How a sovereign fund decided to take the road less travelled

New Zealand’s sovereign wealth fund made a big brave decision in the eye of the storm early last year and introduced a new dynamic asset allocation strategy. The strategy, driven by in-house analysis, involved several large bets on global markets. As Greg Bright reports, the decision seems to have paid off.

New Zealand Superannuation Fund, a NZ$15.65 billion ($11 billion) pension fund designed to provide a separate source of funding for the country’s social security system into the future, is a fund with a relatively high risk profile.

Because it is not expected to peak in assets until after 2050, the fund generally runs an 80:20 growth:defensive asset class ratio mix.

However, last year the fund’s board – called “guardians” – decided to tilt the major asset class allocations in order to gain as much as possible from what they then saw as a big recovery opportunity.

Previously the fund, which has a well-resourced staff of in-house investment professionals, had adopted a largely strategic position on asset allocation, over a relatively sophisticated range of investments, with some tactical tilts by selected managers.

However, in April last year, when the first signs of a tentative global recovery were emerging, the fund made the bold move to introduce a medium-term asset allocation strategy, driven by the board and two committees, based on the assumptions that the markets were ‘overdone’ in their reaction to the global financial crisis.

According to Aaron Drew (pictured), who is senior investment strategist for the fund, because a large proportion of the assets had been in relatively illiquid assets, the financial crisis “wasn’t very good to us”. But the guardians decided to temporarily, early last year, increase its exposure to growth and risky assets on the assumptions that markets would eventually mean revert.

“We didn’t actually anticipate the speed and size of the rebound,” he says. “We thought we’d have to keep our new positions on for a couple of years. As it turned out, we took them off in August (after making the tilts just four months earlier in April).”

The process NZ Super went through is interesting. The standing investment committee was charged with responsibility of putting recommendations to the board, but they formed a second committee, which had no responsibility to make recommendations, just to debate the issues.

“People were sceptical,” Drew admits. “We were putting a lot of the fund’s risk into a relatively small number of bets. We understood that there was a line of thought that this was dangerous. We acknowledged that…..Subsequent to the crisis it seems that there is now more appetite from funds like us to take these sorts of bets.”

Drew was referring to the new popularity for what is being termed dynamic asset allocation (DAA). Several large consulting firms, including Towers Watson, Mercer and Russell Investment Group, have introduced discrete services for DAA.

In NZ Super’s case, the fund returned 17.44 per cent in the 12 months to December last, with the outperformance largely due to the DAA tilts. The fund’s objective is a more modest 2.5 percentage points above the LIBOR rate. Since inception it has returned 6.23 per cent, which is slightly below the target on average. The fund was set up at the end of 2001 and started investing in 2003.

The tilts involved going overweight large-cap equities, credit and property. Implementation of the strategy was largely through derivative positions.

“Initial tilts were in line with our model signals,” Drew says. “This followed extensive internal debate on the crisis, market reaction to it and consultation with asset managers who often had contrasting views.”

The managers which advised NZ Super on the strategy included GMO, Bridgewater and AQR.

“Our key judgement was that the doom and gloom was overdone,” Drew says.

Following the success of the moves, the fund will keep its DAA process in place. Drew says that it is something which should probably be an in-house capability rather than outsourced.

“We will broaden the range of markets we tilt over,” he says.

The fund is also building into its framework portfolio various stress tests and scenario analyses.

“The GFC (global financial crisis) has hardened our organisation backbone,” he says. “We are well placed for future and for current stressed market conditions.”

The fund’s asset allocation, as at the end of January, was:

NZ equities  7.1%

Private equity  1.2%

International fixed interest  16.9%

NZ fixed interest  1.2%

Global listed property  7.2%

NZ property  1.8%

Commodities  5.2%

Infrastructure  6.5%

International equities – large cap  36.6%

International equities – small cap  6.2%

International equities – emerging markets  3.5%

Timber  7.6%

Other private markets  0.7%

Cash, collateral and FX hedges  -1.7%

In May 2009, the New Zealand Government indicated it would like to see the fund invest a bit more in NZ-based assets, although it did not go so far as to instruct the fund to do so.

In response the guardians decided to investigate whether it could look at various new direct investments in New Zealand, including infrastructure and rural opportunities.