Matt Whineray: Active versus passive investment
OPINION: One of the topics brought up in recent debates about the New Zealand Superannuation Fund is the difference between active and passive investment.
The contention is that the Fund, which invests actively, will not be able to sustain its track record of out-performing the market over time and a wholly passive fund would be better.
Active investing is difficult and not worth doing in many markets, and we agree that active investing costs more. This is why the majority of the Fund is managed passively – two thirds is invested in line with an index-linked Reference Portfolio. This is a diversified growth portfolio (80 per cent shares, 20 per cent bonds) that is fully implemented passively at a low cost.
But active investment has some big benefits: in our case, it allows us to increase diversification and fully utilise our natural advantages. As a result, we have earned significant rewards with little additional risk.
We have two relevant investment beliefs:
True skill in generating excess returns versus a manager's benchmark is very rare. This makes it hard to identify and capture consistently
Investors with a long-term horizon can outperform more short-term focused investors over the long-run
The first belief forces us to be very clear about why any particular active strategy could improve the performance of the Fund (whether through lower risk or higher return, or both). Our commitment to selective active investing is informed by research and best practice in the investment industry and supported by well-established views in the industry. (ACC's highly successful investment team is also an active investor.)
The second belief is relevant to how we choose to undertake active investing. The Fund has some natural advantages which mean it is ideally placed to be a successful active investor. It has a long time horizon, a known liquidity profile, operational independence from the government of the day and sovereign status. We combine these advantages with a disciplined, transparent approach that keeps all active and passive investment decisions separate.
The Reference Portfolio forms both the core of the Fund's actual portfolio, and its passive benchmark, a hurdle that active investments have to surpass to add value. It clearly establishes the opportunity costs of all of the Fund's active investment decisions.
We invest actively only when there are clear benefits (after all costs) in doing so. We carefully determine the amount of risk that can be taken in different areas.
Our active investments fit into three broad categories.
The first contains investments that help diversify the Fund's portfolio. Examples include our New Zealand timber and rural assets. These investments exploit the Fund's long investment horizon and known liquidity profile.
The second category, which also exploits the Fund's long investment horizon, contains investments that respond to current market pricing: adding exposure to asset classes that are relatively cheap and lowering exposure to those that are relatively expensive. Our decision to 'double down' on equities during the Global Financial Crisis is a case in point.
The third category, asset selection, contains investments that rely on the ability to select individual assets that will outperform relevant benchmarks. This is what is usually referred to by detractors of active investment. We agree with the contention that picking stocks in efficient markets is a zero-sum game (what one manager gains, another loses, and everyone pays fees). This is why we use very little of this type of active investing and, where we do, it is focused on specific opportunities where there is persistent evidence of market inefficiency.
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 value is highlighted by the fact that the Fund has outperformed its Reference Portfolio by $5.5 billion after all costs since inception. In doing so, the Fund has earned more return per unit of risk than the passive alternative. Taxpayers have had great value to date from our active investment approach.
Not every active investment (nor every passive one) will work out. And not every year will see a positive return from our active investments – trying to target this for each year would stop us from properly exploiting our long horizon.
We have every confidence, however that the Fund's active investment portfolio will continue to create substantial value for taxpayers.
The Fund is well-diversified across many thousands of companies, sectors and global markets; the amount of risk being taken is carefully managed; our approach to active investment is highly selective and aligned to the Fund's natural advantages; our active risk positions are, themselves, diversified; and we are very transparent about whether or not active investment strategies are adding value. Everyone can see it every month in our performance reports.
Matt Whineray is chief investment officer of the New Zealand Superannuation Fund.