Guardians of NZ Super say ‘from peak to trough’ the Fund would lose over half its value in a global financial crisis – but they estimate the losses could be recouped within 20 months

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The NZ Super Fund would lose over $20 billion – more than half its current value – in any repeat of 2008’s Global Financial Crisis, the Guardians of NZ Super say.

However, they do estimate that any such losses may be recouped within about 20 months.

In the NZ Super Fund 2018 annual report released on Thursday, the Fund’s Guardians have outlined an exercise modelling what would happen in the event of another major global meltdown.

Chief Executive Matt Whineray says the Fund’s high exposure to growth assets is set by the board in the ‘Reference Portfolio’, a simple passive low-cost portfolio of listed equities and bonds that serves as a benchmark for the Fund’s investing activities.

“In the short-term, growth assets can be volatile, moving up and down in price. The Fund has the ability to ride out and potentially benefit from these short-term movements. In the long-term, the Fund’s exposure to market risk from growth assets such as shares is expected to pay off in the form of higher returns than the cost to the Government of contributing to the fund.”

Whineray says by taking on the market risk associated with growth assets, the Guardians accept the risk that markets may experience sharp drops in value, be they driven by financial or political shocks, large commodity price movements, natural disasters or war.

‘Largely unavoidable’

“It is largely unavoidable that a growth-oriented portfolio such as the Fund will fall in these periods.

“…Having made the choice to expose the Fund to short-term volatility in order to generate long-term returns, the key is to ensure we have the discipline and resources to hold our course when volatility happens. Critical in this is understanding what these times could look like, before they happen.”

The Guardians have produced the below chart, which shows a simulation of what would happen to the Fund if the Global Financial Crisis (GFC) period of returns (2008-2011) were to be repeated. For the scenario, they used the Fund’s current asset mix and a representation of how the Fund’s active investment strategies would react to market movements.

“From peak to trough (a ten-month period), we estimate the Fund would lose $20.3b (-52.6%) in a repeat of the GFC. The notional Reference Portfolio benchmark would fall by 44.7%.

“The reason we estimate that the Fund would lose more money than the Reference Portfolio benchmark is largely because we expect our strategic tilting programme would buy more growth assets as they fall in value. This is because the times when the global economy and financial markets are in distress are those that present the best buying opportunities for long-term investors such as ourselves.”

Whineray says these numbers would not necessarily be reflected in the Fund’s annually reported returns, as market volatility does not always line up with our fiscal years – “hence the largest annual downturn we experienced in the actual GFC was -22%”.

“The GFC was characterised by both an unusually sharp drawdown and rapid recovery in financial market values. This is a relatively rare occurrence; recoveries from significant market crises can often take longer than this. In general, however, the Guardians believe that equity markets eventually mean-revert to higher fair values following transitory periods of crisis. As a result, the Guardians expect the Fund would earn back losses suffered by our active strategies in subsequent years as markets recover.

“The above simulation also illustrates how, in a repeat of the GFC, the Fund would recover its initial value, and catch-up lost ground, within 20 months.”

Whineray says, however, the expected recovery in the Fund’s value, is only feasible “if we are able to ‘hold the course’ with our investment strategies through a market cycle”.

‘Major risk’

“So, the major risk to the Fund is not that it will experience significant volatility in its returns – we know that will happen. The major risk to the Fund is that we lose our nerve, close down our investment positions and lock in the losses experienced in the crisis. This would significantly impair the ability of the Fund to fulfill its long-term purpose.”

Whineray says as the Fund becomes bigger in dollar terms, and grows as a share of the economy, its gains and losses from short-term market volatility will also increase in size.

“We encourage stakeholders to understand that the main challenge in persisting as a long-horizon investor is in looking through short-term shifts in value and focusing instead on more appropriate and long-term metrics of success. Even considering the risk of market crises, the Guardians’ view is that the Fund’s market risk and active strategies are appropriate and compensated risk exposures for a long-term investor.”

He says the Fund is “well-placed” to withstand short-term losses, as there is no immediate need to withdraw capital from it.  Short-term, volatility in the Fund’s return is an expected outcome of the Board’s choice of the level of equities in the Reference Portfolio. These fluctuations can be treated as “paper losses” with little long-term ramifications for the Fund’s ability to fulfill its purpose.

Whineray says the Fund achieved strong returns in the 2017/18 year thanks to a combination of market growth and its value-adding strategies. Equity markets were characterised by strong returns and exceptionally low levels of volatility in the first half of the financial year, “followed by the re-emergence of volatility at the start of calendar 2018 – a more normal situation and one from which we were well positioned to profit”.

Whineray says the Fund again out-performed global markets, returning 12.43% (after costs, before NZ tax) over 2017/18. The Guardians’ active investment activities added value of 2.02% (NZ$0.7b) on top of a Reference Portfolio (market) return of 10.42%.

The Fund finished the year at NZ$39.37b before New Zealand tax, an increase of NZ$4.0b.

The overall Fund’s out-performance of the Reference Portfolio was due mainly to the success of its strategic tilting programme, a positive performance by its single largest investment, Kaingaroa Timberlands, and the active collateral mandate.

Looking ahead, Whineray says the external environment appears “challenging”.

“Global growth is beginning to decelerate, inflation is starting to rise in some developed markets and financial conditions are tightening with the withdrawal of central bank liquidity. While trade tensions have been escalating, the contagion into financial markets has been limited to date.

“With many markets at or above fair value, our response has been to lower the level of active risk and maintain higher than normal levels of portfolio liquidity. We remain committed to our long-term investment strategies and will continue to take a highly disciplined approach to active investment.”

New Zealand investment

Whineray said because New Zealand is a small economy, most of the Fund is invested offshore.

“This is prudent from a diversification perspective and is considered global best practice. We are, however, committed to finding attractive investment opportunities in New Zealand, and a significant proportion of the Fund’s active, value-adding investments are domestic ones.

“The 2017/18 financial year was notable for the further development of our new Investment Hub approach to generating domestic deal flow. A major milestone in this was the launch of Māori investment fund Te Pūia Tāpapa, with which we have agreed to become a preferred partner.”

Then Finance Minister Bill English in mid-2009 officially directed the Fund “that opportunities that would enable the Guardians to increase the allocation of New Zealand assets in the Fund should be appropriately identified and considered by the Guardians”.

Whineray says while the dollar figure of the Fund’s investments in New Zealand has increased from $2.4 billion to $6 billion in the seven years since 1 July 2009, the proportion of the overall Fund that is invested in New Zealand (in value terms) has reduced from 21.3% to 15.4%.

“The proportional drop reflects the strong performance of global equities in recent years, even after significant new investments by the Fund in New Zealand.”

Whineray says the Fund is one of the largest institutional investors in New Zealand and plays a significant role in New Zealand’s capital markets.

“While we believe the Fund has an advantage when investing domestically (versus internationally), in a global context, New Zealand is a very small investment market (it comprises just 0.1% of global listed equities markets). For our New Zealand investments, therefore, we require an additional return that will compensate us sufficiently for the risk of concentrating more of the Fund’s portfolio here. As one of a few investors of scale in the country, we also maintain a high level of price discipline.”

Auckland light rail

In May the Fund submitted an unsolicited proposal to the New Zealand Government offering to assess the viability of the Auckland Light Rail Project for commercial investment.

Whineray says the Fund’s consortium partner is CDPQ Infra, a wholly owned subsidiary of Caisse de Dépôt et Placement du Québec (CDPQ), a CA$300b pension fund owned by the Government of Quebec. CDPQ Infra is responsible for developing and operating infrastructure projects including Montreal’s 67km light rail network. “Together with CDPQ Infra, we are now participating in a NZ Transport Agency-led procurement process for the project.”

The below table shows exactly where, geographically, the Fund’s money is invested. Note that this calculation includes foreign exchange hedging instruments such as FX contracts and cross-currency swaps, so the percentages for NZ investment look somewhat different to the percentages cited above, which do not include contracts and cross currency swaps.

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