KEY POINTS:
Financial markets have had a tough few months. Global share prices have fallen by about 15 per cent since their peak level in October (as measured by the local-currency Morgan Stanley Capital Index). New Zealand shares are down a similar amount over the same period.
The New Zealand
Superannuation Fund has not been immune to these significant events. We have deliberately invested in a diversified pool of global growth assets. We know these assets are exposed to short-term volatility, but we also know that they deliver considerable financial gains over the long term.
The recent market decrease was also not unexpected even if the timing was unpredictable. After all, share price falls this steep over a three-month period have occurred six other times in the past 30 or so years - which are regular episodes for a long-term investor. Indeed, such moments provide us with opportunities to invest at better entry prices and higher expected rewards for taking risk. This is exactly what we are doing and exactly what defines a long-term investor.
The Fund's return was minus 1 per cent in the second half of 2007, with this year also continuing the negativity. As a long-term investor we do not need to be in the game of shorter-term economic predictions.
But it is certainly easy to think of negative scenarios for the world economy over the next year or so, especially in the financial sector with the credit crunch. The next year or so may be tough for the world economy.
During such periods it is important to stay focused on long-term investment goals. Despite the recent decline we have returned around 13 per cent per annum since we started investing about four years ago.
That return is almost twice what we would have got by holding Treasury Bills over that period, and still well in excess of our self-imposed benchmark, which is the return on Treasury Bills plus 2.5 per cent per annum over rolling 20-year periods.
These statistics highlight that the recent slide follows four years of booming asset prices. Almost everything went up: stocks, bonds, commodities, property, emerging markets. The boom was fuelled in part by low interest rates in most major economies.
We had been warning for some time that returns would come back to more normal levels. We also warned we had no means of knowing when that would happen. Such market timing is almost impossible. This is why we stick to a long-term strategic asset allocation.
The eventual trigger for the downturn in markets was a slump in the US housing market that exposed sub-prime mortgages (high risk housing loans) in the United States. The US sub-prime mortgage market was just the first domino to fall. The problem was that this risk was not well understood by those making and taking the sub-prime loans. The risk was wrongly priced and its impact continues to spread across both borrowers and investors.
What has surprised investors is the degree to which problems in a relatively obscure sector of the financial markets have spread to other sectors. But that's often the way with financial market corrections of the type we are witnessing. They start from obscure beginnings.
So what does this mean for a long-term investor such as the Fund?
Despite the economic uncertainty, the market decline brings good opportunities. Long-term investors reap rewards mainly because they don't lose their heads in times of market stress. The current price correction means the expected return for investors over the long term is better than it has been for many years.
The Fund is worth about $13 billion today, but we expect it to grow by a further $40 billion in the next decade alone. The benefit from being able to invest in the future at these lower prices well outweighs any recent losses. If this sounds brave, we should acknowledge that the downside risks to the global economy are already partly built into prices. Market levels assume that at least some of the scary scenarios come true.
The Fund's strategy of being highly diversified has also helped insulate us. We will continue diversify between and within asset classes.
Other things we are considering, but not near implementing, include buying shares even more aggressively than our strategic asset allocation suggests when prices are particularly attractive. We are also considering how we could provide funds (at a price of course) to companies that are fundamentally sound but need to raise funds quickly.
But we first want to assess whether such short-term activities reward sufficiently. There are significant difficulties and risks, and it takes much more specialist knowledge.
Importantly, we must avoid being distracted from the long game - which is to set an appropriate asset allocation, be diversified, be patient, and not have our strategy dictated by the two emotions characterised in markets: greed and fear.
In sum, markets are volatile. This is not the first big correction we have seen, nor will it be the last. We will hold our nerve, look to be opportune, and stay focused on our purpose which is to generate long-term returns.
* Adrian Orr is the chief executive for the Guardians of New Zealand Superannuation. The Government set up the Superannuation Fund in 2003 to help fund future Superannuation payments. For more information, visit www.nzsuperfund.co.nz.
