All money should be invested offshore
If the Big Cullen Fund were launched today, the initial optimal long-term strategy, from a theoretical perspective, is 100% in overseas growth assets, held passively, actuary Michael Chamberlain says. This is also the most practical solution though politically, it might be unacceptable.
If the Big Cullen Fund were launched today, the initial optimal long-term strategy, from a theoretical perspective, is 100% in overseas growth assets, held passively. This is also the most practical solution though politically, it might be unacceptable. This article looks briefly at the reasons why this is the right approach.
Understanding the liabilities
For an investor (in this case the guardians of the Big C) to determine an investment strategy, they must understand the fund’s purpose and the liabilities the fund must ultimately meet. The investment strategy will fail if the investment outcomes don’t achieve the purpose and meet the liabilities. There are two key characteristics of the Big C’s liabilities that distinguish it from other pools of money:
- First, no income (ie: NZ Super payments) is required for 30 years. Accordingly short-term liquidity is not an issue so an immediate, steady stream of regular income is not required. The fund needs long-term growth. We, the taxpayers, need the fund to be as big as it can be in 25 to 30 years.
- Secondly, from a risk management perspective, the fund must protect New Zealand taxpayers and superannuitants against a poorly performing New Zealand economy in 30-50 years. This means little, if any, exposure to New Zealand assets. If the New Zealand economy isn’t performing, when the Big C is required to partially fund NZ Super, and we have invested in NZ, then either:
- the NZ economy will suffer more as the Big C’s investments are cashed in, aggravating the supply/demand equation, and/or
- taxes will rise - this will also dampen the economy further; and/or
- NZ Super will reduce in some way (eg: lower level, higher age, means test etc.) which defeats the Big C’s purpose.
If growth is needed the answer is . . . . . shares
Because the guardians don’t need income, the only assets they should consider are those that maximise growth. In some cases, this might be achieved by reinvesting returns from income assets, though it will mostly be best achieved by investing in shares.
This should include both listed and unlisted shares (ie: private equity). Diversification principles will demand a spread across economies and industries, and companies within economies and industries.
Diversification won’t mean a little bit of cash, bonds, property and shares everywhere.
Risk management means . . . . . offshore!
Because the guardians need to protect us taxpayers against a poorly performing New Zealand economy, they should focus on overseas assets.
There are strong arguments for not investing in New Zealand at all. Any investment in New Zealand must create genuine growth and not simply act as a substitute for existing capital (buying the shares of existing investors who want out of New Zealand).
So, any allocation to NZ probably means primarily private equity investments and such investments must have no direct or indirect political influence (no roads, schools, job creation schemes etc).
There are other reasons, besides risk, why the guardians shouldn’t buy New Zealand shares. The lack of choice and opportunities are significant enough but the main factor is size.
The Big C will be worth more than $50 bill in today’s dollars. This is larger then today’s sharemarket and about half the size of the total New Zealand economy.
Any sizeable investment in New Zealand will create excess buyer supply and simply flow through to asset price inflation.
Gains from asset price inflation may benefit one investor at the expense of another (a zero sum gain at best) and won’t create real wealth unless the investment is realised, by selling to a foreigner, before the asset’s price falls.
Do we want a weak dollar?
Investing the Big C will create other investment consequences that will need to be to be addressed.
The Big C will put downward pressure on the New Zealand dollar as $50 bill flows out of the country into international currencies and then upward pressure as it all flows back when it is needed to help pay for NZ Super.
This is not insurmountable but will require careful management of the cashflow.
There may be advantages in a special tax on exporters’ overseas earnings to minimise the effect.
Active or passive management?
Should the guardians, or their appointed managers, be allowed to second guess which shares will do better then others?
For a whole lot of reasons, the listed overseas share portfolio is probably better passively managed.
This won’t please fund managers (lower fees) but it will result in higher returns after expenses, on average, over the next 20 to 70 years (ie: the life of the Big C).
Passive management doesn’t necessarily mean index management. The guardians should determine the required diversification by country, industry, number of securities etc, and then manage the portfolio on a long-term predominantly "buy and hold" approach.
They shouldn’t be "traders".
Passive management is also consistent with the approach of private equity investment.
Rather than buy and sell private equity funds, investors select one or more specialist private equity managers who in turn select investment opportunities and then invest for the medium/long-term.
They don’t trade or turn over the investments like "active" managers.
Property a no no
The "guardians" can’t justify property as a long-term investment for Big C. As a rule, the total returns from "owning" property are generally less than the total returns from "using" property.
Also the ability to exit property 30 years hence, when everyone else wants to, will create interesting investment market dynamics.
Overall the investment characteristics of property are just incompatible with the Big C’s objectives.
Green or ethical investments?
One definition of green is naive. Whether this is the right definition is a matter for conjecture.
However, it’s important that the investments are the best ie: have the right income/growth characteristics.
In some cases this will be environmentally and/or people friendly assets. In other cases it won’t – tobacco shares may be a good investment.
To impose specific green or ethical requirements will create distortions that will probably mean lower returns over the long-term.
If the government wants to encourage a green or ethical approach, it should do so by transparent government policy, where the cost/benefit relation can be determined and not by meddling with the Big C.
If the Big C is to be invested prudently, here’s my advice to the guardians:
- There should be no political interference in the guardian’s decisions to invest the assets.
- 100% should be in growth assets (shares) in a diversified portfolio (by country, industry etc but not by greenness or ethics).
- Listed shares should be passively managed and up to 20% should be through private equity (not venture capital) investments.
- At least 99% should be invested offshore.
- The guardians don’t need expensive strategic advice from people like me but I am happy to hop on the gravy train along with everyone else.