The importance of governance in a crisis

From December to mid-March of this year New Zealand Super lost 20 per cent of its assets. It’s the second time in less than 18 months the fund has experienced a significant drop in assets but in an example of how good governance and process can allow for counter cyclical behaviour the fund is now buying equities.

With the portfolio made up of about 80 per cent equities the investment team at the NZ$41 billion New Zealand Super is used to managing volatility.

The high equities exposure comes from the fund’s very long-time horizon and the fact it is not expected to make contributions to the government until the mid-2050s.

“That’s a benefit some others investors don’t have,” says Stephen Gilmore, the chief investment officer who has been in the job for about 15 months. “This means we take a very-long term view, and in trying to harvest risk premia this points us to a healthy exposure to equities. And with that long term view we hope to ride out periods of decline.”

But to do that requires a very strong governance arrangement to stick to the long-term plan, he says.

“The worst thing would be to have a long-term view and lose your nerve.”

From mid-March to December the fund experienced a NZ$8.9 billion loss, on the back of a 21.13 per cent return for the 2019 calendar year.

Chief executive of the fund, Matt Whineray, says if the markets experienced a GFC scenario, from peak to trough it is estimated the fund would lost NZ$25 billion, more than half of the assets of its mid-February peak of NZ$47 billion.

“We believe equity markets eventually recover to higher fair values following periods of crisis,” Whineray says. “As a result the super fund expects it will earn back losses suffered by our active strategies in subsequent years as markets recover.  In the GFC scenario, the fund would recover its initial value, and catch-up lost ground, within 20 months, as long as it can “hold the course” with its investment strategies through a market cycle.”

In the past the team has taken care to remind stakeholders that volatility is expected in an 80:20 portfolio and that right now the portfolio is performing within expectations.

While Gilmore and the investment team are focused on staying the course and sticking to the investment strategy, he says the conditions of this crisis – including a much sharper decline and a much stronger policy response – have prompted him to review some of the assumptions that go into the process.

“What can happen is these events can cause you to relook at some of the assumptions you’ve used with respect to that modelling. What we have seen challenges some of the assumptions people are using. For example in infrastructure, there have been some assumptions about cashflow, so how do people think about that going forward? There may be short-term opportunities and there may be long-term opportunities. There are asset classes out there where people make assumptions and they don’t perform the way they think they will. I try to think about what opportunities there might be for us because of that,” he says.

“There are always lessons from these types of events and for us it’s no different. There are some things we have made assumptions around that we need to rethink, it’s part of the continuous improvement process.”

Gilmore, a Kiwi who returned to New Zealand for the CIO job after working most recently as chief investment strategist at the Future Fund, says he has been impressed with the strength of the fund’s governance, something Willis Towers Watson also highlighted in its recent review.

“I have been impressed with the strength of the governance arrangements and the way stakeholders– the board, government and people internally – understand the process. There is a degree of understanding of how the portfolio and process works and expectations that we will go through times like this.”

From a governance perspective Gilmore is looking at how to make stress testing more robust.

“For me things like the pace of these stock market moves prompts me to look at the stress testing we have. We do carry out regular stress tests but how do we make those approximate reality. The behaviour is different because everyone thinks it’s a test, how do we make it more like the real thing?”

Liquidity

Liquidity is a core part of the risk/return modelling of the fund, and the team keeps liquidity front of mind.

“Liquidity management is as we would expect, there are no big surprises there,” Gilmore says. “There have been opportunities we have taken advantage of when people wanted to raise liquidity. In the future there could be some secondaries opportunities but I don’t think there is a desperate need to rush into that right now. It might take a while for things to work through the system.”

A standard way for the fund to raise liquidity is to switch from physical to synthetic holdings and Gilmore says the fund has done some of that.

“We have a well thought out program, strong analytics when it comes to things like liquidity that alert us to when something may have changed.”

Given the long-term nature of the fund it is no surprise that as equity markets haven fallen it has been increasing exposure to that asset class as the valuations become more attractive.

“As the market rallies we will scale back that position, we tend to buy low and sell high as part of that process. The key thing is we lean in.”

The investment team has had a view for some years that bonds are expensive and in NZ Super’s tactical positions the fund has been short bonds for quite a while. Strategic tilting has been a keen source of value add for the fund and over the past 10 years has added 1.1 per cent, or NZ$3 billion, to the reference portfolio.

“The tilting program aims to lean into markets, when pricing looks more attractive we tend to buy more, and we also have the ability to deploy liquidity where we see opportunities. We think they may persist for some time to come,” he says.

“Given the pace of the moves in the market, we have to think about how confident we are in the potential paths from here which has impacted the pace of how we move. When we are being counter cyclical part of the process is to look at where we could be wrong,”

NZ Super is currently part way through the five-yearly review of its reference portfolio, with the process excepted to be completed by June.

Gilmore says it expects to see more uncertainty over the shorter term but is also exploring whether things have changed materially over the long term.

“The reality is we always have to think about whether there are any material changes and whether the reference portfolio needs to adjust because of those changes. We are always alert to something being different or our assumptions being different,” Gilmore says. “At this point we haven’t got to the stage where we think there are long-term or equilibrium changes, but that doesn’t mean we won’t get to that point.”

Some of the broader thematics being explored by the team include the greater role of government, perennially low interest rates, different protection for workers, the potential for margin pressure, China and the US, diversification of supply chains, the slow down of globalisation, and the impact on the gig economy.