Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Ins and outs of NZ Super’s reference portfolio
Following the five-yearly refresh of reference portfolio assumptions in 2020, the NZ Super, New Zealand’s NZ$53 billion (A$49 billion) sovereign wealth fund raised its forecast cash outperformance to 2.8 per cent – or just 0.1 per cent higher than plotted in the 2015 review.
At the same time, the expected reference portfolio volatility levels jumped to 13.8 per cent in the 2020 report, compared to 13.5 per cent in 2015 and 13.2 per cent in the 2010 analysis
Despite the gentle incline in risk and return for the reference portfolio – which serves as both a triangulation point for the fund’s alpha-generating activities and “a proxy for the cost to the Government to contribute to the fund” – forecast long-term nominal returns for the notional passive asset mix fell from 8.5 per cent in 2010 to 6.8 per cent by 2020. In 2010, NZ Super forecast a 7.7 per cent long-run performance for the reference portfolio.
Stephen Gilmore, NZ Super chief investment officer, says that the reference portfolio is an “alternative portfolio to the actual portfolio the fund invests in and is designed with the fund’s objective and mandate in mind”.
He says: “In practice, it comprises just over half of our actual portfolio, with our active investment strategies making up the balance.
The fund has returned (after costs but before tax) an average 10.1 per cent since inception in 2003, adding NZ$8.5 billion in value above the reference portfolio.
As well as the usual tweaks to asset class return assumptions, the 2020 version of the reference portfolio drops the specific emerging markets equities component of previous years.
“We retained the asset allocation of 80 per cent to growth assets and 20% to income assets, and the 100 per cent foreign currency hedge ratio,” the report says. “The main change from the 2015 review was the decision to combine developed and emerging market equities into a single building block, global equities.”
However, the fund also made some technical adjustments to the underlying index measures used in the reference portfolio design.
“We deviated from the 2015 review in choosing to assign weights to each asset class based on widely used liquid market index weights rather than the full investable market,” the NZ Super review says. “This is because we considered our practical ability to invest the reference portfolio efficiently more important than getting access to the full investable market.”
While the review confirmed the reference portfolio exposure to NZ shares of 5 per cent remained appropriate (although the NZX represents just 0.12 per cent of global equity markets), the fund dithered on its currency hedging policy.
The report says NZ-dollar dynamics have changed in the last decade with the historical positive returns from hedging falling significantly an expected stronger correlation of the Kiwi to global equities reducing diversification benefits.
“In 2020 we expect the equilibrium NZD risk premium to be less than the historical average… on balance, our model assumptions in the 2020 review were slightly less supportive of being fully hedged than in the 2015 review,” the report says.
“Despite this, our modelling shows that the hedge ratio that maximises return is 100 per cent, and that using long-term risk, the optimal hedge ratio lies in the range of 90-100 per cent. Consequently, we decided to retain a fully hedged reference portfolio.”
The review further ruled out including inflation-hedging strategies and commodities exposure in the reference portfolio.
“Our view is that while commodity futures attract a risk premium, this premium is low relative to the volatility of the asset class, largely derives from rebalancing and is thus not a passive source of return,” the report says.
“Moreover, long commodity futures (in which we agree to buy the commodity at some future date) could be inconsistent with our climate change investment strategy, given that the most-tracked commodity futures indices are heavily exposed to energy.”
