When governments set out to launch sovereign funds or public pension funds, they are often biased with an assumption that these funds will never be able to compete with the private sector. Over time, this assumption is given credibility by the fact that the sponsors of these funds under-resource the teams in charge, while over-paying external asset managers and service providers. This creates a vicious downward cycle whereby pensions become increasingly dependent on external managers (who increasingly over-charge them for services they claim are beyond their capabilities). As a result, an awful lot of people genuinely believe that investment management is something that only the private sector can do; that public sector organizations are inevitably dysfunctional and should be protected from themselves...
And then this happens: A sovereign fund drops some science on the investment management industry with a 26% year and a 9% decennial IRR. That SWF is the New Zealand Superannuation Fund, and it is fundamentally challenging the notion that public funds cant compete with the private sector.
As such, I think it may be time that we coin a new top model of institutional investment. But before we get there, lets review some of the existing models:
- The Norway Model: In this model, investors rely almost exclusively on publicly traded securities and are highly diversified (to the point of being almost indexed). The funds returns are basically market returns, as the priority is diversification and cost minimization. Indeed, unlike other models of institutional investment, the Norway Model understands that compounding fees and costs can be devastating for a portfolio. Its for this reason that 96% of NBIMs assets are managed in-house.
- The Yale Model: In this model, investors are diversified across asset classes and allocate a significant portion of assets to non-traditional assets, including hedge funds, private equity and real estate. Its a model that relies on external fund managers and is difficult to scale due to the scarcity of alpha producers. Unlike the Norway model, cost containment is put aside in favor of net-of-fee returns.
- The Canada Model: This is a model that prioritizes in-house asset management and the development of highly skilled teams of investment professionals that can access investment opportunities on their own. The foundation for this model is its independent and expert governance structure, which in turn allows these organizations to properly resource investment operations (i.e., pay decent salaries).
- The Dutch Model: This is a model based on innovation, professionalization and risk sharing. The big Dutch funds, such as PGGM and APG, have also been instrumental in the development of and implementation of liability driven investing.
- The American Model: This is a model that is based on politicized and under-resourced investment operations that one outgoing public pension fund CIO recently described as a travesty. I think its my frustration with the American model (and its replication in Australia, Japan, and the UK) that led me to focus so much of my attention on the Canadian model and, now, the Kiwi Model.
- The Kiwi Model: Id argue that institutional investors out on the frontiers of finance have a new model: the NZSF. This is a public sector investment organization based in Auckland that is generating solid decennial investment returns.
This then begs an important question: What are the differentiating characteristics of the Kiwi Model? As with all the (real) Models, there is a solid governance structure that seems to understand how to resource an investment organization properly. As such, the fund has focused intently on building a strong team of investment professionals and empowering them. But I think what separates the NZSF from other funds is the way it thinks about accessing investment opportunities and what this implies about the organization as a whole.
NZSF Chair Gavin Walker describes the SWFs approach as a simpler and more direct approach to investing: By cost-effective we mean that we pay minimum cost for pure market exposure and only pay more if we have a high level of confidence of value being added. It also means we have an efficient business model and understand the optimal trade-off between internal and external management.
The fund has fewer, but deeper, relationships with external managers. It also has fewer, but more concentrated, investments. In short, it believes that less is more; it isn't playing the over-diversification game.
In a way, then, the Kiwi Model is the antithesis of where this blog post started: It is a public fund that believes in its own ability to execute. Its not entirely in-sourced like many of the Canadian funds. Rather, the Kiwi Model is one in which the sponsor simply believes in the funds ability to pick successful managers and investments. Its confident in its own capabilities, and that confidence creates a virtuous cycle of outperformance...