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The Reference Portfolio benchmark and adding-value at the New Zealand Superannuation Fund. IFSWF Risk Group Case Study 3 on Rethinking Asset Classes Mexico 2012. Outline. I.The Reference Portfolio (RP) concept Alignment with Funds mandate and composition - PowerPoint PPT Presentation
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The Reference Portfolio benchmark and adding-value at the New Zealand Superannuation Fund.
IFSWF Risk Group Case Study 3 on Rethinking Asset Classes
Mexico 2012
1
Outline
I. The Reference Portfolio (RP) concept
1. Alignment with Funds mandate and composition
2. Adding-value to the RP to form the NZ Superfund’s actual portfolio
3. Opportunity identification and scaling
4. Portfolio construction
II. How the RP approach compares to a ‘traditional’ SAA
Slide 2
I. Mandate of the New Zealand Superannuation Fund
Our Act sets our mandate (s58)• Best-practice portfolio management• Maximising return without undue risk• Avoiding prejudice to New Zealand’s international reputation
We also have a New Zealand Investment Directive from the Minister “…opportunities that would enable the Guardians to increase the allocation of New Zealand assets in the Fund should be appropriately identified and considered by the Guardians.” NOTE – this is explicitly subject to s58
Slide 3
I. Reference portfolio concept
• The RP is a notional, low-cost passive portfolio
• Level of risk in the RP appropriate for Fund’s purpose and objectives
• Board decides the RP with management input
• Takes Fund’s endowments and relevant beliefs into account
• Long-run (‘equilibrium’) concept
• Used to evaluate value added in actual fund; our benchmark.
• Performance of the RP and value-add reported on a monthly basis to the Superfund’s Board, quarterly to the Minister of Finance and annually to the public.
• Relevant horizon for performance assessment is a minimum of five years – our Board and stake-holders understand this.
Slide 4
I. Reference Portfolio Composition
Exposure Benchmark Reference Portfolio
Global equities MSCI All Country World Investable Market Indexhedged to NZD
70%
New Zealand equities Customised NZX 50 Capped index 5%Global property FTSE EPRA/NAREIT Developed Index (listed property)
hedged to NZD5%
Global fixed Interest Customised index comprising the market-capitalisation-weighted aggregate of the following indices:
1.Barclays Capital Global Aggregate Indexhedged to NZD
2.Barclays Capital Global High Yield Indexhedged to NZD
3.Barclays Capital Inflation Linked Global Indexhedged to NZD
20%
Foreign currency exposure 0%
Slide 5
I. Building the actual portfolio: anchored to beliefs, clarity around risk, reward and responsibility
Slide 6
Management execution of value-
adding activities
Beliefs
Strategic Tilting: can change risk
profile
Capture Active
Returns: risk
“neutral”
Portfolio Completion: reduce costs
ReferencePortfolio
Actual Portfolio
Value Adding Activities
Absolute return and value add strategies
Board and management
Absolute return and value add strategiesBoard and
management
I. Key Investment Beliefs
Investment Decision Belief FactGovernance and objectives 1. Clear governance and decision-making structures that promote decisiveness, efficiency
and accountability are effective and add value to the Fund.It is important to be clear about investment objectives for the Fund, risk tolerance, and the timeframe over which results are measured.
Asset allocation 1. Asset allocation is the key investment decision.
2. Investors with a long-term horizon can outperform more short-term focused investors over the long-run.
Risk and return are strongly related.
There are varied investment risks that carry premiums/ compensations. Illiquidity risk is one such premium.
Investment diversification improves the risk to return (Sharpe) ratio of the Fund.
Asset class strategy and portfolio structure
1. Expected returns are partly predictable within asset classes and returns can revert toward a mean over time.
Investment markets are competitive and dynamic, with excess returns very difficult to find and constantly changing source.
Market volatility tends to cluster over short horizons but mean-reverts over longer horizons.
Investment risks can be unbundled to make the Fund more efficient. This includes the separation of market (beta) and investment specific investment manager skills (alpha).
Investment and Manager Selection
1. True skill in generating excess returns versus a manager’s benchmark (i.e. pure alpha) is very rare. This makes it hard to identify and capture consistently.
2. Some markets or strategies have characteristics that are conducive to a manager’s ability to generate excess return. These characteris-tics tend to evolve slowly over time, although the shorter term opportunity set available in any market/strategy can vary through the cycle.
3. Identifying the life cycle of an investment is important in assessing the expected return.
4. Responsible asset owners who exercise best-practice portfolio management should have concern for ESG issues.
5. Improving ESG factors can improve the long term financial performance of a company.
Each investment should be made on the basis of its expected value-add to the Fund as a whole.
Principal/agent conflicts exist with outsourced investment managers.
The more efficient a market is, the more difficult it is for a manager to generate an excess return (versus their benchmark).
Most excess return is driven by a combination of the research signals the manager is using, the conduciveness of their market to generating excess returns, beta factors and luck.
Research signals and methods used by managers tend to commoditise over time through market forces.
In some cases, synthetic exposure to a market or factor can provide a guaranteed excess return to the Fund, and represents an additional hurdle that an active manager must surpass.
Execution 1. Managing fees and costs and ensuring efficient implementation can prevent unnecessary cost. Slide 7
I. Strategies exploit our Endowments
What are “endowments”?“Endowment” can be thought of as an essential feature or characteristic of our Fund, which is outside our control; it is not a matter of our choice. It is something that enables us to exploit a belief and invest in a particular way; it is also something that can stop us from exploiting a belief or investing in a particular way. So the endowments establish broad parameters for how we invest to meet our mission. The diagram below is a way of showing this.
Features of the Fund
Features of the way we invest
Endo
wm
ents
Beliefs
Investments
Strategies
Slide 8
I. What are our Endowments?
Sovereign statusThe Fund is a pool of financial assets wholly owned by the Government and it obtains sovereign tax status as result. This is beneficial as foreign countries can have a different taxation approach to entities with sovereign status (i.e. a reduction in foreign tax leakage). Sovereign status can also be regarded favourably by counterparties and it can position the Fund as a potential co-investor of choice within New Zealand.
Certain liquidity profileThe flow of cash into and out of the Fund is governed by a public funding formula. This provides us with certainty, and transparency, of cash flow timing. This gives us the confidence to invest in assets that other investors may eschew given their own liquidity demands. We can buy assets when other market participants are constrained or have been forced to sell to meet their own liquidity demands.
Long Fund horizonThe investment structure of the Fund is designed to exist for many decades. This affords us the flexibility to undertake investments with longer-term return characteristics, such as private equity. In addition, it means that the Fund is more tolerant than other investors to market volatility, enhancing its ability to endure market cycles.
Independent investment responsibilityThe legislation which created ourselves and the Fund also established our investment independence from the Government.Our investments are made for a specific purpose and the investment mandate contained within the legislation requires that they be made on a purely commercial basis. The Government may only direct us about its expectations of the Fund’soverall risk and return. This investment independence gives us confidence to enter into investment arrangements that best suit the Fund’s purpose, with minimum agency risk. The legislated investment mandate also requires us to managethe Fund in a transparent manner, and to have regard to environmental, social and governance standards. We believe this assists in positioning us to be an investor, or co-investor, of choice in many regions.
Slide 9
I. Many of our strategies also aligned with the Fund’s core long-term investment themes
10
• Themes are long-term influences on the economy and capital markets that are expected to be relatively immune to business cycle and other short-term influences.
• NZ Superfund’s thematic focus includes: (1) Resource Sustainability; (2) Emerging Market Segmentation and (3) Changing demand patterns
• Thematic impacts are often “slow burners” subject to uncertainty. As such, they will not usually be fully-priced in by markets given myopic horizons. This suits our long-term investment horizon endowments -- we have the discipline to wait until markets better reflect thematic influences.
• Access points to themes may also play to our tolerance for illiquidity and/or Sovereign Status endowments
• Investment opportunities we decide to pursue will more often than not have an underlying thematic rationale, given our front-line investment professionals are guided in their opportunity selection by a process in which themes are embedded.
• We think the thematic overlay also makes the portfolio more resilient to a range of risks – particularly those that play out over a longer horizon.
I. Opportunity prioritisation and scaling
• Our opportunity prioritisation is in part driven by a heat map tool that incorporates internal and external views on market mis-pricing (valuations) for a large range of asset classes and/or strategies, market efficiency, potential for portfolio diversification and alignment with ESG and themes.
• Opportunities that are assessed as favourable are prioritised for front-line investment search.
• Opportunities seen as least favoured are not pursued. If a previously favourable Opportunity is assessed as having become less favourable – or as no longer existing – any investments we have made subject to that opportunity are prioritised for partial or total divestment. That is, the Opportunity assessment process drives our buy and sell discipline.
• Our investment framework (see Annex) requires that we be neutral to how we access opportunities (e.g. synthetically, directly, via a manager etc) and to the extent pracitical assess all access point options. This assists us to ‘unbundle’ sources of risk and return and to assess which access point(s) offer(s) the highest expected risk-adjusted returns.
• In this evaluation we utilise an investment hurdles tool that includes as inputs our current expected returns for the Reference Portfolio and (if applicable) passive public market equivalents for the access point under consideration, as well as our assessment of the loading of the opportunity onto these market exposures. In doing so we estimate how much the expected return is a function of market risk premiums versus manager skill and other factors.
Slide 11
I. Opportunity prioritisation and scaling
• Our confidence in expected risk-adjusted returns and the value added by the investment over and above the Reference Portfolio will be highest when:
• there is consistency between our endowments and beliefs and the investment
• we can clearly articulate factors that drive investment risk and return and we have considered a range of potential outcomes, including downside risks
• the opportunity does not require a high level of skill (‘pure’ alpha) as the main driver of expected returns
•we have the ability to execute and manage the investment risks ourselves.
• Scaling of the opportunity is driven by a risk allocation process that considers the expected impact on the performance of the portfolio (e.g. its Sharpe ratio), relevant constraints (e.g. liquidity, counter-party risk limits and single asset risk limits), as well as relevant organisational demands (tax, legal, etc) and operational complexity.
Slide 12
I. Portfolio construction: putting it all together
Slide 13
Reference Portfolio
Approved by Board
proxies Rebalancing TargetPre-Tilting
Previously proxy adjusted SAA
“risk equivalent”
Determined by management within
Board approved strategies and exposure limits
Substitution approach (proxies) approved by Board
private market assets
tilting infavour of
tilting against Rebalancing Target
previously modified SAARisk profilecan differ
Determined by management within Board approved strategic tilting strategy and ranges
Rebalancing Target
Determined by management within
Board approved strategy
Determined by management within
Board approved Direct Management Policy (including risk based rebalancing
thresholds)
plus portfolio completion
ActualPortfolio
Risk profilecan differ
public markets “active return”
strategiesPreviously modified SAA
I. Proxy system
In general, the proxy system serves the following purposes:
• It pre-defines public market proxies for unlisted or illiquid exposures. These are chosen so as to keep the absolute risk of the overall Fund relatively stable as exposure to unlisted exposures varies over time.
• It allows the amount and composition of exposure to these value-add investments to be determined flexibly based on the nature of the opportunities rather than by determining fixed target weights (provided that they stay below current limits).
• It ensures there is clear accountability, in terms of the opportunity cost, for the impact these value-add investments have on the Fund returns.
Slide 14
I. Proxy system
• There are two ‘slices’ of the reference portfolio that serve as proxies for assets introduced into the Fund: growth and fixed interest.
• Each value-add investment has a default proxy which is a set percentage of each of these slices as shown in the table.
• Every 1% increase in the Fund weight for timber, for example, would be offset by a 0.3% decrease in the Fund’s growthassets weight and a 0.7% decrease in thefixed interest weight.
• The proxies work symmetrically, so thatdecreases in the timber weight are offsetby increases in the corresponding referenceportfolio asset class weights.
• Default proxies can be overriden by theInvestment Committee with all overridesreported to the Board.
Slide 15
Default Proxy
Growth*Fixed
Interest
Private Equity 110% -10%
Infrastructure 60% 40%
Timber 30% 70%
Unlisted Property 40% 60%
Other 10% 90%
* This percentage applies to the total global equities and global listed property, with the same proportional composition as the Reference Portfolio weights for these two asset classes. Excludes NZ equities.
II. How the RP approach differs from a traditional SAA
Slide 16
RP SAA
Principles • Appropriate to meet Fund’s objective• Passive, low cost• Diversified• Equilibrium concept
• Appropriate to meet Fund’s objective• Typically more diversified• Scope to capture current investment
opportunities
Asset classes • Equities• Fixed interest• Property• Commodities• Foreign currency
Same as RP plus may include unlisted and alternative exposures, eg:
• Infrastructure• Private property• Private equity• Insurance linked (cat bonds, life settlements)• Other potential “asset classes”
Review frequency • Fundamental changes in market conditions
• Fund’s purpose or endowments change• Opportunity set of listed represen-
tative passive exposures changes
• Usually these are set on a calendar basis in order to update for changes in the current opportunity set (e.g. annually)
II. Advantages of the RP approach
Slide 17
Adding-value RP approach gives the Fund an absolute return focus and the flexibility to respond to where risk-adjusted returns are assessed to be highest through time. In doing so it avoids the risk of “bucket filling” to meet a target SAA regardless of the present configuration of the expected risk-reward relationship across various asset classes.
The RP approach encourages thinking on the underlying economic drivers of risk, returns and correlations (e.g. growth, inflation, liquidity and transaction and agency risks) rather than asset classes per se. Allocating capital through this lens may improve the “true” level of diversification of the Fund relative to an SAA approach.
Governance and Performance assessment
RP approach encourages greater separation and delegation of value-adding activities from the Board to internal management. This allows the Board to focus on Governance around the risk allocation and investment process and management to focus on adding value to the portfolio.
Arguably the RP concept provides a clearer accounting of active views and value-adding activities as performance measured relative to a static long-run benchmark.
In an SAA world the benchmark is not typically an “equilibrium” construct and it may contains active views of a Fund’s Board and/or management. Given value-add is usually measured relative to the SAA benchmark performance of this activity is not therefore directly measured and assessed
II. Advantages of the RP approach
SAA
Reference PortfolioReference Portfolio
DiversificationDiversification
Attractive AlphaAttractive Alpha
11
22
33
Slide 18
RP + value-adding activities
If the promise of the RP approach is met we should achieve a higher long-run Sharpe Ratio than the SAA approach
II. Reasons why the approach may not be appropriate for all SWFs
Slide 19
• SAA approach is the industry standard and there may be constraints from moving away from this (e.g. regulatory).
• Potentially higher reputational risk moving to an approach that is not as tested as a SAA and is not as well understood by external asset consultancies.
• In order to maximise value-add in the RP approach there needs to be a high level of delegation of active decisions from the Board to internal management, and in relation, a well-resourced, skilled, more generalist internal management team that the Board has confidence in to take active views and shift the portfolio to where risk-adjusted returns are highest. This may not be realistic for some Funds.
• In relation, it may be “easier” for a Board to own significant allocation changes and wearing this as a value-add as in the RP approach may prevent Fund’s from “doing the right thing”.
• Much of the value-add we think that can be accrued from being opportunistic using the RP approach is also possible to achieve for a Fund operating within an SAA construct provided that capital allocation ranges are “sufficiently” large and there is flexibility to add new asset classes to the SAA outside of formal review periods.
APPENDIX
Slide 20
NZSFs Benchmark History
Slide 21
20031 20051 20071 2010 Change
Global Equities 61.5% 52.5% 50.5% 70%
New Zealand equities 7.5% 7.5% 7.5% 5%
Changed view on value of imputation credits; 5% is the minimum worthwhile allocation to meet (indirectly) the Ministerial directive.
Property 6% 12% 12% 5%Market cap of investable direct property is around 3% of the global investable market; 5% is the minimum worthwhile allocation.
Commodities 3%2 5% 5% 0%Doubt that insurance risk premium exists in equilibrium. Commodities better introduced as a strategic tilt.
Global Growth Assets 78% 77% 75% 80%
Increased growth asset allocation back to levels more similar with 2003; tail not considered “undue” (see next slide).
Global Fixed Interest 22% 23% 25% 20%
Previous work on lengthening duration and a semi-permanent allocation to investment grade credit moved into strategic tilting.
Foreign Cur-rency Exposure 29%3 10% 10% 0%
Given long term premium from hedging, risk reduction more efficiently achieved via lower equity allocation.
1 Passive alternatives to long term SAA using 2007 proxies for private market allocations (see slides 13 to 15).
2 In 2003 there was an allocation to ‘Other Growth Assets (private equity, commodities, infrastructure)’. For these purposes we have assumed 1% private equity, 3% commodities, 3% infrastructure.
3 The 29% FCE in 2003 is implied by the hedge ratios set for Global Equities and Global Fixed Interest (60% and 100% respectively), and assuming Other Growth Assets have the same currency exposure as Global Equities.
Slide 21
Modeling returns for the RP
• The returns model includes mean reversion (a Fund belief) and macro-financial linkages. The distribution of simulated returns are non-normal (left tail skew and kurtosis) and includes scenario based. Specifically:
• A sharp decline in global growth (as we have just experienced);
• A supply side shock that leads to higher global inflation (as in the 1970s); and
• A NZ specific shock (such as a large earthquake).
• Relative to the pre-GFC world we built in higher volatility and correlations, but also a higher expected risk premiums.
• Volatility of global large cap equities from 15% to 16%
• Correlations with global large cap equities:
• Listed property from 0.4 to 0.8
• NZ equities from 0.5 to 0.7
• Key equity risk premium assumption raised from 3.2% to 3.5%
Slide 22 Slide 22
Example of the Proxy system
Asset ClassReference Portfolio
Benchmark
Add Private Market Exposures and remove proxies:Rebalancing
Targetpre-tilting
Private Equity
Infra-structure
TimberUnlisted property
Other Private Markets
Global equities 70.0% -5.1% -2.8% -1.4% -1.9% -0.5% 58.3%
Global listed property 5.0% -0.4% -0.2% -0.1% -0.1% 0.0% 4.2%
New Zealand equities 5.0% 5.0%
Total Growth 80.0% -5.5% -3.0% -1.5% -2.0% -0.5% 67.5%
Fixed Interest 20.0% +0.5% -2.0% -3.5% -3.0% -4.5% 7.5%
- Private Equity 0.0% +5.0% 5.0%
- Infrastructure 0.0% +5.0% 5.0%
- Timber 0.0% +5.0% 5.0%
- Unlisted Property 0.0% +5.0% 5.0%
- Other Private Markets 0.0% +5.0% 5.0%
Total Private Markets 0.0% 5.0% 5.0% 5.0% 5.0% 5.0% 25.0%
Total Portfolio 100.0% 100.0%
Volatility (std dev. over 1 yr) 13.1% 13.1% 13.1% 13.0% 13.1% 13.0% 12.8%
Each proxy is designed to keep the Fund’s absolute risk largely unchanged
C2 - Internal Use Only Slide 23 Slide 23
Elements of the opportunity heat map
Slide 24 Slide 24
• and
Focus on opportunities where there is the strongest link between our endowments and beliefs, and the underlying investment
Access opportunities as directly as possible
Developing and maintaining internal
investment opportunity identification and
implementation skills
Developing investment themes and opportunities around which our
access search efforts can be coordinated
Accessing external managers to ‘partner’ with us in segregated
or co-investment activity
25
Our investment framework