New Zealand Super taking more active risk in managing its portfolio

New Zealand Superannuation Fund, the NZ$55.7 billion ($32.4 billion) Auckland-based sovereign wealth fund, is taking more active risk in managing its portfolio this year, following a decade where equity and bond market beta delivered consistently handsome returns.

New Zealand Super's annual report for its fiscal year ended June 30, released Oct. 31, showed active strategies delivering record alpha of NZ$4.5 billion, even as the fund used just a little over half of an active risk budget targeting 4% tracking error vs. its 80% global equity/20% global bond reference portfolio.

That alpha allowed New Zealand Super to cushion the hit to its portfolio from a year of sharp declines for risk markets to just under 7%, roughly half of the 14.2% drop its stock-heavy reference portfolio suffered.

Since the adoption of that 4% active risk budget in 2014, the fund's tracking error has stayed below 2% far longer over the subsequent eight years than it has pushed above that level. The annual report attributed that, in part, to the strong performance of the fund's passive equity and bond holdings over that period.

Persistent strong gains for global equities and bonds, driven by extraordinary monetary and fiscal policy tailwinds, has posed challenges for New Zealand Super's biggest active strategy: the "strategic tilting" overlay program the fund launched in 2009, employing derivatives to short markets exceeding its team's fair value estimates or go long markets deemed undervalued.

Strategic tilting relies on mean reversion, which was tested at times by the extraordinary policy tailwinds markets enjoyed for much of the past decade or so, said Charles Hyde, New Zealand Super's head of asset allocation, in an interview.

The fact that New Zealand Super's risk usage has remained below budget for such a long stretch reflects the fact that tilting "hasn't been experiencing the full range of market conditions or … cycles … that we would ordinarily expect over the long term," Mr. Hyde said. For much of that time, equities — U.S. equities in particular — and bonds continued to become ever more expensive, he noted.

The annual report warned that contrarian strategies such as strategic tilting can face "an extended period of losses" before an eventual payoff.

The substantial short position in sovereign bonds New Zealand Super built up over the years — as the U.S. Federal Reserve and other leading central banks were flooding the market with liquidity, levitating bond prices while steadily pushing down yields — is a prime example of that conundrum.

The fund's large short position in sovereign bonds — at between 5% and 10% of the portfolio's net asset value — was costly for New Zealand Super as those bonds "kept on becoming evermore expensive but finally the market turned in our favor," he said. With central banks shifting abruptly to tightening over the past 12 months to combat inflationary pressures, bond prices fell and "we did quite well out of that," he said.

The annual report pointed to the fund's short bond position as the biggest contributor to strategic tilting's strong returns for the latest fiscal year.

With bond and equity prices now closer than before to fair value, New Zealand Super has reduced the size of its short positions in those asset classes, Mr. Hyde said.

The fund's 4% active risk budget, meanwhile, is meant to be an average over time rather than a hard-and-fast target, Mr. Hyde said. Consequently, a period of time below that long-term target could imply periods where tracking error exceeds 4% as well, he said.

But the fact that the fund's tracking error has been closer to 2% for the past six or seven years shouldn't be seen as suggesting the level in coming years will be closer to 6%. "That's way too prescriptive," Mr. Hyde said.

"We very deliberately run an opportunistic approach to investing here and so we build a portfolio in response to what we see almost on a day-to-day basis," he said. It's hard to say with any certainty what the macroeconomic environment will be like over the next six to eight years or what investments are likely to be attractive, he added.

"What I will say is that we do take our 4% budget seriously. It's something that we're looking at ... a big internal conversation between us and our board as to what level of risk usage we're running and why it's where it is," Mr. Hyde said.

New Zealand Super's record of deploying active risk efficiently, meanwhile — Mr. Hyde cited a strong information ratio of 0.6 since inception for its active strategies and higher still since 2014 — has given its investment team confidence to do more.

"We're very much focused on this issue of risk usage and we're in particular focused on where it makes sense to increase our risk usage," said Mr. Hyde, noting that tracking error has risen to 2.8% at present from roughly 2.3% as of the June end of the latest fiscal year.

Strategic tilting continues to consume the biggest chunk of the fund's active risk budget, even as declines in bond and equity prices this year make those big asset classes less of a focus. "Yes, we've reduced our short positions (in bonds) and U.S. equities … but we trade credit, real estate, commodities, currencies" and they're not all moving in lockstep toward fair value, Mr. Hyde said.

Beyond strategic tilting, there's a long list of active strategies New Zealand Super's team invests in, from equity, credit and arbitrage opportunities such as distressed debt or natural catastrophe reinsurance to real asset segments, including timber, rural land and infrastructure as well as venture capital and buyouts.

Over the past year, for example, "we've been doing other things, like increasing our resourcing internally on the real asset side, for example, and driving increased risk usage through building our exposures to both real estate and infrastructure through bringing in people with very specific experience and expertise in those particular areas," Mr. Hyde said.

Likewise, "we've been allocating incrementally more to the global macro space, looking closely at trend as a strategy," he said.

New Zealand Super's asset allocation as of June 30 showed those active investment segments expanding over the past year, with liquid alternatives — including global macro — rising to 9% of the portfolio from 6% the year before; infrastructure climbing to 4% from 1%; and property increasing to 3% from 1%. Global equity, reflecting both those shifts and a sharp drop in valuations, tumbled to 48% of the portfolio from 63% the year before.

For the remainder of the portfolio, allocations to debt securities rose to 21% from 16%, private equity edged up to 5% from 4% while investments in rural and timber as well as New Zealand equities held steady at 5% and 4%, respectively.