Part 4: Investment strategy and related policies

Guardians of New Zealand Superannuation: Governance and management of the New Zealand Superannuation Fund.
Key messages
  • The Guardians have developed and implemented an investment strategy that meets the objectives of their founding legislation.
  • The investment strategy is supported by clear and measurable risk parameters that are regularly assessed and considered in the investment management process. In our view, the Guardians use appropriate due diligence processes to test the appropriateness and reliability of the investment strategy.
  • The investment management structure is appropriate for the agreed funding model.
  • The Guardians are in the early stages of their rolling 20-year investment horizon and will need to continuously assess and change their strategies to address the liquidity requirements of the Fund and the changing investment environment.

Investment funds are generally established to achieve particular aims, such as the provision of superannuation benefits, the continued support of an institution (such as a university), or to allow investors to buy a share of a pool of assets diversified in one or many sectors. Whatever its aim, an investment fund needs to have a strategy to guide its ongoing investment activity and to support this strategy with appropriate policies and procedures.

In this Part, we discuss the Guardians' investment strategy and related policies and how they relate to the Fund's legislative mandate and stakeholder expectations. We consider how the investment strategy is set, executed, and monitored by the Guardians, and report on how well related policies were working when we examined them at the end of 2007.

For the arrangements to be functioning well, we expected to find:

  • an established investment strategy;
  • measurement and management of investment risk; and
  • effective management of the Fund's liquidity.

Our findings

Since the Guardians were established, they have concentrated on defining and refining an investment strategy, which is formalised in the Statement of Investment Policies, Standards and Procedures (SIPSP).

Section 60 of the Act requires the Guardians to “establish, and adhere to, investment policies, standards, and procedures for the Fund that is consistent with their duty to invest the Fund on a prudent, commercial basis”. The purpose of the SIPSP is to set out how the Fund's assets are invested and how performance is measured. Management prepares the SIPSP and the Board reviews it annually. The SIPSP is a public document available on the Guardians’ website and in their annual publications.

The SIPSP sets out the investment strategy of the Fund, how the Fund measures and manages risk, and how liquidity is managed through the investment programme. The core consideration whenever investment opportunities are assessed is their fit and relationship with the SIPSP.

In our view, the Guardians use appropriate due diligence processes to test the appropriateness and reliability of the investment strategy.

Investment strategy

Section 58(2) of the Act requires the Guardians to invest the Fund on a prudent, commercial basis and to manage and administer the Fund in a manner consistent with:

  • best-practice portfolio management;
  • maximising return without undue risk to the Fund as a whole; and
  • avoiding prejudice to New Zealand's reputation as a responsible member of the world community.

The Act does not provide any guidance as to what is meant by "best-practice portfolio management", "maximising return", or "avoiding prejudice". The Guardians have defined these requirements in the SIPSP.

There are two elements to the Fund's investment strategy:

  • overall Strategic Asset Allocation; and
  • underlying targeted investment mandates.

Strategic Asset Allocation

The SIPSP requires the Guardians to adopt a Strategic Asset Allocation to determine the proportion of the total Fund to be held in any single asset class. The Strategic Asset Allocation is designed to balance the Fund's assets across market sectors, which will maximise returns in the long term while ensuring that the Fund is not over-exposed to risk from a particular security or market segment. The Strategic Asset Allocation is prepared by management and reviewed and decided by the Board. It is also subject to periodic external peer review.

As expected, the weighting applied to each asset class has changed over time. The weighting reflects the Fund's assessment of how changing market conditions affect each asset class relative to the expected risk and return. This approach demonstrates the Guardians' commitment to maximising long-term returns without taking undue risk.

The Fund manages investments in eight broad asset classes:

  • fixed interest and cash;
  • global small cap equities;1
  • global large cap equities;2
  • emerging markets equities;
  • New Zealand equities;
  • property (global and New Zealand);
  • private markets (alternative assets); and
  • Commodities (alternative assets).

Targeted investment mandates

The requirement to maximise long-term returns guides the Guardians towards constructing investment mandates that focus on asset growth strategies rather than income generation strategies. For example, investment mandates focus on assets generating net risk-adjusted returns rather than income, and can be designed around a particular element within the asset class that is expected to grow. This might include selecting:

  • growth industries;
  • securities in a business that has adopted a growth strategy;
  • securities that are managed in a certain way; or
  • securities with specific financial characteristics.

The Fund had five Investment Managers in 2003, increasing to more than 30 Investment Managers in 2007. Each investment mandate sets out how the funds that are passed from the Guardians to the Investment Manager will be invested. This includes:

  • restrictions on the types of securities held;
  • concentration of the portfolio;
  • markets from which securities can be traded; and
  • securities that the Guardians have excluded on responsible investment grounds.

The individual investment mandates collectively implement the Strategic Asset Allocation.

Hedging strategy

The size of the Fund relative to the New Zealand market and the requirement in section 59 of the Act to avoid long-term significant shareholding and controlling interests means that the Guardians will find it difficult to hold significant New Zealand-based assets in the Fund's portfolio.3 Therefore, the Fund holds a diverse range of foreign assets and is exposed to foreign currency movements.

The Guardians operate a hedging strategy that is largely passive. The primary objective of the strategy is to hedge 70% to 100% of the Fund's foreign currency exposures4 into New Zealand dollars by using forward exchange contracts.5The hedging strategy is agreed by the Board and outsourced under a separate investment mandate.

The Guardians manage exposure to foreign currency by measuring the net foreign currency risk for the entire portfolio. The hedging mandate restricts the external provider from operating outside predetermined risk bands or from using alternative instruments to manage currency risk. This reflects the passive nature of the hedging strategy.

Foreign currency forward-exchange products initiated by the Guardians are placed through the New Zealand Debt Management Office (NZDMO). We did not specifically review the processes adopted by the NZDMO as part of this performance audit. However, we understand that the NZDMO manages currency risk at an aggregate level for the Crown.

We reviewed the hedging mandate and discussed its purpose with the Chief Investment Officer in relation to the overall investment strategy, to understand why the Guardians elected to hedge some currencies and not others in light of the long-term investment horizon. After these discussions and a review of Board papers, we understand that the currencies in emerging markets are not hedged because the holdings are small, spread across a large number of currencies, and typically incur high transaction costs.

The Fund's main currency risk is from changes in the value of the New Zealand dollar and, to a lesser extent, changes in the major currencies in which the majority of its offshore investments are held. The Guardians can effectively and relatively cheaply manage this currency risk by hedging the largest exposures, which are to developed markets. This approach is also consistent with most major investment funds in developed countries. In our view, the Guardians' hedging strategy for the Fund is implemented appropriately and efficiently.

Setting and changing investment strategies

The process to set and refine the investment and hedging strategies is iterative and ongoing. There are a number of factors that require the Guardians to continuously challenge the Fund's Strategic Asset Allocation. These include the emergence of new products and new markets, and global events that affect the risk profile of certain investments.

The Guardians' investment strategy is determined by management and approved by the Board. Management considers a range of information in setting the investment strategy. This includes:

  • external and internal research;
  • changes in the expected future returns of asset classes;
  • opportunities in emerging markets;
  • the need to ensure that the portfolio is diversified; and
  • relative exposures within the existing portfolio.

The investment strategy includes tolerance limits for each asset class. This recognises that changes in the market values of securities can also change the weighted value of each asset class. The Guardians have adopted tolerance bands to avoid making unnecessary and costly transactions to change their buy and sell positions in order to rebalance the Fund's portfolio. The Portfolio Committee is responsible for monitoring the portfolio's compliance with the Strategic Asset Allocation within the agreed tolerance bands. Section 3 of the Guardians' Investment Funding Policy sets out the process for the Portfolio Committee to make unplanned rebalancing in response to unforeseen events or market volatility.

We reviewed the process to set, implement, and change the investment strategy. In our view, the Guardians use appropriate due diligence processes to test the appropriateness and reliability of the investment strategy. The due diligence processes are supported by the detailed portfolio analysis done by the Guardians, and the clearly defined decision-making framework set out in the Portfolio Committee's terms of reference.

However, we noted limited scope in the delegated authorities, investment mandates, and the management committees' terms of reference for management to influence investment activity without the Board's direct input.6 In our experience, global pension funds and sovereign investors can appropriately delegate to management investment decision-making that does not have a material effect on the portfolio. Given the growth of the Fund, it is possible the Board will expend considerable effort in approving investment decisions that do not significantly affect the portfolio. One commonly used method of addressing this issue is to create bands within which management can make decisions.

Recommendation 9
We recommend that the Guardians of New Zealand Superannuation review how the Board approves investment activity to ensure that responsibility for investment decisions is delegated to management where appropriate.

The 2007 Statement of Intent required the Board and management to consider ways to make more dynamic asset allocations. The Board recently reviewed a process for changing asset allocations. We examined that process and noted that it is appropriate and supports the formal separation of the Board and management.

Process for entering into new investments

The Guardians review the Strategic Asset Allocation periodically and consider changes to existing investment strategies for each asset class. The review is conducted by management and approved by the Board, along with any required changes. The review considers the broad investment strategy relative to the investment mandate of the Fund, and changes to the markets within which funds are invested. Outside this broad planning process, management continuously analyses and considers new approaches for investing within each asset class, subject to Board approval. This analysis includes ongoing assessment of existing investment mandate performance, consideration of new market opportunities, and assessment of risk.

The Board assesses management's review of the annual investment strategy against the Strategic Asset Allocation. If a change or new strategy is considered appropriate, the Board will also determine appropriate risk parameters. The Guardians' approach is consistent with processes applied by leading investment funds to develop new products and investment mandates.

Once a new or updated investment mandate is finalised, the Guardians select an Investment Manager to execute the investment mandate. The Guardians' selection process is sound and consistent with the requirements of external provider selection processes promulgated by regulators. We discuss the Guardians' selection, management, and monitoring of contracts with Investment Managers in Part 5.

The investment mandate arrangements agreed with Investment Managers clearly address the requirements of the Fund's investment strategies. The Portfolio Committee is responsible for ensuring that the individual investment mandates collectively correspond to the overarching Strategic Asset Allocation.

We assessed the processes for reviewing the investment strategy and establishing new investment mandates. The Guardians' processes were sound and applied widely used techniques for assessing investment performance and risk. The primary purpose of the Guardians' processes is to either reaffirm or reassess the investment principles and related strategy. The review process considers changes to market conditions, new investment opportunities, and the ongoing appropriateness of previously adopted strategies.

External review of investment and hedging strategies

The Guardians have considered the reasonableness of investment and hedging strategies for the Fund by:

  • benchmarking the objectives of the Fund to peer organisations with consistent objectives; and
  • obtaining advice from external experts.

Internally, the Guardians review asset class performance against several benchmarks, for example, general index and market benchmarks, and those internally determined. All investment mandates include benchmark performance indicators for assessing an Investment Manager's performance. Benchmarking also extends beyond individual investment mandate performance to include benchmarking of the Strategic Asset Allocation to organisations with similar long-term investment objectives. Further, in accordance with the August 2004 Review of Currency Strategy, the hedging strategy is benchmarked to New Zealand dollars, recognising that the Guardians define their role as producing returns from the Fund in excess of the cost of Crown debt.

We reviewed the February 2005 "Finalisation of the Revised Strategic Asset Allocation" presented to the Board by management. We concluded that the Guardians are thorough in selecting who provides advice on the investment and hedging strategies, and in ensuring that this advice challenges the current position.

However, it has not always been clear whether the appointed investment adviser was selected by the Board or by management. It is important that the Board, because of its overseeing role, directly selects the investment adviser who will perform the periodic peer review of the Strategic Asset Allocation and related investment strategy. Ongoing advice, consultation, and review by external parties are important because asset allocation provides about 80% of the returns to the Fund under its investment strategy.

Recommendation 10
We recommend that the Guardians of New Zealand Superannuation formalise the periodic independent review of the Strategic Asset Allocation, and consider independence from management when selecting the investment adviser to conduct the review. The scope of work agreed with the adviser should also include validation of individual asset class benchmarks applicable to the Strategic Asset Allocation.

Alternative asset classes

The Guardians have diversified asset allocation since a review in June 2004.7 Specifically, the Guardians have increased the Fund's exposure to alternative asset classes. The Guardians see the role of alternative asset classes during the life of the Fund as important and have set a long-term goal for 25% of all Fund assets to fall under this category - referred to as Private Markets.

Given the mission of the Guardians to maximise long-term investment returns without undue risk, the Strategic Asset Allocation places a strong emphasis on growth assets. Growth assets, such as shares and property, typically generate high levels of capital growth with moderate levels of income over time. Alternative assets are privately traded assets geared toward capital growth. The Guardians have identified Private Markets in constructing the Strategic Asset Allocation to focus on growth assets. Private Markets are more difficult to trade than listed securities. These include New Zealand and global private equity, timber, and infrastructure. The growing significance of alternative assets in the Fund's Strategic Asset Allocation is illustrated in Figure 6.

Figure 6
Increase of alternative assets in the Strategic Asset Allocation since 2004

Figure 6: Increase of alternative assets in the Strategic Asset Allocation since 2004.

There is a high degree of awareness within the Guardians of the risks associated with investing in alternative asset classes. Private Markets and alternative assets are not always subject to the same degree of transparency as public securities and assets. Public securities are subject to public scrutiny and accountability through market regulatory processes, which enables their market value to be more easily assessed in terms of price-to-asset ratios. Private Markets and alternative assets face increased risks relating to accurate valuation, responsible investment, and determining the risk-adjusted returns of the asset class. These are market risks that all investors in alternative assets have to manage.

The Guardians' awareness of these matters is illustrated by additional processes they have put in place to manage alternative assets:

  • establishing a Private Markets Committee to oversee all investments in this asset class;
  • applying additional due diligence procedures for Investment Managers of alternative assets;
  • seeking to pay performance fees to Investment Managers of alternative assets over a longer time horizon to be consistent with the long-term nature of the investment; and
  • embedding governance and internal controls in investment mandates for alternative assets. This means that the Investment Manager is required to invest in assets that have formalised governance and assurance frameworks.

In addition to the current processes, the Guardians plan to establish a Private Markets team by the end of 2008. The focus of the Private Markets team will include ongoing due diligence procedures for existing and new Private Markets investments and Investment Managers.

Currently, the target allocation for Private Markets assets of 25% of the total asset allocation includes:

  • one fifth to commodity futures (that is, 5% of the total asset allocation); and
  • four-fifths to remaining Private Markets (that is, 20% of the total asset allocation). This is defined as infrastructure, timber, private equity, and "other". Each of these has an individual range (mostly 0% to 10% of the remaining Private Markets assets) as well as collective ranges (10% to 30% of the remaining Private Markets assets). The characteristics of each asset class have been well defined. The allocation to "other" represents 5% of the remaining Private Markets assets. The Fund currently has no assets in this category. The 5% "other" is designed to allow for new investment opportunities arising outside the annual Strategic Asset Allocation review process. The Guardians can invest in any asset class under this category that is not already defined by the existing 95% of allowable assets. Controls over new investments and portfolio compliance ensure that asset purchases cannot be made under this category without appropriate Board approval.

The Guardians' definition of Private Markets is specific and applies restrictions on assets within this class. However, the decision-making authority that the Board has delegated to management is not linked to these definitions or the form by which these investments can take place. The Guardians' current definition of Private Markets includes a category of "other". This is open-ended and as such does not exclude assets that they do not intend the Fund to hold, or which should be subject to different considerations and delegations. This is because relevant asset classes have not been defined within the definition of Private Markets assets. This is not an issue for the Guardians because the current authority delegated to management does not extend to specific investment or divestment decisions. At the time of our performance audit, the Guardians had no intention to delegate such authority.

Management of investment risk

All investment fund managers need ways to manage investment risk in accordance with their strategy. We reviewed the Guardians' approach to investment risk management by examining risk management policies, interviewing senior management, and observing various risk management processes.

We identified four main methods of managing investment risk:

  • understanding and accepting risk exposures of individual investments relative to their asset price and expected return;
  • diversification of assets and strategies within assets, to spread and, where possible, to offset risk within the asset portfolio;
  • analysis of market sensitivity analysis to forecast the potential effect of possible changes in markets in the future; and
  • use of derivatives to cap or control risk exposures.

Understanding and accepting risk

The Guardians perform ongoing analysis to consider the expected return ratio for investments and re-weight the Fund portfolio accordingly. Changes in price affect the asset value within the portfolio, and sharp changes in market prices for the specific asset classes requires the Guardians to reassess and possibly change the target Strategic Asset Allocation. The Guardians can make "out of cycle" changes to the Strategic Asset Allocation if risk increases relative to prices or if expected returns change. This includes the use of derivatives, selling positions (subject to the approval of the Board), or changing the asset allocations in the Strategic Asset Allocation (subject to the approval of the Board).


The Guardians achieve diversification in different ways:

  • The Guardians have a long-term investment horizon, and seek to take long-term positions in various asset classes consistent with their long-term asset allocation strategy. This allows the Fund to continue to hold assets when faced with short-term market fluctuations.
  • The Guardians generally take small interests in a security. All of the Guardians'
  • investment mandates prevent Investment Managers from taking large holdings in a single security. This means that, within the total portfolio, the Fund holds a large number of relatively small positions.
  • Portfolio monitoring is performed every day by the Guardians' Investments Operations team, which receives daily checks on information provided by the Custodian.
  • Every two weeks, the Portfolio Committee formally reviews the portfolio relative to the Strategic Asset Allocation. If asset weighting is outside pre-determined tolerance bands, assets will be sold or purchases made to reposition the portfolio within acceptable bands. This process is managed through the Portfolio Committee in accordance with its terms of reference. The portfolio review ensures that the overall asset mix within the portfolio remains consistent with the requirements set out in the Strategic Asset Allocation.

Market sensitivity analysis

The Guardians have developed a data warehouse to receive investment information from the Custodian. This information is used to analyse the risks associated with particular asset types within the Fund's portfolio and to generate reports that simulate market movements. This allows the Guardians to forecast the effect of market movements if changes are made to securities held by the Fund. The process is used to assess ongoing exposure to various classes of investment risk.


The Guardians also use derivatives to manage the effect of market volatility. Derivatives can be used to cap an exposure to a particular market cycle depending on the objective of the Guardians.

At the time of our performance audit, the Guardians had only ever used derivatives to gain exposure to market risk rather than limiting market exposure. However, scope exists within existing policies and delegations to use derivatives for financial risk management purposes. In markets where a significant portion of the Fund's portfolio is invested the Guardians split the responsibility across the pool of Investment Managers. It would not be appropriate or efficient for the Guardians to ask individual Investment Managers to manage market risk. As such, the use of derivatives to manage financial risk is appropriate given the strategy of the Fund and the use of external Investment Managers.

Management of fund liquidity

Liquidity management is the process of managing cash flows arising from investment activities. For the Fund, this includes the fortnightly capital contributions from the Crown and the cash flows arising from the sale and purchase of securities, dividend and interest receipts, and settlement of derivative contracts. We reviewed the process to set and receive funds from the Treasury on behalf of the Crown, and management of investment transaction activity.

Determining funding levels

Section 43 of the Act sets out how the total annual capital contribution to the Fund will be calculated by the Treasury. The Guardians have no specific role in determining whether future pension obligations are under-funded or over-funded. It is the Treasury's role to determine the Crown's Projected Superannuation Obligation in relation to New Zealand Superannuation.

The Treasury is required to calculate the annual contribution amount in accordance with the Act. Once this amount is determined, the Guardians agree a Contribution Payment Schedule with the Treasury. That schedule states how and when cash will be passed to the Fund. The Guardians are not required to check the Treasury's calculation of the annual contribution amount.

The Guardians use the agreed Contribution Payment Schedule to forecast and manage Fund liquidity. The primary objective of this process is to ensure that funds are passed to Investment Managers in a timely manner, based on a predetermined allocation. This is to minimise the opportunity cost to the Guardians associated with holding cash. This process is also used to manage cash for the purposes of acquisitions and disposal of assets of the Fund.

The Portfolio Committee is responsible for the allocation of funds to Investment Managers for management under their respective investment mandates using their funding model. This is a planned and systematic process designed to keep the Fund in compliance with its Strategic Asset Allocation. However, where major acquisitions or outward cashflows occur (for example, tax) this process is also used to source the necessary funding from current mandates or asset classes.

The actual date when the Crown is expected to start making withdrawals from the Fund has not yet been set, although section 47 of the Act prohibits any withdrawals before 2020. The withdrawals will ultimately be taken into consideration in the annual Strategic Asset Allocation review process as the first withdrawal date approaches. The size, extent, and method of withdrawal are not currently known. As the Fund approaches the date of cash delivery, it will become more significant for the cash delivery model to be agreed with the Treasury. In our view, the cash delivery model should be finalised and agreed at least five years before the date that cash flow streams start to go from the Fund to the Crown.

Our conclusions

The Guardians have developed and implemented an investment strategy that meets the objectives of their founding legislation. This strategy is supported by clear and measurable risk parameters that are regularly assessed and considered in the investment management processes. The Guardians' investment management structure is also appropriate for the agreed funding model.

The Guardians are in the early stages of their rolling 20-year investment horizon and will need to continuously improve their strategies and operations within a constantly changing investment environment.

1: Small cap refers to stocks with a relatively small market capitalisation. The definition of small cap can vary among brokerages, but generally it is a company with a market capitalisation of between $300 million and $2 billion.

2: Large cap refers to companies with a market capitalisation between $10 billion and $200 billion.

3: As at 31 October 2007, 24% of the Fund's assets were New Zealand-based.

4: In this context, exposure is the measure of risk associated with holding a proportion of investments of a portfolio in a particular type of asset category, country, or other.

5: The seven foreign currencies are American dollars, Euros, British pounds, Japanese yen, Australian dollars, Canadian dollars, and Swiss francs.

6: That is to say, beyond the management's standard allocation of the fortnightly distribution to Investment Managers, or the re-weighting of the asset allocation model.

7: Independent Review of the Guardians of New Zealand Superannuation. The first Independent Review of the Guardians, conducted by Jonathan Eriksen, was tabled in Parliament in November 2004. The review is available on the Treasury's website at

page top