There are other risks that need to be addressed as well and in the case of unlisted property liquidity risk would have to be assessed as well.

Risk as the Central Thesis

The reference portfolio model of allocating assets is becoming an increasingly common method of investing and large global pensions funds, including Singapore’s GIC and the Canada Pension Plan Investment Board, are amongst its disciples.

One of the more recent funds to embrace this idea is the Norway’s Government Pension Fund Global, which started to transition in 2014, after a review suggested it needed to diversify its asset allocation more.

In short, the benefits of this model over a more traditional asset allocation approach include the centralisation of risk as a core element in investment decisions, liberating investment managers from the constraints of asset buckets and providing clarity in conversations with board members who might not have a deep understanding of the more complex strategies and financial instruments.

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The opportunity cost of capital to fund the private investment is how we reference [an investment] back to the reference portfolio.

The $28.3 billion New Zealand Super Fund implemented this model in 2010 and reviewed its reference portfolio for the first time last year.

It further simplified the reference portfolio to hold 80 per cent equities, including 65 per cent developed market, 10 per cent emerging market and 5 per cent New Zealand equities, and 20 per cent global fixed interest.

It took out a five per cent global listed property exposure out to reflect a heightened focus on liquid markets.

New Zealand Super Fund head of asset allocation David Iverson explains that in order to invest in asset classes not found in the reference portfolio, such as private market assets, the fund needs to sell a select number of assets that have in aggregate a similar risk level as the new investment.

“The first thing we do is to keep the risk in our market portfolio with private assets the same as the reference portfolio risk and to do that we have to come up with reasonable risk estimates,” he says in an interview with [i3] Insights.

“Take property for example, unlisted property has a very similar risk characteristic to listed property. We will come up with a realistic forward-looking estimate of risk, which is similar to the listed equivalent and when we sell down reference portfolio assets, we sell down bonds and equities to fund a real estate investment, we are selling down a suitable risk adjusted amount to fund that investment.

“So that becomes the opportunity cost of capital to fund the private investment and that is how we reference it back to the reference portfolio,” he says.

There are other risks that need to be addressed as well and in the case of unlisted property liquidity risk would have to be assessed as well.

“We need to jump certain return hurdles before we invest, but once we’ve done that we keep the risk the same as in the reference portfolio,” Iverson says.

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If you would write a book about the reference portfolio model only three people would read it.

Risk is close to Iverson’s heart …, so close in fact that he felt compelled to write a book about it titled ‘Strategic Risk Management: A Practical Guide to Portfolio Risk Management’.

“It was based on the sum of my experience in investment consulting and management. It lays out the key risks, the top level being governance then asset allocation risk, market timing risk and manager selection. It breaks down all those risks and then digs into what sort of decisions need to be made at each of those risk levels and how to best mitigate or manage those risks.

“Maybe the subtitle could have been: ‘How to set up and run an institutional fund’,” he says.

The book is not a simple treatise of his fund’s reference portfolio model, he says.

“If you would write a book about the reference portfolio model only three people would read it.

“There are so many different models floating around and there are different sorts of truth, but I wrote about the key areas that I think need to be covered off.

“When I joined the industry, I couldn’t find any sort of book that gave a comprehensive overview of the decisions you need to face as a trustee or an investment executive.

“So the book is aimed at institutional investors and it discusses issues such as: ‘What sort of questions should you ask an equity manager? How do you measure their performance or returns against the style of the manager?’

Iverson has had a diverse career that includes both the brokerage business, consultancy and asset ownership. He feels that this has helped him getting a better picture of the various cogs and wheels in the financial engine.

“The levels of the industry that you see helps form your understanding; seeing it from a transactional level as a broker and then moving up the food chain as asset manager to see the structure of the industry and the incentives that managers face when they have institutional funds that they are reporting to and then how they interact with the brokers.

“You are getting a good view of the incentives, the institutional constraints and the market dynamics at each level of the industry. That certainly helped me get a better appreciation of how the financial web fits together.

“I couldn’t have written that book unless I had seen a big enough spectrum of the industry,” he said.


[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.