How a New Zealand Superfund “Beat the Market”
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You would think endowments and similar funds might find it intimidating to depart from conventional passive investment strategies.
As Larry Swedroe noted in this recent blog post:
- There’s no evidence of an ability to identify “great-performing” managers before the fact;
- Past performance doesn’t predict future performance;
- “Active share” doesn’t predict future performance;
- The publication of research has led to reduced factor premiums;
- The pool of “victims” who can be exploited is shrinking;
- It’s easier to arbitrage away anomalies;
- The level of skill between the fund managers has narrowed;
- Evidence favoring investment in actively managed mutual funds is “weak”;
- The market discovers and corrects mispricings quickly; and
- Markets have become more efficient, not less.
Educational endowments and pension funds don’t fare much better than individual investors. A recent study of endowments found they underperformed a passive benchmark by an average of 1.6% per year. A composite of public pension funds underperformed by 1.0%.
One well-known study found managers who were fired by large institutional funds in the U.S. outperformed fund managers who were hired:
To summarize, we find that plan sponsors hire investment managers after superior performance but on average, post-hiring excess returns are zero. Plan sponsors fire investment managers for many reasons, including but not exclusively for underperformance. But, post-firing excess returns are frequently positive and sometimes statistically significant.
I was familiar with this research, so it came as a surprise when I found the annual report of the New Zealand SuperFund.
While no one could fault the SuperFund for sticking with passive investments, it chose a different path, with stunning results.
I wanted to find out how it did so.
The New Zealand Superannuation Fund is a pool of assets on the balance sheet of the New Zealand government. The purpose of the fund is to help pay for the future cost of providing “universal superannuation” (the equivalent of pensions or defined-benefit plans in the U.S.).
The fund is required to follow best practices in portfolio management and to maximize return without taking “undue risk” to the fund.
Investment decisions are made by the “guardians” of the fund, who have operational independence from the government. They are overseen by an independent board.
Investment performance is monitored by the New Zealand Treasury and independent auditors.
The Fund uses a reference portfolio to benchmark the performance of its actual portfolio. The reference portfolio consists of 80% equities and 20% fixed income. The reference portfolio consists of passive, low-cost, listed investments.
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Two-thirds of the portfolio is invested passively. The balance is invested actively, using external fund managers.
The fund believes active investing “is difficult and not worth doing in many markets” and is more expensive than passive investing. It also concedes that it’s “rare” for active management to consistently generate excess returns from skill and that, even when this ability exists, it is “hard to access.”
Nevertheless, its core belief is that “active investing, within well-defined constraints, is both prudent and commercial for an institutional investor with a long horizon and the discipline to stay the course.”
Its performance validates this view.
Inception of the fund was September 2003.
The size of the fund is almost $59 billion NZD (approximately $38 billion USD).
Here’s how the fund has performed since inception (in NZD):
Here’s the Sharpe ratio of the reference portfolio and the actual portfolio:
The annual report of the fund summarizes its active management strategies as follows:
We deviate from the Reference Portfolio through our active investment strategies by investing in ways that allow us to benefit from our endowments, whether by investing in illiquid assets, buying assets cheaply in periods of market crisis, or leveraging our horizon in the New Zealand market to make investments that would be challenging for other market participants. We also invest in ways that further diversify the Fund away from equity markets. This covers assets such as timber and rural land, and some insurance-related investments.
It's the expectation of the fund that, over rolling 20-year periods, it will be able to continue to “add an extra 1.0% p.a. above the returns associated with the passive Reference Portfolio because of our active investment strategies.”
It adopted the reference portfolio benchmark in 2010. Since that time, the fund has delivered a return 2.2% p.a. above the reference portfolio return.
The characteristics of the fund are hardly unique. Most endowments and pension funds are long term investors, with the ability to make the types of investments noted by the fund. Yet few of them achieve the stellar results of the fund.
I decided to delve deeper.
My interview with Rishab Sethi
Rishab Sethi is the manager for external investments and partnerships at the fund. His team oversees external-manager relationships.
In an extensive interview, he described his job as “scour[ing]the world to find good investment partners to work with, and to structure the relationships.”
Initially, he and his team focus on “those spaces that are conducive to scale” and likely to generate an excess return. He then determines whether the fund is positioned to participate in the space, based on its unique characteristics.
Those characteristics permit the fund to “take part in very risky programs” with the realization that there will be periods of sustained underperformance.
The fund invests in both listed and unlisted funds. Its external investments include factor-based allocations (like value, momentum and quality), which play a significant role. Sethi favors those funds because “they have a long-enough pedigree and good-enough academic evidence to support them.”
Except for hedge funds, Sethi does not invest with managers who claim to have the skill to identify mispricing in stocks. Instead, “[W]e generally have a lot more faith, let's say, in excess return or risk premium that don't require skill to access.”
I asked Sethi to summarize the lessons others should learn from the stellar performance of the fund. Here are his takeaways:
- Good governance;
- Clearly articulated decision making process;
- The ability to maintain investment discipline;
- Understanding your stakeholders;
- Transparency; and
- Courage to take risks and stay the course.
There seems to be no magic bullet. It remains difficult to explain the outperformance of the fund compared to many comparable funds, some of which are significantly larger, with greater resources and with a similar ability to take risk.
Perhaps the inquiry should be more focused on the skill of the team responsible for selecting fund managers, rather than the skill of the managers themselves.
Dan trains executives and employees in the lessons based on the research on his latest book, Ask: How to Relate to Anyone. His online course, Ask: Increase Your Sales. Deepen Your Relationships, is currently available.