NZ Super debates currency risk

New Zealand Super has completed the latest five-year review of its reference portfolio, with currency risk hedging a hotly debated topic by the internal investment committee.

The NZ$50 billion fund eventually decided to leave its reference portfolio fully hedged, but the discussion went to the board which is an unusual situation for the fund.

“We had a lot of discussion around currency. In New Zealand there has been a benefit to hedging and there has been a currency hedging premium for a long time,” Stephen Gilmore, chief investment officer of fund, said. “We thought a lot about whether that premium would still persist in an environment where rates are low. We eventually came away thinking there would continue to be a currency risk premia but it would be a bit lower.”

Gilmore said there was a lot of very intensive debate over the decision to remain fully hedged with the internal investment committee evenly split.

“Normally the internal investment committee would go to the board with a clear recommendation. In a rarity in this case we weren’t sure, so we presented that situation to the board, that was quite novel and the board also debated it. It was fascinating that we decided to present the nuance of the discussion in the internal investment committee and discus that with the board, the board found that quite helpful.”

The team also came away thinking that foreign currencies would be diversified which Gilmore said was important in an environment where it is harder to find diversifying assets.

In looking at the next five years Gilmore said the biggest change in the assumptions in assessing how to set the reference portfolio, related to rates.

“If we think of the last five or 10 years the one thing we have really underestimated, like many others, is how low rates could really go and how long they would stay low,” he said. “So our assumptions around real interest rates came down, we are now looking for real interest rates to be around 0.5 per cent over the very long term, which is quite a bit lower than before.”

The assumptions around the equity market remained quite unaffected with the assumptions of the equity risk premium “nudged up” marginally.

NZ Super’s most recent five-year reference portfolio review was completed in June, and while it remains largely unchanged – 75 per cent global equities, 5 per cent NZ equities and 20 per cent bonds – the process involved a lot of debate.

“The outcome almost looks like no change, but it hides a lot of detailed thinking and discussion,” Gilmore said. “Some of those discussions were challenging because we were sitting in an environment where we had the COVID shock, and we were trying not to think about the short term but the very long term.”

Gilmore said the reference portfolio review, which takes place every five years, is the most important investment decision the fund makes because it sets the risk appetite.

“And it also helps us get the right perspective, it’s an equilibrium concept.”

The fund’s actual portfolio deviates from this reference portfolio due to active risk decisions.

The biggest area of active risk has been the fund’s tilting program which takes advantage of the fund’s time horizon and strong governance arrangements – it is not expected to make material contributions to the budget until 2050.

The fund has also taken active risk via its exposure to timber, the credit space and through factor exposures.

New Zealand Super incorporated a low carbon approach into its reference portfolio in 2016, and that has added about 60 basis points per annum to performance since it was brought in.

According to Stephen Gilmore, chief investment officer at the NZ$50 billion New Zealand Super Fund, getting the team together for its quinquennial reference portfolio review is a major event.

“It’s really almost like an all-hands-on-deck’ process,” the CIO said.

Speaking at the Investment Magazine Fiduciary Investors Symposium 2020 Digital Conference, Gilmore revealed how crucial the review process is to the investment governance of the fund.

“It’s probably the most important investment decision we make because it sets out risk appetite and it helps us get the right perspective,” he said. “It’s an equilibrium concept, and we’re looking out over the very long term – it can be 30 to 40 years.”

For Gilmore, the core benefit of reference portfolios is that it grounds the fund’s investment governance and facilitates accountability of the investment committee. NZ Super’s reference portfolio is currently 75 per cent global equities, 5 per cent New Zealand equities and 20 per cent New Zealand bonds.

“The idea of course is that we construct this simple transparent portfolio that will achieve our mandate, and we can use that as a device for expressing the risk appetite of the organisation and we can stress test that, but also it’s really important from an accountability perspective because as an organisation we want to do better than that,” he said.

Gilmore explained the parameters NZ Super uses to create and review the portfolio as being relatively straightforward.

“I try to create a liquid or simple transparent, publicly accessible portfolio that actually meets our mandate [while] maximising our return without undue risk,” he said. “We spend a considerable period coming into the reference portfolio review thinking about what the eligible markets might be, what the respective returns from various investments might be and thinking about the relationship between those instruments.”

The reality, however, is often far from simple, especially when the reference portfolio is weighted against the uncertainty of 2020. NZ Super’s most recent five-year reference portfolio review was completed in June, and while the CIO said the reference portfolio looks relatively unchanged, he added there was “a lot of thinking and detailed discussion” behind its construction.

“Some of those discussions were… I won’t say fraught, but I would say challenging because we were sitting in an environment that had COVID-shock and we were trying not to think about the very short term, we’re trying to think about the very long term,” he said.

Rate headaches and hedging bets

Gilmore said the biggest change in the assumptions used in the reference portfolio this year related to rates.

“If we think of the last five or 10 years the one thing we have really underestimated, like many others, is how low rates could really go and how long they would stay low,” he said. “Our assumptions around real interest rates came down, [we’re] looking for real interest rates globally to be around half a per cent over the very long term.”

The investment committee came to the conclusion that scant change was required on the equity side of the reference portfolio, but the issue of hedging against currency risk did cause some consternation.

For the fund there has historically been a benefit to carefully managing currency hedging, Gilmore explained. But assessing it in 2020 meant looking through a prism that included both increased uncertainty and unprecedented interest rate levels.

“There has been a currency risk premia that has been available since the time that the two currencies were floated, and we thought quite a lot about whether that currency risk premia would still persist in a world where rates are lower – particularly at the time when we were doing it, where it was effectively a case of rates being zero in most places we were looking at,” he said. “We eventually came away thinking that there would continue to be a currency risk premia but it would be a bit lower.”

Contention and collaboration

The CIO revealed that the decision to fully hedge the reference portfolio involved “intensive debate”, which the team struggled to resolve. In an rare turn of events, they took the issue to the board and asked for their input.

“This one was unusual because we were evenly split over what we should do,” he recalled. “Ordinarily we would go to the board with a recommendation, [while] also expressing other alternatives. In this particular case we really weren’t sure, so we presented that to the board. It was quite novel.”

In the end – and after “quite extensive” debate at the board level – Gilmore says the team decided to stay the course and maintain the existing hedge ratio. The consultation between investment committee and board, however, was a positive experience for both parties.

“In the end we decided that it didn’t really matter that much in the sense that we were only talking fairly marginal differences in terms of the hedge ration we would have chosen,” he said. “But it was fascinating that we actually decided this time to present the nuance of the discussion we had with the internal investment committee and discuss that with the board. I think the board found that quite helpful.”