Namibia maybe one of the youngest countries in Africa but it has nurtured one of the continent’s biggest pension funds into life since gaining independence from South Africa in 1990.

The Windhoek-based N$61-billion ($6.8-billion) Government Institutions Pension Fund, GIPF, accounts for over three quarters of Namibia’s entire pension assets and is the only defined benefit pension fund in the country.

The GIPF draws on a 98,000-strong membership from employees across Namibia’s public sector and, reflective of Africa’s youthful population, its average member is only 41 years old. Currently only 37,000 GIPF members draw a pension.

“Our funding levels are 103 per cent, but would have been 129 per cent if we hadn’t had to provide for reserves,” says Conville Britz, general manager of investments at the fund, which has just concluded an actuarial evaluation for the last three years.

The fund reported a total return of 23 per cent for the year to the end of February 2013 and since 2009 has returned a total of 17.5 per cent. The secret of its success, says Britz, is holding fast with a bold 68-per-cent equity allocation and the fund’s continued ability to invest a third its total assets outside Africa. Switching from balanced mandates to using specialist managers has also helped, he says.

Homeward bound

It’s a set of results that are all the more remarkable given that the scheme has to invest 35 per cent of its assets inside Namibia’s small economy in a strategy set out in Regulation 28 of the nation’s Pension Fund’s Act.

It’s designed to boost the local economy, but is now limiting the growing fund’s investment universe. Namibia’s buoyant but illiquid equity market is a case in point. The GIPF’s active strategy is almost impossible to pursue since most investors buy and hold the 35-odd traded companies on the index. In another example, the government has pushed for pension funds to invest in local private equity to help businesses access finance.

Last year the GIPF agreed to hike its allocation to unlisted equities, but only a fraction of the 10 per cent allocation has been dispersed because of the lack of opportunity and the GIPF’s own inexperience with the asset class, explains Britz.

“The fund lost money investing in early ventures and Namibia’s regulator has now ruled that the scheme must understand the asset class better before investing here again.”

Finding a balance between using its investment clout to nurture Namibia’s own economy but also push for returns in more dynamic markets is common to most of Africa’s other big pension funds. Rules of one sort or another restrict investment strategies, particularly pushing funds to finance government deficits via large government debt holdings.

“The current situation suits us fine, but we could run into problems in the future if the government wants us to invest more locally. We realise that there are developmental needs in Namibia and that as the biggest pension fund we have to lead the way, but we also want to invest more offshore to cover our liabilities,” says Conville.

The offshore allocation is particularly helpful offsetting the effects of any depreciation in the local currency, he says.

The mentor next door

Britz holds South Africa’s R1.17-trillion ($127-billion) Public Investment Corporation, PIC, up as “beacon” for other African funds seeking to get domestic investment right. Referring to strategy at the asset managers of South Africa’s biggest pension fund, the Government Employees Pension Fund, GEPF, Britz says: “The PIC has successfully invested for the development of the South African economy and for returns, but we haven’t aligned our investment strategy with national developmental objectives yet.”

The PIC’s 5-per-cent allocation to Isibaya, a return-seeking fund that seeks a developmental impact is one example. Investments range from $220,000 to $430,000 and include affordable housing, transport and lending to small businesses via private equity.

Despite the pull of investing at home, the South African fund is also investing more overseas. It recently decided to portion 5 per cent of its assets in the wider African context and 5 per cent outside Africa altogether.

Britz says the GIPF uses 25 managers, mostly South African, in active strategies. Investment consultancy RisCura advises on strategy. The fund, which targets returns of 3 per cent above inflation, allocates 26 per cent to bonds to hedge against inflation with allocations locally, in South Africa and to global bond markets in line with its global allocation.

The remaining 6 per cent of its portfolio is in cash. Investing at home sheltered the fund from the ravages of the financial crisis but now the GIPF wants to spread its wings. “We need to make sure our investments make a return,” says Britz.

 

 

The prospect of a seismic shift from bond to equity investments looks set to pass most of the world’s pension funds by, argue experts. The concept of a ‘Great Rotation’ rose to prominence following its use by Bank of America Merrill Lynch in October. It argued in a note that “the era of bond outperformance has ended” and advised investors to instead position themselves for strong long-term equity returns.

Some six months later, the idea has come under a sally of attack from a host of skeptics denouncing it as a myth. While stock markets have continued to rally and the Dow Jones industrial average has set new all-time highs, data from both BlackRock and Lipper suggest that investments into bond funds have remained steady in the first quarter of 2013.

Nick Sykes, European director of consulting at Mercer, says recent market upswings do not change the fact that he has seen no interest in three years from institutional clients to significantly acquire equities. The primary reason for this, he believes, is the “one-way ratchet of de-risking” that so many of the world’s defined benefit funds are constrained in. Sykes argues that “there is no desire to rebalance by selling bonds when they do well and buying equities”. Instead, pension funds will “only ever step up bond purchases as time goes on to cover liabilities”, he reckons.

Speaking about the UK, Sykes says that “a lot of the funds probably still have more equities than they want”.Sykes_N_115x150

Rather than future equity-market rises being something pension funds are desperate to take advantage of, Sykes (pictured right) argues they could actually further steer closed defined benefit schemes away from equities. He says that a continued rally might see funding-level targets breached and “by the logic of their de-risking strategies”, funds might seek to withdraw further from equities and pile even more heavily into bonds.

Great Rotation skeptics stress that the closure of many large defined benefit funds in the US and UK over the last decade means de-risking is likely to remain a priority for the distant future. Added to that is the assumption that bonds are likely to become even more attractive to institutional investors as fund memberships slowly age.

Then there is the prospect in Europe of insurance-style regulation from the European Commission that may limit the amount of risk-seeking assets – such as equities – a fund can hold.

Laith Khalaf, from financial services provider Hargreaves Lansdown, says that as a consequence there is little prospect of UK pension funds’ equity allocations recovering from current historic lows. The prospect of UK funds returning to the 80-per-cent equity weighting common in the 1990s, roughly double the present situation, certainly looks unlikely.

Off the mark?

For anyone rushing to rubbish the very existence of a Great Rotation, it is perhaps worth reading the Bank of America Merrill Lynch note that launched the debate. It mentioned merely that the phenomenon “could start” in 2013 “if the US successfully navigates the fiscal cliff, Europe continues to stabilise and Chinese growth re-accelerates”.

Without needing to delve into that trio of weighty issues, should funds at least be positioning themselves to take as much advantage as they are able to from a possible rotation if the global economy does decisively turn a corner?

Not even, says Sykes. He points out that the established theory of de-risking implies that interest rate risk should not be rewarded. By this thinking, any move from the mass of defined benefit funds to take more risk would likely wait until there is some upward trajectory in interest rate rises.

Various commentators agree that the shock of the world’s central banks unwinding their ultra-loose monetary policy in the future could send interest rates spiraling upwards over a short period. While Khalaf (pictured right)  says investors “could be in for a rude awakening”, Sykes advises funds not to second-guess the world’s central bankers. He says “we just don’t know when and where interest rates will go. Many people were predicting interest rate rises three years ago, but that has been very wrong. The conditions we are in are new to everyone and investors don’t know how the policy will play out”. Laith-Khalaf-140x140

Khalaf adds that predictions of a future spike in bond yields neglect to consider that a swell of downward pressure is being maintained on yields by regulation that has created large institutional buyers of government debt. As defined benefit funds are protected from rising interest rates by linked reductions in liabilities, the threat of interest rate spikes should arguably not concern them in any case.

Diverse appetites

Investors unconstrained by liabilities such as sovereign wealth funds and endowment funds seemingly have more scope for swapping bonds for equities should they be convinced the bond boom’s days are numbered.

There are also pension funds freer than others to benefit from a possible Great Rotation. Sykes points to open public sector funds that “have more appetite for risk assets” and in the UK are subject to less stringent regulation than their private counterparts. The relatively high existing risk profiles of those public sector funds (which Sykes estimates to be 10 to 20 percentage points more of risk-seeking assets) means that their appetite for more equity might be limited though.

The heightened investor sentiment in North America, along with looser accounting rules, might also leave more scope for ‘rotating’ there, Sykes adds.

There is some data suggesting that moves in this direction are already afoot. Towers Watson’s latest global studies of pension asset allocations indicate that US pension funds’ equity allocations surged from 44 per cent to 52 per cent in 2012, with bond holdings dropping from 31 per cent to 27 per cent. Other figures paint a different picture, though, with a recent study from top1000funds.com and Casey Quirk suggesting that a large proportion of global fund chief investment officers, 35.7 per cent, plan to reduce their domestic equity holdings in 2013.

A US consultancy, NEPC, suggested at the turn of the year “valuations might suggest an opportunistic overweight” in emerging market and non-US equities, but warned about the potential for volatility. At the end of January, $255-billion fund CalPERS was overweight its policy target on public equity, with 52 per cent of its giant asset base in the class, and underweight on ‘income’.

Meanwhile, bond-heavy Swiss pension funds are showing signs of wanting to take more risk to counter low bond yields, says Stephan Skaanes of the PPC Metrics consultancy in Zurich (pictured below right). He thinks that a desire to meet return targets is driving increased equity, corporate bond and emerging market debt investment among funds that can convert a higher share of active members into a higher risk profile. A new survey from Credit Suisse supports Skaanes’ assessment by finding average overseas equities allocations to be at an historic high of 17.9 per cent in (non-EU) Switzerland.SKAANES Stephan

Risk appetites also seem to be have changed somewhat in pension systems where defined contribution arrangements are predominant. Consultants in Denmark, for instance, talk about equity holdings being increased at the end of 2012 – albeit from relatively low bases. The $50-billion Danish fund PFA recently announced a desire to sell some of its “traditional bonds” in exchange for US equities – as part of a DKK5-billion ($900-million) purchase that puts it overweight on equities.

The funds of the future in Denmark look certain to have greater equity investments as existing funds are due to be phased out in favour of unguaranteed lifestyle products. In 2009 PFA launched a new lifecycle product that has a “much higher” allocation to equities (some 65 per cent of the $3.75 billion in assets) than its existing funds. In its 2012 report, PFA argued that “the future-oriented potential for return [from bonds] is estimated to be extremely limited as the absolute interest rate level is now at a historic low. In actual fact, there is a considerable risk of a negative return on both government and mortgage credit bonds in the coming year”.

The largely defined-contribution group of Australian super funds also managed to up their equity holdings from 50 per cent to 54 per cent in 2012, according to the Towers Watson survey.

Sykes agrees that defined contribution schemes are better positioned to take advantage of a sustained equity rally, should that occur. In addition to their freedom from liabilities, he says that there are signs defined contribution designs are becoming more equity-friendly. “We are seeing some reconsideration of the asset mix at the risk-averse life-stlying stage of DC pension plans,” he argues, with an allocation in purely defensive assets in later stages “possibly looking unappealing”.

The sum of it

Given the small proportion of global assets in defined contribution or risk-hungry plans, skeptics still have good reason to doubt that a Great Rotation could ever occur across the world’s pension assets. The prospect of new regulation in Europe also means the great reservoirs of bonds in continental Europe – where a bond weighting above 50 per cent is a rarely challenged norm – are unlikely to be depleted for the foreseeable future.

Possibly the most likely rotating here will be a continued interest in alternatives and a reshuffling of bond assets. For instance, the $9-billion Vita Sammelstiftung in Switzerland began selling domestic bonds in the second half of 2012, while launching an infrastructure portfolio and exploring further real estate opportunities.

Sykes adds that low yields on corporate debt have intensified interest in “more exotic credit assets” such as emerging market debt, high yield and private debt.

While he admits there “has been a rotation in sentiment”, there appears good reason to believe that pension asset allocation fundamentals won’t be revolutionised any time soon. Should the current equity rally continue, funds able to take advantage no doubt will, but liability headaches and regulation will likely keep many away from the party.

 

Its core business involves expanding the realm of science by beaming particles close to the speed of light and it invented the web – as we know it – as a nice little side project. You would perhaps then expect the CHF 3.6-billion ($3.9-billion) pension fund of the European Organisation for Nuclear Research, CERN, to be bold and innovative.

After a few seconds in conversation with Theodore Economou, the fund’s chief executive, you still can’t help being instantly impressed though by a real determination to break new ground in institutional investing.

“The approach we have implemented could be the ideal investment governance for any pension fund,” Economou says. “We have taken the fund from a difficult situation to setting recognised best practice on a global basis – a model based on the efficiency of transforming risk into returns.”

The story of the revolution brought about under Economou’s stewardship is a fascinating one that starts with a “traditional” risk-heavy fund and ends (for now) with the investment committee monitoring its transformed investments daily with a custom-designed iPad application.

From tradition to revolution

When Economou arrived in 2009, the fund had 60 per cent invested in “risk assets”. While he recognises the reasoning behind this, a calamitous minus 19-per-cent investment return in 2008 left a gaping deficit against the final salary-linked liabilities and left Economou convinced that the model was broken.

Controlling risk became the imperative obsession for Economou and his colleagues. While many pension funds would have decided at this juncture to tweak its existing investment strategy to squeeze out risk, the CERN fund flipped the idea on its head. It first defined an appropriate risk appetite and allowed a “dynamic asset allocation” to run free within that, according to its set of investment principles.

Minimising medium-term losses while allowing the fund to capture enough upside to meet return objectives became the priority in setting the risk budget. This is defined annually and is currently set at a 5 per cent worst-case scenario risk of 8-per-cent maximum investment losses across the fund. As much tinkering with the asset mix as deemed necessary can ensue, provided the risk limit is not breached – something the investment committee will shortly be able to check daily on its iPads.

The asset mix became radically transformed under the new approach. “We now view asset allocation in terms of risk classes instead of asset classes”, Economou explains. Cash holdings of 6.2 per cent form a risk-averse foundation, while the rest of the fund is split into three chunks of a little over 30 per cent each.

An absolute return class is the alpha-seeking part of the trio. It contains the fund’s real estate holdings (on which risk has been reduced by a move into entirely direct holdings), alternative investments and a smaller portion of private equity. Economou summarises its objectives as “strong downside protection with high efficiency”.

On top of that comes an “asymmetric” class of long-only bond and equity investments “managed to a very strict risk discipline” – in other words the CERN fund’s homemade smart beta portfolio. “These strategies incorporate risk-management into what are otherwise traditional mandates”, Economou adds.

Index strategies form the final risk class, offering the “highest upside potential, however with high volatility”. These have been reduced from 60 per cent to 30 per cent of the portfolio in recent years as part of the drive to control risk.

The asymmetric and absolute return classes have both been growing at the same time (from zero and 15 per cent respectively to around 30 per cent).

An active approach has been taken to shuffling the weightings of the three risk classes, just as the management of assets has been transformed from being largely passive to significantly more active.

Over half of the portfolio is now run internally, an approach that Economou says has led to “clear efficiency benefits”. “Going from asset class classification to a complete risk factor allocation is where the industry is going and is one of the next challenges,” Economou says.

Reflecting on the successes of the new investment strategy, Economou beams. “For the past two years we’ve been able to demonstrate we are running a Sharpe ratio in excess of two,” he says. Successfully navigating the 2011 summer downturn is one of the proudest achievements of the new focus on downside avoidance, he adds. The fund is also on track, Economou says, to meet the demanding return objective of outperforming local inflation by three percentage points. It saw returns of 6.9 per cent in 2012, helped by a performance of over 10 per cent on the fund’s equity bucket.

The thinking on returns has been totally changed too, Economou adds. Returns are now judged “against the actuarial return objectives and not against any market-based benchmarks as these don’t appropriately match the many constraints that most boards have”. That is not to say that the CERN fund neglects to make investment calls on the basis of market potential. It is constantly conducting “top-down macro-analysis” to seek investments opportunities. A major recent change is transforming the bond mandates to gain exposure to what Economou terms the “re-rating of the emerging world”.

Risk and efficiency have joined returns though in making the “three dimensions” that the fund measures as part of its “matrix of objectives”. Economou explains: “We want our staff to focus on maximising the rate of conversion from risk into return instead of focusing on a benchmark.” The deficit of the fund remains sizeable with a 66-per-cent funding ratio, but the shortfall has been cut and is projected to narrow further with the current strategy.

Radical new structure

What further distinguishes the CERN fund is the innovations it has embraced to redefine the governance of its investment strategy. Defining the exact purpose of its board is, Economou explains, “allowing our board to express its utility function in terms of risk appetite and return objectives while ensuring the fund is run to these objectives.”

Economou says that focusing the board on these specifics “ensures all assets and performance are controlled by the most qualified entities”. An external risk consultant (Ortec) has been appointed and a single master custodian (State Street) has been tasked with providing daily risk, return and efficiency data. Economou says daily reviews have enabled the fund to gain “greater visibility, has eliminated watch lists and has been able to take action much faster to redeem underperformance and modify allocation”. You get the feeling that as with anyone aspiring to join CERN’s technical staff, only the best need apply for its pension fund’s asset mandates.

CERN’s culture of attracting expertise from far and wide as a pan-European organisation has carried into the running of the pension fund under Economou’s watch, with several external experts drafted in to advise from other funds and the investment industry. The fund has also taken some more direct inspiration from its sponsors, using the same quality assurance procedures that were used in constructing the organisation’s famed Large Hadron Collider. The fact that Economou demanded the Geneva-based CERN fund be brought up to the German regulator’s net asset value reporting standards is another clear indication of its outward approach.

A membership that contains multiple Nobel-prize winners has also been an asset, Economou says. “One of the reasons we have been able to make these changes is that the intellectual firepower of the CERN board made them willing to challenge the status quo on investment strategy and enthused by bringing innovation.” Economou is aware that these changes “are resonating internationally” – proving perhaps that it is not just in physics where CERN is able to make major breakthroughs.

APG, which manages €314 billion ($480 billion), has always been innovative.

Ronald Wuijster earned a reputation as somewhat of a pension rockstar when he introduced the idea of intellectual property rights as an asset class and bought the music rights to a number of high profile musicians from the contemporary to classical.

That investment, which amounts to about $917 million, is ticking along nicely. Now run out of the New York office, it earns income every time there is a CD sale, a song played on the radio or performed live, and increasingly in today’s music world, as songs are sampled by other artists.ronald-wuijster_tcm124-90548

In addition to out-of-the-box, opportunistic investments, APG takes seriously the evolution of its portfolio management and implementation, and has a close tie to academia.

Wuijster himself is studying a doctoral degree, crudely under the subject of decision making.

“Critics say people don’t understand finance. So, if we understand how people make decisions, we can know how to present financial products that they know what to expect and have a guide on how to improve regulation,” he says. In fact, many of the developments at APG have been driven by academic thinking.

Under the smart beta umbrella

About three years ago APG started implementing some of the strategies that broadly fit under the smart beta umbrella.

The practice started in commodities, where it excluded some of the commodity classes, such as natural gas, that have certain behaviours, in a bid to have a more optimal beta exposure. And in its equities exposure, the fund has more than 50 tilts along the “quant spectrum”.

Between 50 and 60 per cent of the developed markets equities exposure is managed using quant strategies and APG started using smart beta three years ago including value, momentum, quality, fundamental indexing, and risk tilts.

“We created a separate asset class for minimum volatility, and we are now researching to allocate to credit and emerging market equities in that. Clients can allocate to that building block,” he says.

APG also applies smart beta to real estate and in particular looks at the environmental spectrum in direct property, overweighting to environmentally friendly buildings.

“In real estate, environment tilts add value,” he says, adding APG was a partner on the 2013-GRESB-Survey.

Similarly, in the fund’s credit analysis, it will look at minimum volatility and quality strategies, and is increasing the focus on quality companies. Smart beta is pervasive at APG.

“Valuation is relatively basic but the majority of investors don’t pay attention to it; they favour glamorous stocks and that’s accepted because of the short-term pressures,” he says.

“Many investors are talking about smart beta, but there are not many doing it. The ideas are less than half the exercise; it is hard to execute and implement. We are well advanced but we could also do more; we are still trying to think of new ways.”

Sticking to the core

APG manages 80 per cent of assets in house and also implements its own passive strategies, which make up a minority of the whole. Instead, Wuijster describes APG as a moderate active investor.

“Our basic approach is we are in it for the long term and we stick to our core, so there are no rapid changes in asset allocation. Even since five years ago, it hasn’t changed that much,” he says. “We are a pension fund asset manager and manage relative to pension liabilities, which effects the overlay structures we apply. But we have always believed in diversification and still do.”

He describes the fund as well diversified and says in analysing asset allocation there is attention paid to the role an asset class plays in a portfolio, and what it adds to a certain characteristic such as return, hedging or diversification.

The analysis also includes decomposing assets into other risk factors such as liquidity.

APG is on a path to increase illiquid assets, and while it is by no means the endowment model, it will increase illiquids to between 20 and 30 per cent.

Seeking return

Wuijster says the biggest challenge for investors in 2013 is finding return.

“We have had a number of excellent returns, but in fixed income it is hard to see how you will get good returns. In traded equities there are still some opportunities but [these are] also already discounted in valuation.”

He believes emerging markets, both equities and debt, still present good opportunities, and within fixed income the fund is focusing on core treasuries, which it considers to be Germany, the Netherlands and France.

It also has a focus on “taking care of interest rate risk”, mainly because of the current regulatory framework, and inflation hedging.

Focused alpha

APG, and Wuijster personally, get a lot of inspiration from academia.

“In January I spent time off looking at academic insights. We are looking at a cultural shift that may take years but we’re trying to have investment professionals focus less on alpha and more on organising asset class exposures as well. So, we will focus on a small number of alpha strategies where there’s a good chance of achieving alpha.”

The fund will be slick, managing liabilities through smart beta and focused alpha, reducing costs and good implementation.

An example of a more concentrated alpha approach is in equities, where it will look to find a small number of companies with an ESG approach.

“We have a lot of money managed internally, but some companies are better at a certain alpha strategy. We will look at what a team is good at doing and then decide.”

Within asset management, APG is looking at three areas:

1. Moving money in house

One example is the development of an internal private equity team, which will be a manager-of-managers structure and still use the expertise of Optinvest.

2. Negotiation on fees with managers

“Asset management is a high margin industry it is a bit over the top how you can make money. We are looking at using collective bargaining power and that is working. For example, in infrastructure the fees have developed and we’re not paying private equity-like fees anymore.”

3. Improving operational infrastructure

No one who works at New Zealand Super has a business card that has an asset class attached to it. This simple representation speaks volumes to the investment approach taken by the fund.

One could work for the strategy team or the investment analysis team, but the investment structure by which NZ Super invests, such as equities, is seen as a legal structure, an access point, not a predetermined allocation, desire or need. So having staff organised according to those lines makes little sense.

“Everyone is working on or for the same fund. It is very hard to implement and you have to be very disciplined,” chief executive of the NZ$24 billion ($19 billion)NZ Super, Adrian Orr, explains.

“It has changed how we recruit, and the culture, everyone has to understand what each other does as much as the whole part and what they do as individuals. You have to be very open-minded and encouraging to understand where everyone’s coming from.”

The reference portfolio and reality

In a similar way to how the Canadian Pension Plan Investment Board approaches investments, NZ Super has a reference portfolio, which is the low-cost growth-oriented portfolio that could achieve the fund’s objectives.

“The reference fund is deliberately chosen as passive, the listed cheapest access point to the risk we want to achieve our goals. It’s not a strategic asset allocation in that sense. The actual portfolio can be and is very different to that – but at our own peril,” Orr says. “We are judged on the total return and value add.”

In this context active investment is viewed as anywhere the asset allocation differs from the reference portfolio, for example, even adding private equity to strategic asset allocation is an active decision.

It also provides a clear benchmark to assess the value added as an active manager, something NZ Super does through dynamic asset allocation, investment strategies (such as timber, private equity and infrastructure) and treasury management (such as foreign exchange and liquidity management).

The asset allocation of the reference portfolio is really simple: 70 per cent in global equities; 20 per cent fixed interest; 5 per cent global listed property; and 5 per cent New Zealand equities.

In reality the portfolio looks quite different to that and at the end of January 2013 it had 61 per cent in global equities, 9 per cent in fixed income, 8 per cent in infrastructure, 6 per cent in timber, 6 per cent in property, 5 per cent in New Zealand equities, 2 per cent in other private markets, 2 per cent in private equity and 1 per cent in rural farmland.

The access point, or asset structure, is the last thing to be considered.

Orr says there are three lenses to look through the portfolio: asset class, risk factors such as market, credit, liquidity, duration, price/asset, and an economic lens such as exposure to growth or inflation. NZ Super continuously cross-checks all of these, taking the attention off the asset class lens, which Orr says is useful but is just the legal form within which those investments are bundled.

Playing to advantage

NZ Super doesn’t change the strategic asset allocation every couple of years, because it doesn’t have one.

“How we choose to actively invest through dynamic asset allocation or active strategies is done through a stable consistent framework: we look at what are our advantages and play to them,” he says. “We primarily invest in price/valuation gaps where we are confident that gap truly exists. We are more contrarian in our investing than trend or momentum driven. We were long equities in March 2009 when the natural position was the foetal position.”

In recent years there has been quite a lot of active risk in the dynamic asset allocation.

The fund strategically tilts underweight or overweight across major asset classes, equities, fixed income, property, credit and has been heavily tilted towards growth since March 2009. It has been long equities and short fixed income plus increasingly long the US dollar, where it has been tradition to be 100-per-cent hedged to the New Zealand dollar.

“This was done on the best estimates of valuation gaps,” he says.

Rankings, relationships and risk management

The process is in constant evolution. The fund recently introduced a new ranking system so that every investment opportunity can now be ranked on consistent financial attractiveness and confidence factors. This has resulted in the fund managing more internally, a reorganisation of the investment teams and an impact on costs – which, net of performance-fees expenses, remain flat at 0.45 per cent of funds under management – and it has changed the dynamic of its external relationships to include more flexibility.

About 45 per cent of the fund’s exposures are through derivatives, and the treasury, asset tilting, investment analysis and asset allocation are all done in house. It has also recently established a New Zealand active-listed-equities desk, and the internal team also conducts external manager-search activities.

The $22-billion fund has about 30 external mandates, which include private equity and multi-strategy hedge funds.

“We are pushing very hard on external relationships,” he says. “We are narrowing those down, we have to understand the opportunity set they’re looking at. We don’t believe in skill alone but have to understand the opportunity set and then decide whether to manage that inhouse or externally.”

The internal team has grown from 17 to 90 in six years, decreasing the fund’s cost base and increasing the range of internal activities. But Orr says it doesn’t have aspirations around the team size.

“We do want to look at the scalebale bits and how to make the ships go faster,” he says.

Next for the fund is an increased focus on risk management and the development and integration of investment themes, which it has identified as emerging markets, resource sustainability and evolving demand patterns.

One of the first actions is to look at how responsible investment can be embedded within investments rather than being learned outside the investment decision-making process.

“We want to look at ESG up front as part of the investment decisions and the expected return in terms of sustainablility.”

NZ Super has exceeded both its predetermined measures of performance since inception, outperforming the New Zealand treasury bill by 3.28 per cent and the reference portfolio by 0.74 per cent.

They may be on opposite sides of the Earth, but Chile in Latin America and Central Asia’s sparsely populated Mongolia share more than a few similarities. Both boast some of the biggest copper deposits in the world and now Mongolia has turned to Chile for advice on how best to steward income from its forecast bounty that stretches out beneath the Gobi desert. It is sourcing help from one of the architect’s of Chile’s rocketing $22.9-billion sovereign fund. Eric Parrado, former international financial coordinator at Chile’s ministry of finance and now advising other emerging economies on the steps to managing resource wealth, has become synonymous with Chile’s global reputation on wealth fund expertise. “At the beginning in Chile nobody thought there was any point in saving money because we were an emerging market economy. Chile needed to spend money, so why save it?” says Parrado, just back from the Mongolian capital Ulan Bator. “But by saving in the good times, we were able to spend in the crisis and now all our critics applaud us.”

A guide for novice sovereign savers

His advice to Mongolia starts with tight fiscal management. Mongolia passed a new fiscal stability law in 2011, the foundation, says Parrado, on which any successful sovereign wealth fund must stand and the key to establishing discipline in commodity-driven economies prone to boom and bust. In a next step, Mongolia is drawing up a bill to create a framework for several sovereign funds, which will likely take on similar lines to Chile’s Pension Reserve Fund, established in 2006, and the Economic and Social Stabilisation Fund (ESSF), set up in 2007. The concept behind any stabilisation, or rainy-day fund, is to keep investment strategy liquid and conservative so financial help is close to hand in times of economic crisis. A pension reserve fund would cover future state pension liabilities and Mongolia is also considering a future generations fund, through which returns, but not capital, could be used to invest domestically. “Mongolia has only just begun discussions and there is no money to invest as yet, but it is likely assets will be split between these types of funds,” he says.

In his guide for novice sovereign savers, Parrado counsels that assets be allocated to safe and liquid allocations overseas to avoid Dutch disease, so-called after The Netherlands economy slumped following discoveries of natural gas in the North Sea in the 1960s. Investment strategy for countries without any experience of “formal strategies” should mirror the same asset allocation as their central banks use to manage international reserves. “This is what we did in Chile,” he says. It meant that in the embryonic years of Chile’s sovereign fund, assets were split between a 70-per-cent allocation to US, European and Japanese sovereign debt and a 30-per-cent allocation to money market instruments. “It was plain vanilla but it was very good,” says Parrado. “Between 2007 and 2010 Chile had some of the best returns in the sovereign wealth fund world because we chose safe assets.” He doesn’t advise rejigging allocations in the early stages of a fund’s life, drawing on the experiences of seasoned sovereign saver Norway during the financial crisis as an example of the merits of leaving investment strategy well alone. “Take the case of Norway,” he says, referring to Norway’s $650-billion Government Pension Fund Global. “In 2008 they decided to boost their equity allocation to 60 per cent. Equities were falling yet they had to buy more equities to reach the 60-per-cent mark. They lost $100 billion in 2008. It was really crazy and there is no way Chile could have done this.”

Benchmarks rather than indices

Only after what he calls “an essential learning process” did Chile begin to think about diversifying to other asset classes to manage risk. Assets were split to encompass equities and corporate bonds in passive, global strategies. “An active strategy isn’t worth it because it’s too difficult to gain against the market. There shouldn’t be any cherry picking, but following benchmarks rather than investing in indices.” Since Chile’s central bank had no specific experience of managing these riskier allocations, it used external managers for its equity and corporate bond portfolio. “One hundred and 10 external managers were invited to the ministry of finance,” he recalls. “Because it was 2008 and the middle of the crisis, we postponed allocation until 2012, awarding the biggest to Blackrock, Bank of New York Mellon, and Rogge. We have benchmarks and tracking errors for each one in passive strategies.”

Parrado acknowledges that saving is a hard sell in developing countries in need of investment in infrastructure, schools and health, but warns that Mongolia, one of the poorest countries in Asia, should only draw on sovereign reserves if they are channelled through the budget. It’s a strategy Norway leads on, with the government spending just 4 per cent of its sovereign fund’s annual return. It rules out strategic investment such as equity stakes in local companies, something Singapore’s sovereign fund GIC favours, but it ensures against downside risk. “Investing in local companies could work, but in my view, emerging market economies should only use the fund as a financing mechanism and shouldn’t invest directly in this way. It would involve careful allocation of money and an awareness of what type of investment was actually needed to ensure there weren’t white elephants everywhere.”

Risk rather than return

Nor does he suggest new funds target returns. Instead they should focus on risk, a strategy he believes is key to “preserving capital and legitimising the savings process” in poor countries. “All funds should begin from the point of expected risks rather than expected returns.” His advice to Mongolia is also to avoid some sectors of the economy to reduce risk further. In Chile managers are asked to not invest in Chilean copper companies because the risk correlation is too high in terms of economic activity.

In an era when sovereign wealth funds have become “flavour of the month”, Parrado doesn’t recommend any flamboyant asset diversification or that countries fashion strategic funds targeting local development. He espouses rigorous institutions and frameworks and cautions strategies in a model that now speaks for itself. “Of course there are different strategies and it is entirely dependent on what a government wants to do,” he says. “But from Chile’s experience in starting a fund from scratch in an economy that is close to other emerging market economies, this is the strategy we recommend.”