- New Zealand’s NZ$55.7bn ($32bn) sovereign wealth fund is approximately one year into its introduction of a new sustainable investment strategy.
- In 2022, it successfully switched its benchmark portfolio from the broad-based MSCI ACWI IMI index to reflect two MSCI Paris-aligned indices.
- The NZ Super Fund added a record NZ$4.5bn ($2.58bn) in value above its benchmark, despite an overall negative return in 2021/22.
The New Zealand Superannuation Fund launched its Sustainable Finance Strategy in 2021. So far, it has successfully implemented key parts of the strategy, but there is still more work to be done.
The strategy has three pillars: to lift the ESG profile of the fund, impact investing and leadership. Specifically, the fund is seeking to improve the ESG rating of the portfolio, as measured by MSCI, by 10% relative to the previous reference portfolio benchmark.
Charles Hyde, the NZ$4.5bn fund’s head of asset allocation, says the precursor to the fund’s Sustainable Finance Strategy was called Responsible Investing Strategy. The new strategy differs in a couple of ways, Hyde tells Capital Monitor:
“It doesn’t just consider how ESG considerations impact our portfolio, but it also incorporates the notion of the impact of our investments on society and the environment…. There’s also an explicit goal of working with others to overcome barriers to sustainable investing.”
While some specific targets have been put in place, – for example, excluding those stocks which have the lowest ESG score – the fund has decided not to adopt targets for other parts of the strategy, opting more for a principle-based, rather than prescriptive, style of oversight.
Nonetheless, the fund is involved in several global target-based initiatives including Climate Disclosure Project (CDP); Investor Group on Climate Change (IGCC); Climate Action 100+; Net Zero Asset Owners Alliance (NZAOA).
The fund has had a climate strategy since 2016 with the goal of reducing carbon intensity and potential emissions by 20% and 40% respectively by 2020, relative to the 2016 portfolio. These targets were met ahead of time, achieving reductions of 40% and 90% by 2020. Now, new targets have been set for 2025 that have already been exceeded, currently tracking at reductions of 47% and 94%. The same strategy has been applied to its reference portfolio (RP) – its benchmark.
Tailored benchmark indexes
One major change under the new strategy has been to move away from a conventional broad market index for the reference portfolio, the MSCI ACWI IMI index, and replaced with two MSCI Paris-aligned indices; the MSCI World Climate Paris Aligned Index and the MSCI EM Climate Paris Aligned Index.
This means a change in benchmark for the 75% allocation to global equities in the reference portfolio, while it also impacts 45% of the total portfolio currently allocated to passive global equities. There will be an additional impact on the 19% of the portfolio invested in developed market equity factor strategies. The MSCI Paris-aligned indexes are constructed to ensure they are on the trajectory to reach net zero by 2050.
Hyde explains the process of developing the fund’s actual portfolio: “We start out with the [RP] and the ‘actual’ fund exactly mirrors that. Over time, we sell some of the passive equities and fixed income to fund our active investments, so the active part of the portfolio grows and now it represents just under half of the portfolio’s net asset value.
“First, we addressed the passive equities and over the next year or so we will consider addressing the passive fixed income part of the portfolio.”
The RP is 80% global equities, 20% global fixed income. Within this, there is a 5% allocation to New Zealand equities.
About half the actual portfolio consists of RP holdings (mostly global equities), the fund also had to rebalance its passive global equity portfolio to align with the two Paris-aligned indexes. Previously the fund had met its climate targets by using a customised version of the MSCI ACWI IMI that screened out the high carbon-emitting and carbon reserve companies. But the Paris-aligned indices do much of this screening already, simplifying the process of RP and portfolio construction for the fund.
The fund views the RP not only as a benchmark but also as an alternative portfolio that could replace the actual portfolio at a very low cost. “Because our mandate requires us to use best practice portfolio management, it follows the [RP] must also reflect this requirement,” Hyde notes.
Active investment strategy
The principles of the Sustainable Finance Strategy are being applied not just to the passive part of the portfolio but also to the active portfolio, says Hyde. But it is more difficult to measure the ESG profile of private investments, such as infrastructure and real estate, for example.
“We have a dedicated sustainable investment team, which [is] currently six full-time employees,” says Hyde, “and they work in tandem with our internal and external investment managers to make sure that the active investments we bring into the portfolio satisfy our sustainable finance goals.
“Of course, there are some [less sustainable] active investments, such as our external global macro managers have portfolios, for which it is difficult consistently to know the constituents, and they can have long or short positions. We require our managers to make their best efforts to be aligned with our strategy.”
The fund is now tackling the 20% of the portfolio, in terms of net asset value, allocated to active equity. This strategy involves identifying stocks with strong value, momentum, quality and low-risk characteristics.
It is easier to apply the new Sustainable Finance Strategy here, says Hyde, because the listed equity universe has good ESG metrics coverage by ESG providers. “The approach is not exactly the same. We’re likely to give our managers more latitude in terms of how they reach our ESG goals.”
The fund also has an active New Zealand-listed equity strategy for which ESG, along with valuation and structural considerations, shape investment decisions.
These include private market timber and farmland assets, which have always been managed carefully from a sustainability perspective because they are direct investments in New Zealand. “We look at what effect climate change is having on them and also what effect our investment is having on the communities these assets exist in – the social part of ESG,” says Hyde.
“For example, the damage caused by the cyclone that came through [in early 2023] swept a lot of forest waste into the streams which clogged them up and caused some flooding. So, while our assets didn’t contribute to this problem, there is a heightened awareness of the risk of such impacts on local environments and communities.”
The external/internal management split in terms of capital allocation is 75%/25%, although in active risk terms, over half of the active portfolio is managed internally. “Our largest strategy for the active risk budget,” says Hyde, “is an unfunded strategy, so it has no capital allocated to it, is a dynamic asset allocation strategy which trades in derivatives. We call it ‘strategic tilting’.”
The fund’s annual report defines this tilting strategy as using “derivatives to take positions across a number of investment markets (including equities, bonds, currencies and commodities)”. The programme also buys ‘risky’ assets during financial market shocks, like the Covid-19 crisis, while aware that in the short term, this might lead to losses.
Hyde describes some of the opportunities that the fund is able to take advantage of through the Sustainable Finance Strategy. “These could be described as a sub-asset class, for example, natural catastrophe bonds that might be issued by reinsurance companies seeking to offload risk.” There is also the “Sustainable Transition Opportunity”, where the sovereign fund invests in companies that are either producing renewable energy or equipment and inputs for the production of renewable energy.
“We developed an impact investment plan about a year after introducing the Sustainable Finance Strategy,” says Hyde. For the fund, impact investments must satisfy three criteria: investment with the intent to deliver measurable social and environmental impact, delivering the fund’s required financial return and without material ESG risk.
“We’ve developed a framework for impact investment qualification, measurement and management. We are currently testing that framework with some of our existing investments such as those in our Sustainable Transition Opportunity,” says Hyde. The framework is based on global best practices such as the five dimensions of impact, one of the most popular frameworks used by impact asset managers and owners.
“The focus at the moment is on internal reporting,” says Hyde, “It’ll be a year or two before we’re able to report externally. And we’ve deliberately not set ourselves specific goals or allocations for impact investments, but rather will integrate the impact framework across our whole portfolio.”
Exclusions and engagement
There are few stocks that are excluded from the fund’s investments. “The largest number of exclusions,” says Hyde, “relate to the marijuana industry. Being a sovereign wealth fund, we take our lead from New Zealand laws, and it is illegal here.” Other products and activities are also excluded, such as cluster munitions and tobacco.
The fund has rarely led an engagement effort outside New Zealand but does collaborate with peers on a range of global issues, for example, modern slavery. Its major engagement in the past few years was over social media companies‘ coverage of the March 2019 terrorist attacks in Christchurch. “We have led an engagement on improving corporate governance standards for the listed market here [in New Zealand] since 2015,” adds Hyde.
Hyde sums up: “We aren’t confident that ESG is going to bring alpha in the short to medium term as the empirical evidence of positive alpha over this timeframe is weak. But we do think that over the long term, it is prudent to make sure we are not exposed to stranded assets and that we achieve a successful transition to a sustainable economy, otherwise, future generations could pay the price.”[Read also: Why Sweden’s Alecta believes bondholders can effect change]