Volatility and Risk
Te kumukumu me te tūraru

Volatility and risk:
understanding the difference

 

For the Fund to meet a significant portion of the future cost of New Zealand Superannuation, the ability to take market risk to earn investment returns over long periods of time is crucial. But market risk means the Fund will experience mark-to-market losses from time to time when financial markets fall in value.

In addition to taking market risk, the Fund’s endowments (long-term horizon, known cash flow profile, operational independence and sovereign status) enable it to embrace active, contrarian investment strategies in order to further enhance returns.

 
THE FUND TAKES MARKET RISK TO EARN INVESTMENT RETURNS OVER THE LONG-TERM

In keeping with the Fund’s long investment horizon (no sustained withdrawals are projected until the 2050s), and in order to meet its mandate of “maximising return without undue risk”, we have deliberately weighted the Fund towards growth assets (80% equities, 20% fixed income). This is a similar approach to the “growth” mandates offered by typical KiwiSaver funds.

The Fund’s high exposure to growth assets is set by the Board in the Reference Portfolio, a simple passive low-cost portfolio of listed equities and bonds that serves as a benchmark for the Fund’s investing activities.

In the short-term, growth assets can be volatile, moving up and down in price. The Fund has the ability to ride out and potentially benefit from these short-term movements. In the long-term, the Fund’s exposure to market risk from growth assets such as shares is expected to pay off in the form of higher returns than the cost to the Government of contributing to the Fund.

 

THE FUND USES ACTIVE INVESTMENT STRATEGIES TO EARN ADDITIONAL RETURNS

The Fund uses active investments to diversify away from equity markets (for example, into timber and rural land). It also employs active investment strategies that take advantage of its long-term horizon and known cash flow profile, such as investing in illiquid, privately held assets.

The Fund has the ability to act as a contrarian investor, buying when other investors are selling (and vice-versa). This is the purpose of the Fund’s strategic tilting programme, which uses derivatives to take positions across a number of investment markets (equity, bond and currency). This programme relies on a belief in mean reversion in asset prices towards fair value and is a buyer of “risky” assets during financial market downturns. Since the tilting programme began in 2009, it has been a significant contributor to the value the Guardians has added to the Fund. See page 40 of the Annual Report for further details.

 
IN A MARKET CRISIS, THE FUND MAY SUFFER LARGE FINANCIAL LOSSES

By taking on the market risk associated with growth assets, the Guardians accepts the risk that markets may experience sharp drops in value, be they driven by financial or political shocks, large commodity price movements, natural disasters or war. It is largely unavoidable that a growth-oriented portfolio such as the Fund will fall in these periods.

The Fund is well-placed to withstand such losses, as there is no immediate need to withdraw capital from it.* Short-term, volatility in the Fund's return is an expected outcome of the Board's choice of the level of equities in the Reference Portfolio. These fluctuations can be treated as “paper losses” with little long-term ramifications for the Fund’s ability to fulfill its purpose.

* On current projections, sustained withdrawals from the Fund begin in 2053.

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