NZ Superannuation Fund stays level with strategic tilts

New Zealand Superannuation Fund's investment team is working to bring as much science as possible to the art of profiting when capital markets deviate from fair value.

One hint that the Auckland-based fund's approach to dynamic asset allocation might differ from that of other big asset owners: the precise 690-basis-point maximum risk limit the NZ$25.5 billion (US$21.6 billion) sovereign wealth fund's board currently imposes on its 5-year-old “strategic tilting” program, as a tracking error from the fund's passive reference portfolio.

That figure is calculated from the combined risk exposure limits the fund sets for the liquid asset classes covered by strategic tilting: equities, bonds, credit and currencies. The fund doesn't disclose its risk limits for specific asset classes.

As of April 30, the fund had 62% in global equities, 11% in fixed income, 6% in property, 5% in timber, 5% in domestic equities, 4% in infrastructure, 3% in private equity, 3% in “other private markets” and 1% in rural farmland. But after tilting, the posted numbers could diverge sharply from the actual allocation, which isn't released because of concerns about front-running.

In recent interviews, senior fund executives said they believe New Zealand Superannuation's approach — which they variously described as “hyperactive rebalancing” or “rebalancing on steroids” — is more model-driven and less dependent on discretion and qualitative judgments than many other big asset owners' dynamic asset allocation programs.

New Zealand's strategic tilting program — launched just as global stock markets started to rally from the ravages of the global financial crisis — is a “classic, (mean reversion based) long-term investment strategy,” with New Zealand's team incrementally adding or reducing exposure to liquid asset classes as and when their prices diverge from fair value, said Adrian Orr, the fund's CEO.

In New Zealand Superannuation's annual report for the year ended June 30, 2013, Mr. Orr pointed to strategic tilting as “an area in which we aspire to be a global leader.”

Mr. Orr credited David Iverson, New Zealand's head of asset allocation, and his team for the enormous amount of time they spent developing “the science of the program,” effectively boiling down its key elements — such as expectations of risk-adjusted returns and measures of “confidence” in the fund's ability to harvest those returns — to numbers. That calibration allows New Zealand to move quickly when responding to market fluctuations, he said.

“What we try to do in this program is be really explicit about the assumptions that go into it ... and not just conflate them all into one sort of thing so you can't really tell what's moving: Am I more confident? Have I put more risk on? Has my signal changed?” said Matt Whineray, the fund's general manager investments, in a recent interview.

While that leaves the investment team with ample room to exercise judgment with regard to position sizes and how they're implemented, executives said the tendency is to move where their models point.

“Everything is subjective evaluation. We're just trying to make sure when we have our subjective evaluations being brought to bear on a portfolio position, it's disciplined, it's consistent — essentially formalized subjective evaluation,” Mr. Iverson said in a separate interview.

For the latest fiscal year ended June 30, 2013, strategic tilting — which New Zealand Superannuation lists as one potential source, along with active management and internal trading/execution capabilities, to add value over and above its reference portfolio — delivered its strongest returns ever.

According to New Zealand's 2013 annual report, the strategic tilting program accounted for NZ$891 million in gains, a roughly 4.8% contribution to the fund's record 25.8% surge for that year.

That was partly a matter of previous big tilting positions — into equities and out of bonds — paying off, but it also reflected the board's decision to increase the risk allocated to the program over time, Mr. Whineray said. The maximum risk limit — now 690 basis points of tracking error from New Zealand's reference portfolio — has been raised twice over the program's five-year life, so “all other things being equal, you should see greater returns,” he said.

In addition, the program — launched at a moment of historic volatility — has evolved to harvest potential returns from less dramatic market fluctuations, executives said.

It was always a matter of incrementally adding or reducing exposure as markets got more and more out of whack, but previously it had to hit some trigger — say, one standard deviation from fair value — before the team began taking positions, Mr. Iverson said. “Now, in that middle bit where we didn't do anything, we do do something — a very, very small amount ... but we can make money in that little zone,” he said.

New Zealand executives said their discussions with other big asset owners lead them to believe their approach is relatively rare. “I think if you contrast (New Zealand's approach) with that of other investors, and I've spoken with quite a few, you'll find the way they run their tilting program is, they wait until (markets) get very, very far away (from fair value), and they put a position on. And then they wait again ... it takes a while for it to move,” said Mr. Iverson.

By contrast, for New Zealand Superannuation, “the whole point in calibrating, and acting consistent with what you think, is you've got to keep doing it constantly — not just at one point in time,” Mr. Iverson said.

The key elements needed for the strategy are “having a very clearly disciplined board, that hangs with you” — should markets continue to move further away from fair value — and “a very clearly disciplined asset allocation strategy,” Mr. Orr said.

“If you don't get the calibration right, in terms of how extreme you thought markets could be, you're going to lose your ability to allocate and act as a disciplined investor,” Mr. Iverson said. He pointed to the example of clients firing Jeremy Grantham's GMO LLC during the technology bubble, when Mr. Grantham — a co-founder of the firm as well as chief investment strategist — went defensive a few years before that bubble burst in March 2000, as one reason why a program such as strategic tilting has to be managed internally.

While New Zealand's luck in putting its first tilting positions on in March 2009, just as equity markets began to rebound strongly, made it look easy, the investment team and its board have since been tested, Mr. Orr said. He cited the fund's lack of hedging for the fiscal year ended June 30, 2011 — a 12-month period when a surge by the New Zealand dollar cut into the value of the fund's overseas holdings — as a particularly trying time. That year, the program accounted for a 1.6% drop in the portfolio's value.

The current year, meanwhile, is unlikely to see a similarly strong contribution from strategic tilting.

Last year, “we knocked the ball out of the park, (but now that) an enormous amount of markets are around fair value and those that aren't you've got a big question mark around your confidence of where fair value lies, it means less opportunity for us,” Mr. Orr said.

“We've actively reduced our tilt positions across equity, credit and bonds,” leaving the fund with “very small positions” and few obvious segments offering opportunities now, Mr. Orr said.

Still, Mr. Iverson declined to describe the current moment in markets as a tricky one for New Zealand Superannuation's strategic tilting program. It might be tricky for the bulk of asset owners that have return targets, but New Zealand Superannuation isn't bound by what he referred to as an official “expectation” that the portfolio deliver returns of at least 2.5% above New Zealand's cash rate, Mr. Iverson said.

“If assets become less attractive to us, we don't take the larger positions we had,” Mr. Iverson said. “With the fund's opportunistic approach, if it's fair value, we've got zero position on; if it's undervalued, we're overweight; if it's overvalued, we're underweight. Very simple. If that changes tomorrow, we'll change our position,” he said.

On the drawing board now, Mr. Whineray said, is work on the fund's risk budget — effectively “taking the concepts of tilting more broadly into all the other opportunities that we look at, and being much more deliberate about our risk allocation across those opportunities.”

Citing the difficulties of adjusting exposures to an asset segment such as timber, Mr. Iverson called the risk budgeting work the team is pursuing now an enormous project — “similar in concept to what we're trying to do in tilting, but it certainly is not similar in terms of practical issues.”