New Zealand Super has radically slashed the holdings in its passive equities portfolio as it re-aligns the portfolio with a Paris-aligned benchmark. It’s part of the fund’s shift to a sustainable finance focus which includes improving the fund’s already-good ESG profile and a more long-term future focus on impact investing.
The decision on what benchmark to use is important for asst owners, and never more so than when they seek to achieve a net zero or sustainable finance target. New Zealand Super recently decided to change the benchmark of its large passive equities portfolio to a Paris-aligned benchmark as it seeks to improve the ESG profile of its investments.
It’s part of a move to sustainable finance by the fund which follows a two-year review of its responsible investment position. With ‘sustainable finance’ referring to the consideration of the impact of investments on society and environment as well as thinking about the ESG risks on investments.
Rishab Sethi, the fund’s manager of external investments, describes how the last review in 2019 by Willis Towers Watson included a fulsome review of RI practices but recommended that the fund needed to think a bit deeper about what RI looked like over the decade and how the fund wanted to set itself up for that.
“Others may have leapfrogged us in terms of global best practice,” he lamented.
The most recent review initially looked at what other institutional investors were doing, what constituted best practice and how NZ Super’s existing activities and RI frameworks stacked up against that.
The upshot of that was a fairly significant pivot to ‘sustainable finance’.
“We always integrated ESG into investment decisions,” Sethi told Top1000funds.com in an interview. “We would keep doing that while fulfilling our financial purpose but we also wanted to think about the consequences of our decision on society and the environment as well. Not just the risks of it, but the consequences.”
The naval gazing also resulted in the NZ$56 billion fund being firm in its commitment to be part of the solution.
“In effect the system as a whole may be considered to be not very sustainable so what could we do to make the financial system as a whole more sustainable? Recognising we are a small fund at the end of the world,” Sethi says.
Choosing a benchmark
New Zealand Super took a big step back in 2016 to shift its policy benchmark to a climate benchmark (See New Zealand Super adds climate alpha) on the premise that climate risk was not suitably compensated.
“We wanted to rid the portfolio of the uncompensated risks,” Sethi says. “But there is more to sustainability than just climate, so we were doing a disservice by not having a bigger picture approach to sustainability.”
The result was twofold. A big picture approach to impact, which will result in a significant shift in the way the fund invests, and will take three to five years to rollout.
The second more near-term change was improving the ESG profile of investments.
“We asked can we continue to achieve our financial objectives but improve the ESG content of our portfolio and make the portfolio better or stronger?”
While the intention is to cover the entire portfolio, the most obvious starting point was the biggest piece of the portfolio, the NZ$25 billion passive equities portfolio.
“The hardest decision that we had to make was: do we change the benchmark or do we change the actual portfolio and leave the benchmark unchanged?” Sethi explains.
“The board chose to own it and to change the benchmark itself.”
The result was a move from a custom version of the MSCI All Country to the MSCI World Climate Paris Aligned index and the MSCI Emerging Markets Climate Paris Aligned index.
In the process about 7,000 securities were culled from the portfolio, reducing the passive equities to about 1,000 names.
Sethi , who took on the role of running the process and thinking around improving the ESG content of the equities portfolio, says one of the biggest lines of enquiry following these changes was whether the portfolio would be diversified enough.
“We had to gain comfort that we are diversified enough. The benchmarks serve as our reference portfolio which have certain principles including diversification, low cost, simple etc.”
As part of the process the fund reviewed 25 indexes across four different providers considering three broad themes.
“We looked at whether the new index matched up to the financial characteristics we are leaving behind. Also what do the sustainability characteristics look like and do we have a measurable improvement? Is it readily implementable, are there outstanding derivative contracts we can use, will banks give us quotes on these at low costs?” Sethi says, adding that 12 months ago the MSCI
Paris-aligned index that was selected was in a good position on all of these criteria.
One of the fund’s goals as part of the sustainable finance re-think is to change the system as a whole, and in order to do that it wants to be a leader and bring other investors along for the ride.
“We are hoping by choosing an off-the shelf product it could provid greater liquidity and help make it a market standard.”
Active is harder
While the passive equities significantly shrunk in the process, the actual equities portfolio has about 3,000 portfolio companies.
“We still have a bunch of active strategies – in value, low-volatility, quality and multi-strategy portfolios – which re-introduce some names to the portfolio. Some of those names may have been in the passive equities and so culled but now may survive in the active part of the portfolio.”
Sethi says the team is undertaking a piece of work to think about active strategies and what is needed to make that portfolio sustainable.
“Research on our active portfolio is under way, it is hard,” Sethi concedes. “When canvassing for value stocks, quality, momentum etc when combing the world for those, if you start restricting your world you won’t find the factor alpha you are looking for. You do need to start with a broad universe. I would be surprised if we are able to say in a year that an actual portfolio of 1,000 names is sufficient to represent passive and active.”
While Sethi says within the passive portfolio the main management decision is the choice of the benchmark, there is also a question of replication and for New Zealand Super that is normally done by third parties such as Northern Trust, State Street and UBS. It also uses derivatives in house.
All factor equities portfolios are managed externally by AQR, Northern Trust and Robeco and they are doing work on how to incorporate sustainability factors into the typical factor portfolios.
For example Sethi says AQR is doing research to introduce sustainability in a classic mean-variance optimisation framework.
“Given that model looks to maximise return for a given level of risk, it’s asking can you maximise returns and sustainability for that given level of risk, tackling it as a portfolio construction issue.”
The fund uses a lot of Bridgewater’s research on this topic as well.
“One of the questions we get is are you doing it this in the pursuit of alpha? For us the answer is categorically no. We don’t know if there is excess return to be gained from sustainability investments, but we believe it won’t detract from returns.”
From passive and then active equities the fund will look at its fixed income and private market portfolios.
“The overall aim is to be sustainable across the entire portfolio. That might not be the same thing as being Paris-aligned across the entire portfolio. For us that is not an objective but a solution that is helping us become more sustainable.”
The fund does have a net zero 2050 goal, so everything is evaluated in that context.