Cullen gives lesson on diversification

Finance minister Michael Cullen gives the Institute of Directors a lesson on diversification.

Tuesday, December 10th 2002, 11:48PM

We are also managing to the longer term with Crown financial assets. The government does have large financial portfolios in the Government Superannuation Fund and Natural Disaster Fund. Both are around the $3.5 billion mark. The New Zealand Superannuation Fund will have around $2 billion in it by the end of this financial year, rising by about that amount each year after that for some considerable time.

It is important that these funds are managed well, to maximise the returns we get from them, subject to the appropriate spread of risk. The overwhelming evidence of history is that a better return, with very limited risk, comes from a diversified fund, with a mix of bonds and equities, foreign and domestic. That is why we have made the decision to diversify the Crown financial portfolio, with the diversification overseen by experienced professionals, not politicians.

In such a fund, there will be good years and bad years, and different parts of the portfolio will experience different rates of return in any year. These funds are there for the long term. The NDF is there to cover some of the costs of a natural disaster. We don't know when it will be needed. We do know that the GSF will be drawn down over many decades. We have actually passed a law stopping any withdrawals from the NZSF before 2020.

All of these funds are managed in terms of detailed statements of investment principles and policies, and they are reviewed annually. It is legitimate to question the judgement behind the principles and policies and the asset allocations that have been developed as a result. That is informed debate around long term objectives.

It is ludicrous to judge the financial performance of only parts of the portfolio of the funds, over periods as short as three months. And yet try as we may to lift discussion to a more rational plane, that is precisely where it is conducted in the political and popular media arenas.

If I could turn this around and look at some criticism that I hear from time to time, it is also important to take the longer term view of the impact of diversification of these funds on New Zealand capital markets. I hear suggestions that all, or a very large portion of these funds should be locked in to domestic securities.

I must stress that the primary purpose of diversification is to get the best return on our assets, consistent with a prudent management of risk. However, I have always thought that an inevitable and welcome by-product of diversification is that it will deepen our capital markets.

This will happen over time. It is the long term impact that we must focus on. There will be limits to the amount and pace of what our capital markets can absorb without creating an asset bubble. Each fund will make its own asset allocation decisions, and these will change over time as investment performance is reviewed. As an example, though, consider the GSF. It has set a long-term target of having 14 percent of its assets in New Zealand bonds and one eighth of its portfolio in New Zealand equities. That is over $400 million of new equity into our stock market. If the NZSF follows a similar asset allocation, new equity of around $250 million will be injected each year. So there will be a not inconsiderable deepening of our capital markets, but as always, we need to keep the focus on the longer term.

As John Maynard Keynes pointed out, "in the long-run we are all dead". As with many of the great axioms of economics, Keynes' statement is self-evidently true. However, it should not be taken as an encouragement to take a short term approach to encouraging economic growth or to managing public finances. Prior to our own long-run demise we of the baby-boom generation hope to enjoy a lengthy and comfortably Keynesian retirement. To achieve that we need to plan for the long term, both individually and collectively.

Moreover, although we will be gone in the long-run, our children will still be here. They will be living with the legacy of today's economic leadership, and I would hope that that legacy would comprise a strong capital base and healthy skills-based industries. I would hope that their judgement will be that we served their long term interests in a distinguished manner.

This is an extract from a speech Finance Minister Michael Cullen gave the Institute of Directors.