exceed 30% of the cost of New Zealand Superannuation for several decades. In June 2006, Standard & Poor´s said New Zealand was one of the best placed nations in the world to meet the challenges of an ageing population.
In the words of David May, chairman of the Guardians of New Zealand Superannuation, "As it moves from its start-up phase to become an established investment institution," it is instructive to look at how the fund's managers have developed their asset allocation and some of the issues they now face in developing it further.
The members of the board of the guardians of New Zealand Superannuation are appointed by the Governor General on the recommendation of the Minister of Finance. They have no involvement in the day to day management of the investments.
All investment decisions are directed in-house by the largely Auckland-based investment team, which splits its activities between public and private markets.
Chief executive of the fund is Adrian Orr, a highly-experienced economist and former central banker who took up his post at the Super Fund in February this year, following the departure of Paul Costello to Australia's Future Fund. The investment team is headed by chief investment officer, Paul Dyer, and head of public markets, Tim Mitchell, both highly experienced fund chiefs who are actively engaged in manager selection.
They have built a central core competency that directs all the traffic around them and the objectives of managers and consultants. The fund does not currently retain any investment consultants. Their advantage, in having no liabilities to meet and therefore being able to invest for absolute return, means they can follow what head of public markets Mitchell describes as "thoughtful investment processes that integrate stakeholder risk tolerances, investment beliefs, seasoned judgment and advanced portfolio management technology".
Adrian Orr adds: "We are using our advantage of this long term horizon to appoint managers in a wide variety of asset classes and expose elements of the fund to the higher volatility and growth end of the market.
"We don't have to be worried about liquidity, at least until 2020, and even after that the fund will keep going. And since the management of the fund has evolved to a point where we have implemented our strategic asset allocation and manager selection, we can now go in search of the alpha."
The management team has worked on developing core relationships with, firstly, strategic managers such as BGI and Goldman Sachs. They have also worked on strategic alliances, where the super fund can line up in partnership with another fund with common objectives.
They also use specialist consultants, which provides some level of confidence for the board. In January this year, the guardians announced the appointment of Northern Trust as the new custodian for the super fund. The search process was supported by global custody advisory firm Thomas Murray, with specific consideration given to the fund's increasing diversification into private markets.
Since September 2003, 37 investment mandates have been awarded. As at 31 January the fund's assets totalled $12.2bn (see table 1). At present, 80% of the fund is allocated to growth assets (equities and other growth assets including property, private equity, infrastructure, timber, commodities and absolute return strategies) and 20% to defensive assets (fixed income).
To reduce the volatility of returns due to foreign currency fluctuations, the majority of the fund's non-New Zealand exposure is hedged back to New Zealand dollars.
The 13% allocation to alternative assets has some elasticity around it. Target ranges have been set for each sector, and mid-points nominated (see table 2).
The fund's major performance target is to exceed the risk free rate of return by at least 2.5% a year over 20 years.
According to the fund's 2006 statement of intent, return expectations for the next 10 years assume a risk-free rate of 5.3%. Its investment modelling generates an expected beta over the next 10 years of 2.4%, expressed as an annual compound rate.
The reward for active management is calculated at 0.5%. The board states: "It is very difficult to distinguish the alpha and beta in our private market assets like timber and private equity. These issues aside, we estimate the total return across the portfolio will be lifted by 0.5% from active management."
This means the estimated nominal average return over the next 10 years is 8.2% per annum.Can this level of excess return be maintained? It is most unlikely, say the board: "We estimate that continuing to generate more than 9% annually above the risk-free rate over the next 10 years has a probability of only a few per cent. This should not be seen, in any way, as us being resigned to delivering whatever markets bring."
The team is generally sceptical of active managers and considers a beauty parade is a poor method of manager selection.
"The right way is to get right into their processes and ensure that what they do matches up with what you require," says Mitchell. He suggests trustees should be prepared to think seriously about passive management. "Until you have the necessary degree of conviction about the asset class and the manager."
The super fund faced a good deal of criticism in its early days from those who either objected to the idea of a taxpayer-funded reserve for future superannuation, or to the idea that this money would then be invested overseas.
And despite the fund's good performance so far, there remain dissenting voices in New Zealand who would like the board to review how it runs its money.
In particular, activist groups, with the support of coalition partner the Green Party, is lobbying for the super fund to divest from all arguably unethical companies.
Among the firms highlighted for exclusion are Exxon-Mobil, Boeing and the US mining company Freeport McMoran, which was the subject of a high-profile divestment by the Norwegian Government.
Freeport operates the world's largest copper and gold mine in West Papua and has come in for fierce international criticism for the environmental devastation its waste management system has had on the land and its people.
The NZ Super Fund has been forced to explain its position in the face of mounting criticism at home. The fund's newly appointed head of responsible investment, Anne-Maree O'Connor states: "We're not so focused on divestment as a strategy, we're much more focused on using our position as active, responsible share owners in companies to bring about change."
The super fund is a founding member of the United Nations Principles of Responsible Investment. The fund takes an active stance in ensuring its investment mandate is respected and has a framework for screening companies against the UN Global Compact. It has started to engage with companies identified as having poor practices and aims to work with other investors under the auspices of the UN PRI.
"We believe that's the way we, as a small player in the market, can have the most impact," said O'Connor. "Our holdings are generally less than half a percent of a company - if we divest, the board doesn't really take much notice."
When they talk about ‘refining a workable framework for managing reputational issues within the operational realities', the governors are recognising the complexity of the issue and acknowledging that they need to work hard to ensure they observe the correct ethical procedures. While that allows them a certain flexibility to hold firm or to divest (they have sold out of companies involved in whaling and land mine manufacture), overall they are committed to a policy of engagement.
The phasing-in of the increased allocation to property and alternative assets over several years reflects what the super fund sees as significant implementation challenges associated with investing in these areas.
Adrian Orr says: "We are committed to both private and public markets. The two most developed asset classes in the private space are unlisted property and private equity. The challenge for us is that the economies of scale don't work as well as in the private markets. It's a very people-intensive process and once again, that's a question of getting comfortable with the asset class and the people in the business. How do you manage that process? How much do you have out-sourced? That's where the fund is still growing. We still don't get the economies of scale and we will have to make decisions as to how we deal with that in terms of staffing."
However the single biggest obstacle to developing a meaningful portfolio of private investment is the shortage of opportunity. Orr adds that "Everything we do has quite a long gestation. But you get less time to assess these opportunities. We are pleased to be able to move into the private markets on schedule, but we will be treading with caution."
Orr says he brings not only his skills as an economist, but "the ability to get on with the mandate within the bounds of operational independence. That's something I am used to. I am tasked with leading a group of very smart people broadly in the same direction. I say broadly because these people are paid to have opinions, but to act as a team."
The act is set up in such a way as to allow us to bring in experts in their field and to have robust discussion while retaining that inclusiveness. We have to have to framework in place, but for it to work you have to bring the people with you. So we allow them to go out and think wide, but they have to bring it back to a workable framework."
A whole new discussion has arisen in New Zealand this year with the imminent introduction of the Government's KiwiSaver workplace superannuation scheme.
It's still a long way from the 9% of salary compulsory scheme operating so successfully in Australia, but it's a start. And it has allowed the Super Fund to put its activities into context as part of its work to educate the public on the need to plan now for 30 years' time.
Politically, the future of the super fund looks secure. The opposition National Party has indicated it will not be scrapping the super fund if it comes to power at the next election. Reflecting on the fact that good investment performance has dampened much of the criticism at home, Orr says: "I think we can be reasonably comfortable with the work we've done so far."