The NZ Super Fund says most of the major asset classes and investment opportunities it is tracking are trading close to fair value. As a result, the NZ Super Fund is taking less risk than it was a year ago.

In this ‘Investment Environment Report’ Dr Roland Winn, Manager – Investment Analysis, explains the global investment environment and its implications for the NZ Super Fund.

Economic Backdrop

The global economy is growing slowly. While the US economy is performing well, from a global perspective it is the only cylinder really firing. Even aided by substantial policy support, self-sustaining growth in Europe and Japan remains elusive. Emerging markets are currently slowing, although we believe their long-term outlook is positive. Closer to home, the NZ economy remains closely tied to the fortunes of emerging markets.

Market Update

Global equity prices have now largely recovered from the remarkable volatility of early 2016. This period of market weakness was triggered mainly by concerns about Chinese growth. Most of the asset classes and investment opportunities we are tracking are neither cheap, nor expensive. We do, however, see some unusual price gaps. These include: low interest rates; a very strong US dollar; heavy discounting of emerging markets; and low energy prices.

Credit spreads (the difference in yield between two bonds of similar maturity but different credit quality) rose sharply. Wider spreads indicate growing concern about the ability of corporate borrowers to service their debts, and a substantially lower appetite among investors for credit risk.  There was a particular concern around large-scale defaults amongst energy companies.  This risk has lessened somewhat, but remains above normal.

Medium-term Themes

The global economy continues to struggle to recover from the GFC. We expect that interest rates will stay low for longer than in a normal recovery. We believe new technology will continue to disrupt economic activity, and that regulatory change will continue to reduce liquidity in both commercial and investment banking.

Implications for NZ Super Fund

As a genuinely long-term investor with “patient capital” we are in a fortunate position to be able to look through market cycles and pursue long-term investment strategies without the pressure to chase markets.

With many asset classes at or above fair value, there is a relative shortage of outright good investment opportunities.  Consequently, we are taking on less active investment risk than a year ago.

The fund currently has a below average number of investments outside its low-cost, listed Reference Portfolio.  The proportion that is invested outside the Reference Portfolio represents our active views on markets – in one sense, it reflects our view on the attractiveness of opportunities out there.

With this backdrop, we are currently working on three strategic priorities:

1) Portfolio robustness

We are focusing on:

• how our different strategies interact and fit together (e.g. understanding and managing the degree to which active investments load up on common factors such as China risk or the hunt for yield);
• improving the diversification of the Fund;
• optimising the Fund’s portfolio to account for disruptive themes such as technology, regulation and climate change impacts.

2) Better (systematic) passive management

We are working on ways of getting the most value out of the passive part of the Fund’s portfolio which, at around 75% of the Fund, is very substantial. One strategy that we are considering is “factor investing”, a way of systematically constructing an alternative index according to pre-determined  factors that we believe will deliver superior risk-adjusted returns over the long-term. The factors we are interested in are Low Risk and Value.  For more information on factor investing see this excellent Robeco video.

3) Optimal use of our illiquidity

We are also focused on ensuring that the illiquid assets in the Fund (i.e. those that would take a long time to sell) are the best possible ones for the Fund, with strong return and diversification benefits. As part of this, we are continuing to focus on:

• making better use of our liquid (cash) assets;
• opportunistic private market deals where we believe assets are mispriced; and
• funding trades (e.g. loans) where we can fill gaps in the market left by financial institutions that need, generally as a result of regulatory requirements, to reduce their balance sheets.

Highlights from our Portfolio

Strategic Tilting

Our strategic tilting programme, through which we dynamically alter the Fund’s exposure to asset classes over time, continues to be a key source of active returns. Periods of market volatility, such as we saw in early 2016, provide opportunities for tilting. Tilting is a contrarian investment strategy that aims to exploit the Fund’s long investment horizon and our belief in mean reversion.

Rural Land

We recently purchased two New Zealand dairy farms, bringing our total portfolio to 14 (0.8% of the Fund as a whole). These two new farms, both in Canterbury, were our first purchases since 2013. In our view, the New Zealand dairy sector faces some difficult short term challenges, but continues to have strong long-term potential.

Why do we like it?

We see rural land as a relatively under-developed asset class which delivers a range of investment exposures, including:

• macro themes such as demographics around emerging Asia and clean green food;
• scope for adding value through active management; and
• improving portfolio diversification.

We are conscious of the key risks to rural land investments, such as weather, regulation and commodity prices, but note that these are weakly correlated to equity prices. While some of these investment characteristics can be achieved in cheaper, simpler ways, rural land offers an overall package of exposures that is attractive at the right price.

The Fund’s farms are managed by FarmRight.

What does the current investment environment mean for Fund returns?

In recent years both global market and Fund returns have been very strong. Looking forward, we expect lower, more normal market, and therefore Fund, returns. Since inception, we have delivered 9.5% p.a., which is 1.3% over the market return (as measured by our Reference Portfolio).  Over the last 12 months the Reference Portfolio return has been -1%. The Fund has exceeded this, returning 1% after costs and before New Zealand tax.  Long-term, we expect the Fund will generate an average return of 8%-9% p.a.

Feedback on this newsletter is welcome via [email protected].

Important Notice

This report has been prepared as a high level summary of certain matters of interest.  It is necessarily generalised and may not be relied upon.  It does not constitute financial,  taxation, legal or professional advice.  Any forward-looking statements in this report are subject to risks and uncertainties, and actual events may differ. No representation or warranty is given as to the accuracy or completeness of this report.  To the maximum extent permitted by law, Guardians of New Zealand Superannuation as Manager and Administrator of the New Zealand Superannuation Fund (and its affiliates, officers, employees and agents) exclude any liability and responsibility in connection with this report.