The NZ Superannuation Fund (NZS) has slightly lifted both long-term outperformance and risk expectations in its latest ‘reference portfolio’ review while removing an explicit emerging markets benchmark from the process.
Following the five-yearly refresh of reference portfolio assumptions in 2020, the NZS 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 NZS alpha-generating activities and “a governance benchmark” – expected 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, NZS forecast a 7.7 per cent long-run performance for 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% to growth assets and 20% to income assets, and the 100% foreign currency hedge ratio,” the NZS 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 NZS 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,” the NZS says.
“… on balance, our model assumptions in the 2020 review were slightly less supportive of being fully hedged than in the 2015 review. Despite this, our modelling shows that the hedge ratio that maximises return is 100%, and that using long-term risk, the optimal hedge ratio lies in the range of 90-100%. 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.”
Stephen Gilmore, NZS chief investment officer, says in the report 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”.
“In practice, it comprises just over half of our actual portfolio, with our active investment strategies making up the balance.”
The now almost $54 billion fund has returned (after costs but before tax) an average 10.1 per cent since inception in 2003, adding $8.5 billion above the reference portfolio.