Dynamic asset allocation is a valuable source of diversification when running a liability aware investment portfolio, according to ACC’s David Iverson
When investing an investment portfolio for an insurance-style organisation, such as New Zealand’s Accident Compensation Corporation, the best way to do this is to match its liabilities.
Traditionally, insurance companies have done this by investing large portions of their investments in fixed income instruments, which throw off a steady and predictable income stream.
But sometimes the bond markets produce particularly little income, as was the case in the 15 years after the global financial crisis. Even in good times, bonds tend to have somewhat different durations than the time horizon of an organisation’s liabilities.
In that case, active management and dynamic asset allocation (DAA) can provide a diversifying source of returns, according to David Iverson, Head of Dynamic Asset Allocation at the ACC.
Iverson joined ACC in 2021, after spending more than 12 years at New Zealand Super, where he was instrumental in establishing the strategic tilting program, a form of DAA.
“Where we fit in is, we bring a source of return that we had proven to be successful at NZ Super, and diversify the sources of alpha at ACC, because active returns are just the most important thing we can do,” Iverson says in an interview with [i3] Insights.
Where we fit in is, we bring a source of return that we had proven to be successful at NZ Super, and diversify the sources of alpha at ACC, because active returns are just the most important thing we can do
“If you can’t get bonds to fully match, and equities are a mismatch – you can’t guarantee they’re going to deliver returns – then you need to diversify,” he says.
In the context of an insurance-style organisation like ACC, DAA is particularly powerful as the incremental level of risk from the program is negligible under the net asset liability risk calculations.
“Let’s say the volatility of the portfolio is seven per cent, then we would only add a few basis points [risk to that]. It goes to 7.1 per cent, or something of that order. But that is at the asset level only,” Iverson says.
“When you think about assets versus the liabilities, the 0.1 per cent added to the asset volatility, won’t be seen at the net asset liability risk level. The returns drop straight to the bottom line,” he says.
And since ACC has liabilities that sometimes run the lifetime of a member – for example, in the case of permanent disability it can be around an 80 year commitment – it is hard to simply match these with existing assets. DAA helps with these liabilities in providing just that little extra return.
“The issue we’ve got is with very long-tailed liabilities and short-dated asset instruments, from the matching perspective. But if you can get returns without a lot of risk, that’s gold,” Iverson says.
Building on Solid Foundations
NZ Super’s strategic tilting program was started in 2008 under Neil Williams, who previously ran a DAA program with Brian Singer at UBS. Iverson, who was appointed as Head of Asset Allocation in 2009, was heavily involved in shaping the program in the following decade.
The program started small, as the board gained confidence in the process. But at ACC, Iverson was able to start with a much broader set of asset classes, including equities, bonds and currencies, as DAA had proven to be a persistent source of alpha.
“[At NZ Super] we started originally with a very basic program, which had very few levers, and there was a problem, because you need diversification, you need more levers. We have the benefit of taking all the experience that I’d gone through at NZ Super and starting off with a well-diversified set of instruments,” he says.
Matt Whineray, former CEO and CIO of NZ Super, revealed in a previous interview with [i3] Insights that in the early days of the strategic tilting process, the fund ran up a currency position that ballooned to 40 per cent of the net asset value of the total fund.
Iverson says this is an example of why you need more levers to run a DAA process.
“It is very important to get diversification right up front, get the program that you want to implement up front,” he says.
“We had very few levers back then. It was a lot in currency and it was a lot in the NZ Dollar versus the rest of the world,” he says. “We don’t have that here. We do all cross-currency pairs.”
This doesn’t mean he plays in every single asset class, although he is thinking of adding credit derivatives to the program.
“Adding another equity market doesn’t actually do too much. Adding another bond market doesn’t do too much. The one we’re looking at, but haven’t yet implemented, is probably credit. But we do need to have credit synthetics created before we trade them,” he says.
Concentration of Markets
The increasing concentration of the US equity market, with the dominating performance of the Magnificent Seven, has made DAA more difficult.
Although a number of superannuation funds in Australia have tried to mitigate the impact of these seven technology stocks on the overall performance of international equity portfolios by taking a direct exposure to a basket of these stocks, Iverson does not have this luxury. He can only implement views by using derivatives over broad indices, not take views on individual stocks.
“The problem I’ve got, that everyone faces, is the concentrated nature of these companies means individual company announcements and events will affect the overall index. And the big ones affect the index more. This has been a big issue,” he says.
“I’ve got to short everything. So we benefit from Nvidia coming off to the extent it affects the S&P 500 or the NASDAQ futures, but I’m not trying to pick whether Nvidia is going to fall or Meta is going to fall or go up,” he says.
The problem I’ve got, that everyone faces, is the concentrated nature of these companies means individual company announcements and events will affect the overall index. And the big ones affect the index more. This has been a big issue
He has been keeping a close eye on the Magnificent Seven and views a number of them as being richly priced. But capitalising on this view is tricky because it is hard to tell how the individual stocks will affect the broader market.
“The more concentrated it becomes, the more idiosyncratic it becomes, the more momentum tends to drive things, which is exactly what you’ve seen. We had a massive rally post-COVID with all the money printing and government spending.
“We then had rate hikes and that came off in the US and it was already concentrated back then. And then we had excessive concentration with the AI rally. That’s very hard to fight.
“It just looks expensive, but when you’re dealing with an index future and you’ve got a few names driving a large portion of what’s going on in the index future, that’s where it becomes problematic. We’ve got a blunt tool to deal with concentration issues,” he says.
Internalisation and Fees
Returns are one part of the equation, but fees are equally important in managing liabilities. After all, producing great returns is not helpful if the level of fees is so high that it erodes the net performance.
To minimise cost, ACC has been an early adopter of in-house management. The fund runs internal teams for New Zealand and Australian equities, New Zealand bonds and private assets, including real estate and infrastructure. It still outsources the management of global equities and global bonds, but these form a relatively smaller portion of the overall portfolio.
Internalising has enabled the team to run the investments at a very lean cost base.
“To give you a sense of the cost of running the organisation, we run the whole thing at about 15 basis points. It is extremely low cost, which helps the levy payer and reduces the costs of insuring accidents. So we were longtime adopters of internalised asset management before it became a thing,” Iverson says.
Yet, there is a limit to the extent you can reduce fees, he says.
“Our history of success is that we’ve even been pretty good at manager selection, and it is enormously helpful to diversify alpha and to try and replicate a successful program like NZ Super’s,” he says.
“Clearly, you want to lower costs, but not minimise them. That is passive management,” he says.
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[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.