Ordinary investors best to avoid successful scheme's strategy.
The New Zealand Superannuation Fund (NZS) was conceived by Michael Cullen, Labour Finance Minister from 1999 to 2008, and created by an act of Parliament in October 2001. Its mission is "to maximise the fund's return over the long term, without undue risk, so as to reduce New Zealanders' future tax burden".
The establishment of the fund recognised New Zealand's ageing population as a significant and multigenerational social and financial challenge. History will probably record the NZS as one of the best things Michael Cullen did for New Zealand and this good deed almost offsets the damage wrought on retail investors' asset allocation strategy by his other lovechild, the ridiculously unfair Foreign Investment Fund tax rule, whereby international share portfolios are subject to a de facto capital gains tax. But that is another story.
Today we will look at the extraordinary recent performance of the NZS, a 16.5 per cent return in the 12 months ended March 31, 2011, try to understand how the return was achieved and consider whether the Super Fund's strategies have any lessons for retail investors.
But first some background. The NZS attempts to address the looming problem of the future cost of funding New Zealanders' retirement while "smoothing" the tax burden between generations of New Zealanders.
The original asset allocation was announced in August 2003 and the following month the fund began receiving contributions from the Crown. On September 30, 2003, the investment programme commenced with $2.4 billion in cash. However, the National Government, in May 2009, suspended future government contributions for up to 10 years, because of falling revenues and rising government spending. It may have also been persuaded by the argument that it doesn't make much sense to borrow, even if you are the Government, to invest in shares.
This logic rests on the idea that risk is priced efficiently and the extra return you get from shares over government bonds is offset by the higher risk; that is, there is no free lunch in the long run.
At March 31, 2011, the fund's assets totalled $18.8 billion, versus $14.88 billion in government contributions. That works out to a total long-term return, since inception, of 7.9 per cent a year. The average pension fund returned 5.6 per cent a year in the same period.
The issue before the panel today, however, is the extraordinary return achieved by the NZS in the 12 months to the end of March 2011. Somehow its fund managers have conjured a return of just over 16.5 per cent after costs in the year. In the same period the typical portfolio as held by a balanced superannuation fund or average-risk KiwiSaver account would have returned an estimated 7 per cent, before fees, if it had done as well as the benchmark index in each category.
This sort of outperformance of the benchmark is worthy of a Warren Buffett. The performance figures for each benchmark are listed in the table.
The NZS was reluctant to disclose its performance in each asset class, but it has given us enough information to make some judgments on where some of the outperformance might have been achieved.
A cynical journalist might suspect, as has happened with some hedge funds overseas, that illiquid assets such as private equity have been revalued arbitrarily to produce this sort of extraordinary gain. That doesn't seem to be the case with the NZS as its allocation to private equity is only 1 per cent of total assets. However, the NZS is a shareholder in Greenstone Energy, with Infratil, and last month Infratil announced its 50 per cent share in Greenstone had produced a total return in the year of 55 per cent. The NZS investment in Greenstone is worth $210 million, so it isn't a big number in the context of the fund's $18.8 billion size, but every bit helps. So where else did the NZS fund managers add value?
The major reason for the NZS's outperformance was its investments in higher-growth/higher-risk asset classes, which performed particularly well in the period concerned. The average pension fund has 60 per cent in shares and property, whereas the Super Fund has almost 89 per cent in growth assets, with above-average weightings in emerging markets, smaller companies and alternative assets.
In the year to the end of March, in NZ dollar terms, international shares returned 6 per cent, global smaller company shares returned 16.2 per cent and global emerging market equities returned 10.2 per cent, whereas a portfolio split equally between global bonds and NZ bonds returned 3.8 per cent.
The average pension fund has, for the past 30 years or so, typically invested around 40 per cent of its assets in local and international bonds, whereas the Super Fund had allocated only 11 per cent of its money to bonds. If we adjust for the Super Fund's orientation towards growth assets, this boosts the return to about 9.5 per cent in NZ dollar terms.
But the NZS had hedged 72 per cent of its assets back into New Zealand dollars, which is significant because in the year to the end of March the kiwi was very strong against most currencies, firming against the US dollar by 7.5 per cent, for example. Most retail investors don't hedge their overseas currency positions and probably shouldn't.
It doesn't make much sense for Mum and Dad to hedge long term for two reasons. Much of our day-to-day expenditure, such as milk, meat and petrol, is denominated in US dollars, and we all know that a diversified portfolio of currencies is less risky in the long run than having all your money in one currency. In addition, work by Dimson, Marsh and Staunton in the Global Investment Returns Yearbook argues that in the long run hedging currency is a waste of time; unless, of course, you have a short-term investment horizon and you are skilful/lucky.
Whatever the long-term pros and cons of hedging currency, the strategy paid off handsomely for the NZS in the 12 months to the end of March, probably to the tune of about 7 per cent. So if we add the 7 per cent gain from currency management to our 9.5 per cent, that gets us to the Super Fund's 16.5 per cent.
This is a great victory for fans of the Super Fund. But what does it mean, if anything, for the investment strategies of Mum and Dad?
The first thing to remember about the NZS is that it has a very long-term perspective, much longer than your average retail investor, and doesn't need any income from its investments until 2031. So it can afford to take much higher risks.
Also the NZS, by virtue of its size, is able to negotiate reasonable fees on alternative asset classes, whereas retail investors are often forced to pay unrealistically high fees on infrastructure, venture capital and other alternative investments. Similarly, because of its size the NZS will have access to the best managers and, in respect of venture capital and infrastructure, will get offered the best deals ahead of retail investors.
For these reasons retail investors should, when putting their portfolios together, probably err on the side of caution and structure their portfolio more like that of the average pension fund than the NZS model.
* Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.
