It's our money so do we want safe and steady or a bit of a fling - or both?
Last October consulting group Mercer prepared an independent review of the performance, objectives and asset allocation of the Super Fund for the Treasury.
One of the first issues the review looked at was the suitability and appropriateness of the fund's performance objective.
However, it may be that the objective has been mis-specified as the Super Fund has a high-return asset allocation but the objective looks modest, especially relative to past financial market returns, and possibly those of the future as well.
The fund is normally 80 per cent invested in growth assets with a high weighting in international shares and, of late, alternative assets. The remaining 20 per cent is invested in lower-risk asset classes such as government and other bonds.
So it's an aggressive asset allocation orientated towards growth. However, the performance objectives against which the Guardians are assessed is just the return on 90-day government bonds, plus 2.5 per cent, over a 20-year period.
With short-dated government bills yielding 2.6 per cent, that's a pretty modest objective of just 5.1 per cent a year. Given the aggressive asset allocation of the fund, a margin of just 2.5 per cent over 90-day bills seems a little too easy relative both to the historic excess return of shares over short-dated government bonds (known as the risk premium) and the forward-looking risk premium.
But prospective returns for the Super Fund are even better than this - a good part of the fund's portfolio could reasonably be expected to outperform the broad sharemarket.
The Mercer report noted and the fund stresses the ability of the fund to invest in illiquid assets such as timber and private equity and thus capture an additional "illiquidity premium" above and beyond the return of equities.
The Guardians responded to this by saying that they have not structured their portfolio and nor do they invest with the primary objective of T-Bills plus 2.5 per cent. The Guardians' primary performance objective is embedded in their establishing legislation and requires them to "maximise returns without undue risk", and their portfolio and consequent investment activity are focused instead on that.
The Guardians say that the significance of T-Bills plus 2.5 per cent is as a performance reference point. They believe that, given the need to balance risk and return over a very long investment term, it is realistic to average T-Bills plus 2.5 per cent over rolling 20-year periods.
They stress that they aspire to outperform that reference point where possible and point to the performance expectation they set out in their Statement of Intent for 2009 (10.70 per cent over the next 10 years or T-Bills plus 4.8 per cent, reflecting that markets should improve significantly off a low base) and the fact that so far this financial year they are outperforming T-Bills by nearly 11 per cent, as consistent with that.
The Guardians also note that the asset allocation process is being reviewed and the conclusions will be published in the 2010 annual report.
International shares have, according to the 2009 version of the Global Investment Returns Yearbook, returned over the last 109 years 4.2 per cent a year more than short-dated government bonds.
This is a lot better than the 2.5 per cent above 90-day government bills objective and is without the benefit of the active management, alternative investments or tactical asset allocation policies which are typically promulgated by investment consultants.
The Super Fund in 2009 spent about $7 million on investment consultants and a good deal more on fund management fees. The 4.2 per cent a year is simply the result of a buy and hold strategy.
The 5.1 per cent overall return objective also looks modest because 10-year government bonds are yielding about 6.0 per cent so the fund could today substantially outperform its objective without taking any equity risk at all simply by investing in longer-dated government bonds rather than short.
Unfortunately this is not a serious option for the fund in the long term as the margin between short-term and long-term bonds hasn't been this wide in some time and could quite easily revert to a negative position.
But what is significant is that the fund, with such a high weighting in equities and other illiquid assets with even higher prospective returns, could reasonably be expected to beat its objective without too much effort.
After reading this report Treasury should be asking what degree of "value add" is implicit in the objective? A critical analysis of prospective returns suggests that the degree of required "value add" may be zero or even negative based on the long-term asset allocation profile and a reasonable estimation of prospective returns despite the expenditure on investment management.
The most significant asset class in the Super Fund portfolio is international shares, where some 45 per cent of the money is invested.
As we saw in a story late last year, Dimson, Marsh and Staunton, three professors from the London Business School and authors of the world's most comprehensive long-term history of global bills, bonds and equity returns, estimate that the prospective additional return of shares over short-term government bills is 3.2 per cent a year.
This is quite a bit better than the 2.5 per cent objective, so theoretically the Super Fund could dispense with the expense of consultants, tactical asset allocation, governance, investment risk management, strategic tilting and scenario analysis, to list just a few of the highlights of the 204-page review, and instead place 80 per cent of the money in a global equity index fund and 20 per cent in a mix of international and local government bonds.
According to research from DMS the prospective return from this portfolio is 2.72 per cent a year above 90-day government bills. If we then deduct management fees of, say, 20 basis points, we get 2.5 per cent.
Problem solved, money saved, objective met.
There is other academic support for the DMS estimate of a 3.2 per cent a year risk premium. Robert D. Arnott, in a paper jointly authored with the late Peter Bernstein in the Journal of Portfolio Management, estimates an average risk premium of 2.4 per cent a year for the US stockmarket.
But in their report they are estimating the premium of equities over government bonds. Longer-term government bonds have outperformed short-term government bonds by about 0.8 per cent a year since 1900 so the Arnott/Bernstein paper is exactly consistent with the 3.2 per cent estimate from DMS.
Instead, as the table shows, the Guardians have put together a complex portfolio involving liberal helpings of last year's favourite asset classes - private equity, commodities, timber and other risky and illiquid assets.
If as is likely over the long term this high-risk strategy manages to exceed zero risk short-term government bonds by more than 2.5 per cent a year, the objective will have been met and congratulations and presumably bonuses will be delivered to all concerned.
But are New Zealanders getting value for money? On the basis of the estimated future returns set out in the table, the objective may be a little too easy.
The weighted average prospective return on the basis of the October 2009 asset allocation, with DMS's forecast returns for bonds and shares and assuming a 1 per cent illiquidity premium where appropriate, give a total weighted average expected return of 3.0 per cent a year over 90-day government bills.
From this number we should subtract maybe 20 basis points for fees to give an after-fee return of 2.8 per cent a year.
If you think, "big deal, what's the difference between 2.5 per cent a year and 2.8 per cent a year?", then think again. On the Super Fund's assets of $15.2 billion over 20 years, that's a difference of about $1 billion. Probably worth having.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
