New Zealand Super just returned its best-ever result of nearly 30 per cent reflecting the souped-up risk profile of the fund. In addition to the gains from its overweight position to equities, the fund under CIO Stephen Gilmore also fully hedged the currency. Amanda White explores the fund’s strategy and the risk budgeting review currently under way.
New Zealand Super’s long time-horizon – it doesn’t need to make payments until 2050 – allows it to take a lot of risk that other investors might not have the luxury of taking. But without the strong governance of the fund, this time horizon alone would not be enough to execute a risk-taking strategy, the fund’s CIO, Stephen Gilmore, told Top1000funds.com in an interview.
“We have a reference portfolio of 80:20 so that does pretty well in environments of rapid gains in equities,” he says of the financial year return. “In addition to that we had fully hedged the currency so we got the benefit of that currency risk premium. And a number of our active risk activities did pretty well too.”
In big picture terms, Gilmore says the whole approach is guided by a number of factors that allow for risk taking. The really long horizon is one, and the strong governance arrangements to facilitate that long view is another important part.
“We have to have strong governance in place to buy when it’s a bit nerve racking.
At time of the COVID shock, when credit spreads widened, we leaned-in to the sell off buying equities and taking greater credit exposure and we’ve got the benefit of that.”
One of the more important discussions at the fund in the past little while has been currency hedging. Gilmore describes this discussion as “rigorous debate on how much to hedge”. In the end the fund decided to fully hedge the currency.
“The considerations were multiple. We have a high level view there’s a currency risk premium associated with NZD, we get paid for taking exposure. We have to trade that with the liquidity implications of hedging, and what that means for diversification in the portfolio.”
Another driver of return recently, and one that has added value over many time periods, is the fund’s dynamic asset allocation, tilting, program (it’s added 1.1 per cent for the 10 year-period to 2019).
Gilmore says the tilting program has a lot of latitude to take risk and “we took a meaningful amount of risk”.
“The tilting program has been extremely successful. Conceptually it’s reasonably simple, we think about where fair value may be and the tendency for markets to move towards fair value, we don’t necessarily have concept of how quickly that will happen,” he says. “We have good risk appetite and decent time horizon.”
But to make that strategy work it is essential to have strong governance to support the sometimes uncomfortable buying opportunities.
“You have to stick with it, it’s a form of volatility harvesting and you need to focus on where you think the value is. We are continually updating those views on where the equilibrium is,” he says.
Risk budgeting
New Zealand Super introduced a formal risk budgeting process in 2014 and conducts that every five years. It’s now going through that process.
Currently some of the biggest sources are internal, the DAA tilting is one of those as well as
credit and funding mandates that lean in when there is a market sell-off.
“Those could change as we go through the current risk budgeting exercise,” Gilmore says.
“There are a few things that are different this time. When we introduced the formal process we didn’t have the history of experience and we didn’t know if we were any good at being active, we now have that information as well as more information on things like correlations. We keep refining the work and improving the information.”
More specifically the fund is doing more work to integrate liquidity aspects.
“We are incorporating information from our experience, some areas turned out to be more successful and some less which may impact the overall level of risk, as well as liquidity and correlation between different investment opportunities,” he says. “The secondary consideration is we do vary risk through time. We will have a target for many of those areas that will vary through time depending on how attractive we think it is.”
The risk budgeting exercise will be completed by June next year.
Scenario planning for the future
Gilmore said that the pace of the COVID-induced market downturn surprised many investors and for New Zealand Super was a conduit to question assumptions.
Scenario testing and the investigation of some possible structural shifts as well the work on risk budgeting ensued.
“We are looking at higher inflation, how transitory is it, how sustained is it, and what’s happening to growth and productivity. We want to think about the portfolio performance in different regimes,” he says.
The fund has a particularly high growth orientation and so when thinking about the future an interrogation into strong growth or weak growth or high inflation or if rates change.
“For a growth-orientated portfolio like ours the worst case is a downturn in growth like depression, but also stagflation where get high inflation and no growth is also bad for the portfolio,” he says. “Given our long horizon we don’t do too much but at the margin we are increasing our exposure to real assets. The real thing is to understand what happens when we come to those environments.”
So what if something has changed? For some time the team has been looking at a “structural shifts assessment” where it has investigated a lot of possible contenders for shifts which has been narrowed down to five core possible shifts.
The first of those is income and wealth distribution inequality, and whether there are shifts from capital to labour, what that means for margins and equities and redistribution and the confluence of monetary and fiscal policy.
“We’re thinking about a world of fiscal dominance, the attitudes to budget deficits and public debt levels, and if rates are at zero what does that do to the allocation of capital and efficiency of market, and to growth.”
Gilmore says the team has questions around how this plays out the long term and a world in which more is determined by policy action rather than prices.
Geopolitics, the relationship between China and the US and the implications for globalisation, capital of markets and technology, is also a key consideration.
Other key topics include work flexibility and digitalisation, including crypto and smart contracts, and how that changes the investment universe. Climate change of course is also on the agenda.
“We are looking at all those things and asking so what? Does it have any impact on the way we do things? We’re unsure at this moment.”
