New Zealand Super has added commodities to its strategic tilting program, taking views on corn, copper and oil.
The commodities program has only a small allocation since it is still in the initial implementation phase, but is on track to become an important part of the broader program that has added 1.1 per cent a year to fund returns since its inception 10 years ago.
“We have brought commodities online: corn, copper and oil. Those are the ones that have fundamentals that are conducive to mean reversion. Other ones a little less,” David Iverson, Head of Asset Allocation at NZ Super, said at the [i3] Global Investment Strategy Forum in Singapore last month.
If I were a market timer, I would buy right at the bottom and sell at the top. But that is not what we are doing, because once it falls below our fair value estimate we start going long
“We haven’t gone to full weight on this until we confirm that our models are behaving as expected and get comfortable trading these markets.
“Some of the positions we want to trade are not that liquid, which is part of the challenge, so scaling up may be a bit of a challenge. And then we are also refining our valuation models; that has been an area of focus.”
The strategic tilting program is essentially a form of dynamic asset allocation in which the team takes views on equity, bond, credit and currency markets, and now also commodity markets.
The team does this mostly on a country basis and sets fair value targets for each of these markets.
“The basis of this approach is pretty simple: it is taking a long-horizon view on the underlying fundamentals of equity and bond markets and we do this by country,” Iverson said.
“For equities, we look at what the normalised earnings are for the US equity markets and the Japanese market, for example. What is the risk premium likely to be in the long run for these countries?
“And given where rates are now, where do we think these will settle in the long term? It is thinking about long-term real rates and inflation that gives us our valuation.
“We compare that valuation for all of those markets against the prices that are available. If they are cheap, we are going to go long and if they are expensive, then we are going to go short.”
The program is different from market timing as it only observes prices relative to the estimated fair values and does not try to call the peak or trough of a market.
“If I were a market timer, I would buy right at the bottom and sell at the top. But that is not what we are doing, because once it falls below our fair value estimate, we start going long,” Iverson said.
The strategic tilting positions are reviewed every day and most days the team makes some adjustments.
“Say you have a 2 per cent long position on and things get a little bit cheaper, then you might go to 2.1 per cent. So on the day, I’ve got a 10-basis-point trade that we are putting on,” Iverson said.
“We trade through derivative markets, so we trade exclusively synthetic instruments: futures for equities, interest rate swaps or futures for bonds, credit default swaps for credit and forwards for currencies.”
The strategic tilting program is unusual among institutional investors, so much so that a recent independent review of the fund’s activities by Willis Towers Watson recommended confirmation of the board’s level of comfort with the allocated risk budget to this program.
The board has since confirmed it remains comfortable and is supportive of the program.
But the returns from the program do tend to be lumpy.
We trade through derivative markets, so we trade exclusively synthetic instruments: futures for equities, interest rate swaps or futures for bonds, credit default swaps for credit and forwards for currencies
NZ Super’s most recent annual report shows that over the 2019 financial year, the risk basket of market pricing, of which the strategic tilting program is the main part, added only 0.17 per cent to returns, while two years earlier this was 2.27 per cent.
Yet, Iverson said he doesn’t plan to move away from the country focus to make the tilting program more granular as he questions whether this would add much value.
“We probably wouldn’t get more granular. There is a possibility to look at sectors and we’ve toyed with that idea. You can do that for the largest market, which is the US, where there is a decent sectoral breakdown,” he said.
“But with adding new markets, or getting more granular, you are getting more complexity and greater overhead in running those strategies. You would have to trade it off against the additional return you would get in doing that. We are always balancing that off.
“Right now, the next thing is commodities and commodities are very different. We do that ahead of looking at sectors. We may do sectors in the future, but not at the moment.”