There has been a great deal of coverage in the last few days of the New Zealand Superannuation Fund, all prompted by the news that the chief executive, Adrian Orr, had been given a substantial pay increase by the Fund’s Board, over the objections of the State Services Commission and the then Minister of Finance.
I don’t have a strong view as to how much the chief executive should be paid. In general, I also don’t have a particular problem with that amount being determined by the Board, without ministerial involvement. Then again, this is simply a body managing a large pool of (borrowed) government money, and I couldn’t see a particular problem if the relevant Act was to be amended to make the terms and conditions of the chief executive a matter determined by the Minister of Finance, or the State Services Commission, perhaps taking advice from the Board. After all, that is exactly the model that applies for the Governor of the Reserve Bank.
Amid the recent media coverage, there has been a lot of hyper-ventilation about the performance of the Fund, and of Orr himself. In his Dominion-Post article, Hamish Rutherford reports that
One commentator suggested if Orr had achieved such a return in New York he might have made a billion dollars.
That seems unlikely frankly. Orr simply isn’t – and I wouldn’t have thought he’d claim otherwise – some investment guru, blessed with extraordinary insights into markets, prospective returns etc etc. He was a capable economist, and a good communicator (at least when he doesn’t lapse into vulgarity), who turned himself into a manager and seems to have done quite well at that. He always seeemed skilled at managing upwards, and his management style (in my observation at the Reserve Bank) seemed to err towards the polarising (“are you with us, or against us”), attracting and retaining loyalists, but not exactly encouraging diversity of perspectives or styles. He isn’t exactly a self-effacing character. (That is one reason I’m not convinced he is quite the right person to be the next Governor of the Reserve Bank.)
The New Zealand Superannuation Fund has made money, both before and since Orr took over a decade ago. Of course, amid a trend increase in global asset markets it has been hard not to. The NZSE50 gross index, for example, has increased at an annualised average rate of about 9.8 per cent per annum since 1 September 2003 (when the NZSF opened its doors).
As for how good the NZSF have been, it is probably too early to tell. Don’t take my word for it: here is how they themselves put it
It is our expectation, given our long-term mandate and risk appetite, that we will return at least the Treasury Bill return + 2.7% p.a. over any 20-year moving average period.
The Fund has now been operating for only about 13.5 years. In some respects, the returns to date look quite good – they’ve averaged 5.6 percentage points per annum above the Treasury bill return – but for a Fund with the sort of risk parameters they have adopted one can only really evaluate performance over very long periods. And global asset returns have been pretty attractive over much of the last 15 years. Will that be repeated? Will there be a big sustained correction? The only honest answer is that no one knows. (And the 20 year time horizon is probably a reason why the institution’s CEO shouldn’t be remunerated to any significant extent on some investment performance formula – unless there are clawbacks built in for the next 20 years).
But even on the returns to date, it might be reasonable to pose some questions. The Fund puts a lot of emphasis on expected returns, and not a lot (at least in the published material) on the risk they are running. In some respects, that is in line with Parliament’s mandate for them to be
maximising return without undue risk to the Fund as a whole;
What, we might wonder, is “undue”? Who decides, and under what constraints?
A common measure of risk, especially on assets that are frequently marked to market, is the variability of returns. One tool for relating returns to risk is the so-called Sharpe ratio, which compares the incremental returns obtained through the fund manager’s investment management choices (ie the margin above a risk-free rate) with the standard deviation of those returns. If the resulting number is very low, the incremental gains might often be prudently best treated as “noise” – good luck, perhaps, rather than the result of a consistently superior investment strategy. On the other hand, all else equal a high Sharpe ratio, over a reasonable period of time, provides greater reassurance that the fund manager is adding value. When I ran the Reserve Bank’s financial markets operations, we had able staff proposing all sorts of clever active management schemes to add value to our foreign reserves operation. Sharpe ratios were one of the tools we used to evaluate prospective and actual results.
How has the NZSF done on that metric? Since it opened the doors, the average annualised return has been 9.9 per cent (recall that NZSE50 return of 9.8 per cent). Treasury bills – the Fund’s risk-free benchmark – provided an average return of 4.3 per cent, so the average margin over the Treasury bill return was 5.6 per cent.
But the standard deviation of those annual excess returns over the full period since September 2003 is around 13.5 per cent, for a Sharpe ratio of just over 0.4 per cent (and these are all pre-tax numbers). That is pretty low. In other words, while the headline returns – through a period of strong asset price growth – may have looked impressive, the risks they have been running have been (deliberately and consciously) high. I checked, by way of comparison, the returns on the low-risk (low return) superannuation fund I’m a member (and trustee) of: since 2003 the standard deviation of the annual returns on that fund since 2003 have been around 4.5 per cent.
Adrian Orr has now been CEO of the NZSF for almost a decade. In that decade, annual returns (above Treasury bill) look to have averaged just over 5 per cent, but the standard deviation of those annual returns has been higher at around 17 per cent. In other words, the Sharpe ratio for the Orr years, is even lower than that for the full period of operation. But, as a reminder, the Fund itself reckons one needs a 20 year run of data to evaluate their investment management performance.
Based on the NZSF’s own data the monthly returns are also pretty volatile. The standard deviation of monthly returns (over the risk-free rate) over the life of the Fund has been around 3.3 per cent. Given that many of the Fund’s holdings are quite illiquid, one probably shouldn’t put too much weight on the monthly return numbers, but it is a reminder of just how much risk the NZSF is incurring – not for itself, but for the taxpayers of New Zealand. At best, they might just have been getting compensation for the risk they’ve taken, but there doesn’t seem to be anything exceptional about their performance given that level of risk. That, in itself, isn’t intended as a criticism: why would we expect a public agency in New Zealand to be able to add much (risk-adjusted) value, whether through asset allocation, or tactical departures from their own internal benchmarks? But it is a bit of a reality check. And as Hamish Rutherford noted, on deals like Kiwibank, the super fund’s returns are, over time, likely to be flattered by the privileged position NZSF had going into negotiations – there were very very few buyers acceptable to the government, and ACC and NZSF will have known that, and reflected it in the price they offered NZ Post.
My own unease about NZSF is rather more fundamental, and doesn’t reflect on any of the individuals involved in managing the funds or the organisation. The NZSF is often loosely described as a sovereign wealth fund. In fact, it is nothing of the sort. Norway and Abu Dhabi have sovereign wealth funds – accumulated from the proceeds of the sale of state-owned natural resources (oil and gas). It is real wealth, and needs to be managed somehow. Of course, it could all be passed on to citizens to do with as they please, but there are plausible – not necessarily 100 per cent compelling – reasons for managing the flow of the proceeds of the sale of a large non-renewable natural resource over time. If so, the money is there and has to be managed somehow.
By contrast, the New Zealand Superannuation Fund arose because successive governments took more in taxation from New Zealanders than they needed to fund their operations. At one stage at looked as though the New Zealand government would manage to build up a large financial asset position. But, except briefly just prior to the 2008/09 recession, they didn’t even manage to do that. Instead, we now have a quite large stock of government debt outstanding, $33 billion of which is used to run a state-sponsored and managed quite-risky hedge fund. It is a discretionary commercial operation, and it should be evaluated on the same sorts of grounds Treasury and the government lay down for other investment projects. And given that risk imposed on us by the government is risk (capacity) we could ourselves otherwise choose to utilise elsewhere, it should also be evaluated by looking at the sorts of returns private sector businesses require in analysing possible uses of capital.
Treasury has recently revised downwards the pre-tax discount rates it recommends government agencies use in evaluating projects. Their default recommended rate is now 6 per cent real (or around 8 per cent nominal), but over most of the period of the life of the NZSF they were recommending a real discount rate of nearer 8 per cent. They continue to assume an equity risk premium of 7 per cent. Against those sorts of asssumptions, average annual nominal returns of 9.9 per cent just don’t look that attractive, especially when subject to huge variability (that 13.5 per cent annual standard deviation). I don’t know what assumptions NZSF are making about expected absolute returns over the next decade, but it would be a bit surprising if they were forecasting/assuming returns as high as those on offer for the last 14 years.
Another way of looking at whether the NZSF is a good business for the Crown to be in, on behalf of taxpayers, is to look at the returns private sector businesses require. I’ve linked previously to a nice article from the Reserve Bank of Australia, drawing on a survey of private sector businesses asked about what hurdle rates they used in approving/declining investment decisions. I summarised it previously thus:
They report survey results suggesting that most firms in Australia use pre-tax nominal hurdle rates of return in a range of 10-16 per cent (the largest group fell in the range10-13 per cent, and the second largest in a 13-16 per cent band). Recall that nominal interest rates in Australia are typically a little lower than those in New Zealand, and their inflation target is a little higher than ours. In other words, it would surprising if New Zealand firms didn’t use hurdle rates at least as high in nominal terms as those used by their Australia peers. The RBA reports a standard finding that required rates of return were typically a little above the firms’ estimated weighted average cost of capital. The literature suggests a variety of reasons why firms might adopt that approach, including as a buffer against potential biases in the estimated benefits used in evaluating projects.
And here is one of their charts
Bottom line: private citizens shouldn’t want governments getting into businesses – especially not relatively risky businesses – where the returns are less than 10 per cent.
There are other reasons to be concerned about the economics of the NZSF:
- putting money into NZSF required tax rates to be higher than otherwise (as would the shared commitment to resume contributions at some point). Higher tax rates discourage some economic activity that would otherwise occur here, and New Zealand tax rates are not now unusually low by international standards (our company tax rate is quite high),
- the scheme involves all New Zealanders in direct financial exposures to companies/industries they may disapprove of. NZSF attempts to get round that with their ‘socially responsible’ investment policy, but your view of “socially responsible” companies/activities may well differ from that of your neighbour. Personally, I’d be quite happy to have money invested in whale fishing companies. Many others might not. Making those choices simply isn’t a natural or necessary business of government.
- large pools of government financial assets encourage the misuse of those funds in the event that the country/government comes under financial stress at some point in the future. Those sorts of tail risks aren’t captured in the monthly or annual standard deviation numbers.
- NZSF, being a quite high risk fund, tends to perform well in periods when the government’s finances are not under stress, and to perform badly (very badly in 2008/09) when government finances come under most stress. Because the assets are quite widely held, it provides some protection against some sorts of shocks, but in any severe global economic and asset market downturn – the sort of event New Zealand is never immune to – the NZSF investment strategy simply ensures that when problems hit they are compounded by investment losses. As the government is already, in effect, an equity holder in all New Zealand business (through the tax system), it isn’t obvious quite why it should be attractive for New Zealanders to have the government further compound their exposures. To take those risks might be reasonable for the prospect of exceptional returns, but the NZSF strategies look to do little more than cover a bare minimum cost of capital – while aggravating our problems when things turn bad.
The NZSF may have been a sensible practical political option back at the start of the 2000s. Governments were running large surpluses, positive net financial assets were in prospect, and the retirement of the babyboomers was still a decade away. It makes little sense now, and if anything is a distraction from the necessary discussion about adjusting the NZS eligibility age in line with the longer-term trend improvements in life expectancy. Rather than debate how to remunerate the CEO, or whether Board members should be replaced, we’d be better to look seriously at winding up the Fund now, reducing the risks taxpayers ar exposed to and using the proceeds to repay government debt.
croaking cassandra 
The usual estimates of the dead weight cost of income tax is 20%. For the company tax rate, it would be much higher. I very much agree that the NZ Super Fund is not meeting any reasonable hurdle rate.
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In the last 7 years since the GFC, Central Bankers have been printing cash, making capital profits from equities and properties have been a no brainer. Anyone could have easily made those returns without blinking.
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given the ability to diversify, not sure the NZSF return should be compared with a specific project hurdle rate?; but take your point, repaying debt is risk free so might as well crack on…..
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but then the portfolio variance is still rather large – perhaps more than the impact of a single project on a firm’s overall earnings variance?
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…not sure I follow; the Reference Portfolio seems the relevant benchmark in this instance (given the current fund structure/governance) so think the Sharpe Ratio point captures the the issue of ‘value add’ perhaps better than comparison to pre-tax discount rates used by government agencies when evaluating projects?
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From my quick scan of the annual report there are two performance benchmarks – the reference portfolio
and the performance against the treasury bill. – and that on a 4 year horizon. – which will be a matter of luck.
Not sure how good the reference portfolio metric is.
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The reference portfolio benchmark isn’t particularly useful for these purposes: it reflects a basic asset allocation structure, and deviations from it just reflect the impact of specific tactical and longer-term deviations from that. That might be useful to the Board, in assessing the value from specific trades over time, but isn’t the relevant metric for citizens, or ministers, evaluating the overrall value in the fund operations.
The monthly return data on all three components – actual Fund, T bills, and reference portfolio – is on their website, for the whole life of the Fund.
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If this discussion was held in 2008, we are discussing why the fund’s value-added on the reference portfolio had been lost in one year in the global financial crisis and then some.
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Michael,
When you talk about the variance or the standard deviation, is that for a data that have a trend? I do not have the data, but trended data have large and “growing with time” variances and standard deviations…( non-stationary). In that case the calculations must be applied to trendless data.
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No, it is a series of annual percentage returns, so no trend
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Thank you for this Michael. The fact that the returns are simply a function of risk – to the taxpayer – gets completely lost in all the gushing. And don’t get me started on the recent deal where the ownership of NZ Post got reshuffled in the govt’s accounts and out popped $400 mill or so against OBEGAL.
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I wouldn’t call a Sharpe Ratio of 0.4 ‘low’ — that’s exactly the long-run SR for the US stock market: 6% excess return and 15% standard deviation (and that magnitude is itself puzzlingly high — the so-called equity premium puzzle). 0.4 is also on a par with many estimates of carry trade returns. The NZ stock market SR would be lower still (without looking up the numbers, I’d say less than 0.3).
The hurdle rate puzzle (required hurdle rates > WACC) has been documented around the world and its causes aren’t well understood, but it relates to widget-making companies investing in widget factories and seems likely to reflect market frictions (imperfect liquidity and diversification, for example) that aren’t too relevant for an investment fund.
Having said that, I agree there’s no real evidence of significant out-performance at the NZSF. In theory, investing in Vanguard would have produced precisely the same outcome at a fraction of the cost.
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Interesting comments. When we were evaluating active mgmt proposals at the Bank we’d certainly have been reluctant to take on anything as low as 0.4. But in practice we probably aren’t far apart – as I noted, basically NZSF has been getting paid for taking (a lot of) risk. (And that at what many would think of as near the peak of an asset price boom – if prices fall back (and that isn’t an attempt at a forecast) the returns (and the Sharpe ratio) will look much less attractive in hindsight than the “par for the course” sorts of numbers we see now.
I’m less sure that the private sector hurdle rates aren’t relevant. NZSF is just another investment project for the NZ govt – and actually one with unattractive covariance properties – so why should we think of it much differently than a large corporate evaluating an individual investment project?
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Because costless recapitalisation is a dream for corporates (even large ones). So a nasty shock (even if totally unsystematic) exposes them to financing constraints on other investment opportunities, and it’s compensation for that risk which leads them to require a premium above WACC (potentially that is, nobody really knows for sure). For governments that can credibly claim to have the power of taxation to fall back on, frictions and financing constraints are less of an issue. There are certainly many parallels between government and corporate investment decisions, no question there, but I’d be wary of stretching the bow too far as there are also some important differences.
An unattractive covariance (if that’s indeed the case) just means a high WACC — it can’t explain a hurdle premium over WACC.
Getting back to Sharpe Ratios, the Hansen-Jagannathan bound tells us the maximum SR attainable on any investment can be no greater than the ratio of the SDF standard deviation to its mean. Given that the mean is approximately 1, a good-sized SR requires a volatile SDF. But this in turn requires implausibly high risk aversion, so even a SR of 0.4 is a significant puzzle. Requiring a high SR therefore involves requiring a big premium for something that’s not recognised by standard asset pricing models.
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Re the final para, thanks. If I read it correctly though, isn’t what you are saying just another angle on the unexplained question of why equity risk premia have been so high? I certainly don’t have any compelling answers, but if I”m considering an investment (fund) proposal, I’m not going to be keen on one’s that don’t generate the sort of return apparently available in the market as a whole (that is especially so when, as with NZSF, it is a case of borrowing to fund the investment).
Re your first para, I think the parallels are closer than you allow. Yes, governments can (typically) legally increase taxes to the extent required, but they often don’t (and raising tax rates has rarely been a successful path to closing deficits). In the same way, govts with their own currencies can always print money, but they don’t always do so, sometimes preferring default. But a government that internalised citizens’ own perspectives, would recognise, inter alia that (a) citizens are coerced into supporting the Fund, (b) the deadweight costs of taxes, and (c) failures of government, including lack of proper incentives,that private sector entities are less prone to. The costs/disruptions are different in character to private sector bankruptcy costs (which of course don’t even apply in some sectors, like banking) but it isn’t obvious that they are sufficient to leave citizens wanting govts to use hurdle rates less than those private sector companies (owned by citizens) would do, especially for activities (like NZSF) that are purely commercial in nature.
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Adrian Orr was on 9 to noon this morning defending the superfund and at the 16 minute mark of the interview criticising my recent op-ed in the New Zealand Herald. You might want to listen to that part to see whether his reasoning checks out.
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I’ve now listened to Adrian. I didn’t find his comments very persuasive at all, either on the specifics of your points, or more generally. Neither did I find the OIA response to you particuarly persuasive – esp the amusing attempt to introduce return data from the very bottom of ther GFC.
Having said that, my own view tends to be that (a) NZSF has done a reasonably competent job, although (b) they are still riding a global upswing in asset returns, which flatter all thier results, and (c) those results will be further flattered by sweetheart deals (few potential purchasers) like Kiwibank. I agree with you that the evidence on active management globally isn’t good, and even tho they aren’t mostly “stock picking” their approach is still mostly prone to the same criticism. but whereas you called for them to go back to passive, I’d still focus on the huge risk (“high octance” Adrian called it) they run even in the reference portfolio, and the returns on that just aren’t that impressive, relative to a reasonable corporate or govt hurdle rate/cost of capital. So i’d focus less on the active vs passive issue, and more on the establishment and continued operation of a risky leveraged fund at all.
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His radio reply was essentially that we think we are really smart investors and can spot business opportunities others miss. I have not enquired I get the feeling that many of those we saw it first business opportunities are rather undiversified ranging from Kiwibank, Z service stations and those Portuguese bank lines.
His reply today by letter also went on about how a good majority of their portfolio is passively invested and they do not engage in active stock picking. It would be interesting to see the Sharpe ratio on the non-passive part of their portfolio.
They should have two portfolios. The passive part and the rest and report separately.
I remember reading that one of the reasons why active funds do well for a while is a good part of their portfolio is effectively passive and well diversified so they are only gambling the lot that the small part of the portfolio.
To quote the reply by letter today:
“The majority of the Fund assets are invested passively in line with the Reference Portfolio.
When we invest outside the passive portfolio in order to add value and improve the Sharpe Ratio of the Fund, we seek investments that align with the NZ Super Fund’s endowments as an investor”
Would it be meaningful to ask under the official information act for a Sharpe ratio on these two parts of their portfolios?
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It is easy enough to calculate a Sharpe ratio on the returns to the Reference Portfolio (effectively their passive strategic asset allocation) relative to T bills using the data on their website. On my rough calculation it is about 0.37. on the active portfolio (deviation from the reference portfolio it has been about 0.45.
Personally, i downplay the distinction. After all, the reference portfolio isn’t some natural benchmark related to the structure of their liabilities, but a somewhat arbitrary (if not totally unreasonable) decision by the Fund about how to structure its baseload assets. It plays a more useful role for internal governance – enables the Guardians to see how much staff are adding by incremental “active” strategies – than for the wider public. The reference portfolio is also skewed to make their active choices look a bit better than they are: they argue that being a sovereign long-term investor with few liquidity constraints they can produce superior results, but none of those features are built into the expectations in the reference portfolio (which is all about global equity and bond indices, emphasising liquidity and high frequency revaluations).
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thanks, so the active portfolio added nothing over the reference portfolio?
Your other points are correct but I think that is a losing battle. Also the fund is not going anywhere so might as well minimise the risk in it.
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I guess the problem is that “minimise the risk” has little independent meaning – given the somewhat arbitrary way the reference portfolio is constructed. Simply adopting it as the actual portfolio wouldn’t be an obvious gain – compared to say a legislative change that mandated a different approach to risk and return (eg somethng that, say, restricted them to 50% equities, and no holdings in any company more than perhaps 5% of that company’s value)
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Thanks. I’d been meaning to have a go at his brief letter to the editor in the Herald rejecting your op-ed, so it might be time for another post.
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that said this in a letter just received
” We note from your email that your request was stimulated by a blog post of 23 February 2017.
For your information, there are some inaccuracies in that post. Without trying to be exhaustive,
these include:
• the actual standard deviation of monthly returns is about 2.8% rather than 3.3% as stated
in the blog;
• it is not practical to use monthly data to calculate the volatility of returns in the Sharpe
Ratio calculation because of the illiquid, infrequently valued nature of the Fund’s unlisted
assets (such as timber). For this reason annual returns are preferable when calculating
the volatility over time;
• publicly funded projects have very different risk and return characteristics to those of a
superannuation fund. Employees of a corporate pension plan would not necessarily have
their pension assets invested in their employer’s projects instead of a diversified portfolio
of equities and bonds, for good reason. And the use of hurdle rates of return without
reference to the underlying risk of the projects ignores a key part of the investment
decision. The NZ Super Fund’s returns should be compared to similar institutional funds,
on a risk-adjusted basis, rather than Treasury’s absolute discount rate. We do this using
global data and CEM benchmarking.”
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Thanks. I’ll double check the std devs – i just downloaded their spreadsheet, but perhaps i made a mistake (altho my own discussion focused on annual variances for the same reasons they cite). [UPDATE: Yes, found the error in my monhtly std devs – although my discussion and analysis and Sharpe ratios all used mostly annual data]
The rest is pretty unpersuasive – the superannuation fund example i used does not invest in employee stock, and NZSF has material exposures to the NZ economy (highly correlated with the ecnomic performance of its sponsor, the NZ govt, so providing little diversification in extreme circs)
And their assertions about the appropriate basis for comparison might make some sense if what we had was a wealth fund, but in fact we have a leveraged fund – which appears to be at least as risky as the typical crown investment project.
for anyone interested, the full OIA response Jim was quoting from is here
Click to access SUPERDOCS-%232147418-v1-Response_to_Jim_Rose_OIA_Sharpe_ratios.pdf
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Thanks to alerting me to their response to me is on the World Wide Web including with my email. I have complained to the Fund pointing out there is a Privacy Act.
The second after that letter was private correspondence that was not relevant to the Official Information Act request and should not have been put on the web.
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Adrian orr is at it again in the morning paper in the Vernon’s small column. Again, the attacks are personalised suggesting we are just stupid for disagreeing with him.
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I”m just writing a post in response now.
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I put in Official Information Act request to the super fund about its performance relative to the NZX50. Their reply was that “Since its inception in 2003, the New Zealand Superannuation Fund (after costs) has exceeded the NZX50 index by around 1.2% p.a. or an estimated $7 billion.”
The entire response will go up on their website pretty soon I assume
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Thanks. Will be interested to see their numbers – i just got my NZX50 series number from one of the providers like yahoo finance.
Checking again, it looks as tho their numbers are right – i must have been excessively approximate somewhere. Not sure how that difference can come to $7bn tho. 1.2% per annum for 13.25 years only compounds to about 17%, and even 17% of the current fund is less than $6bn, and obviously for most of its life the Fund was quite a lot smaller than it is now.
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The superfund still refuses to address my central question about risk and reward. Their main response is to say that they think they are pretty good
Have not seen much about written on whether leverage should be included in these type of funds.
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I just read their OIA reply to you. It is a fair cop that somehow I miscalculated the annualised NZSE50 returns, but actually i was struck by the chart they produced, which shows that it is only a year or so since the cumulative returns were the same on the two (notional) portfolios.
Since that is so, at most the difference in actual earnings isn’t $7bn, but something like $5bn, which could easily disappear in the next adverse market movement, as it has done previously.
That said, I agree with them that the NZSE50 isn’t the relevant benchmark – i only ever mentioned it in passing – but then (contrary to Adrian’s letter in the Dom-Post this morning) neither is their self-identified reference portfolio. The latter matters for their internal performance management purposes, but for citizens what matters more is the total (risk-adjusted) return. (For what it is worth – probably not much – i was interested that several of the other funds they quoted had done better than them in pre-tax terms)
Leverage is automatically factored in when doing something like a Sharpe ratio – it should increase both the returns and the variance of the returns.
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