NZ Super ditches SAA for reference portfolio

NZ Super has diverged from allocating assets according to a long-term strategic distribution and now actively allocates assets away from a reference portfolio. Head of portfolio design, David Iverson, discusses why this approach is superior for the fund’s purposes.The $19 billion NZ Super has restructured the way it approaches investing, moving away from a strategic asset allocation construct to a reference portfolio, fit for the fund’s purpose.

The reference portfolio is set at 70 per cent global equities, 5 per cent New Zealand equities, 5 per cent in global listed property, and 20 per cent in fixed-income.

This reference portfolio acts as an investment benchmark against which any active decision away from that portfolio can be measured, in both risk and return measures.

The reference portfolio acts as a “shadow” portfolio, appropriate for the fund’s long-term horizon and risk profile, it is comprised of simple, low-cost investments and is capable of achieving the fund’s objectives. It thus becomes a reference against which active decisions are made, and justified.

Head of portfolio design, David Iverson, says any decision to move away from that allocation becomes an active decision. It may be supplemented with a corresponding sale in the reference portfolio.

It’s similar to the Canada Pension Plan Investment Board’s (CPPIB) total portfolio approach where any move away from the policy portfolio to the real portfolio must be funded by a corresponding shift in assets in that policy portfolio.

“If for example we buy timber assets, we will sell 30 per cent global equities, and 70 per cent global bonds in the reference portfolio,” he says. “This keeps portfolio volatility constant, and we can measure how much return for risk we are taking.”

The fund makes active decisions in three main areas – capturing active returns, strategic tilting, and portfolio completion or identifying and reducing the direct or indirect costs of investment.

It looks for active returns in public markets, infrastructure, timber, private equity, property, rural land, and direct New Zealand investments.

In the past financial year to June 30, 2010, the fund’s passive benchmark returned 14.62 per cent with the actual portfolio returning 15.45 per cent. This was due to capturing active returns (-0.24 per cent), strategic tilting (0.77 per cent), and portfolio completion (0.29 per cent). After fees the value added was 0.83 per cent. The 2011 results will be published in the next couple of months.

Iverson, who was formerly head of Russell Investment Consulting in New Zealand, says in addition to being able to attribute performance to the active decisions, so being a real measure of the investment team’s success, it also acts as a governance benchmark.

“This way of allocating investments is a performance benchmark, it measures how well we do, and the board holds us to account. It’s also a governance benchmark, we don’t need as many people to run the reference portfolio as what we do the actual portfolio,” he says.

In many discussions, governance is referred to in relation to a board, but NZ Super is regarded for integrating the concept of good governance all through the entity. About one-fifth of the fund’s annual report is dedicated to governance.

“Governance is a focus all the way through the entity, we pay particular attention to it,” he says.

A reflection of this is the fact the 25-person investment team has autonomy, and is able to act on opportunities, and so act efficiently.

While it has to go to the board for certain investments, most of the investment ranges are a legacy of the SAA approach.

“With the reference portfolio construction, investment limits become less relevant. We care about the liquidity we have, and how much we should have speaks less to the buckets we have,” Iverson says. “Portfolio expectations are more important.”

Those expectations are run, to a large extent, by what opportunities the markets are presenting: it is very fluid.

“For example, there are no implicit targets for private equity, but we ask is it rewarding us right now.”

The difference between reference and actual is fluid because of market movements. These deviations may be intended when we have strategic tilting on,” he says. “Strategic tilting is part of the DNA.”

Strategic tilting, which the fund introduced in 2009, means a decision to go long or short on currency, equities, bonds, credit, relative to the reference portfolio, and while the activity and intent may be the same as some funds which engage in “dynamic asset allocation” the difference is that the decision-making rests with the investment team and they can act on it.

“We are responsible for that and get measured against that,” Iverson says.

The fund manages some assets in-house, particularly derivatives, but also has some external mandates.

Under the new structure it doesn’t employ what Iverson calls traditional active managers, but allocates mandates according to the market opportunities.

“We have managers that specialise in particular areas, we change the manager set according to the changes in opportunities. The bulk of exposures are now through passive, derivatives and where there are particular opportunities. For example Bridgewater and AQR are currently employed for a particular set of markets we think there’s an opportunity in.”

The fund has only operated according to this particular opportunity-driven approach to mandates for a few years so it is hard to measure how it will change as markets change.

It is driven mainly by the opportunity and less by the fundamental assessment of a manager’s skill, Iverson says.

Since inception in September 2003 to the end of the 2010 financial year, NZ Super has returned 8.06 per cent.