Investment Strategy


Summary Overview

Given the long-term nature of the Fundís liabilities, the Commission has traditionally adopted a long term view when formulating the Fundís Investment Strategy. Following a Ministerial Direction to invest in Allied Irish Banks and Bank of Ireland in early 2009, and the fact that the Commissionís statutory investment policy does not apply to the directed banking investments, the Commission decided to separate the NPRF into two parts for management purposes Ė the Discretionary Portfolio (the investment of which remains the Commissionís responsibility) and the Directed Investments (where the investments are made at the direction of the Minister for Finance).

Subsequently it was announced in November 2010 that the NPRF would provide up to Ä10 billion of the Stateís Ä17.5 billion contribution to the Ä85bn EU/IMF Programme. After an NPRF contribution of Ä10 billion, the value of the assets remaining in the Discretionary Portfolio based on provisional year-end 2010 valuations would be approximately Ä4.9 billion. This would include capacity for the proposed investments in Irish infrastructure assets and water metering services as set out in The National Recovery Plan 2011-2014.

The provisions of the Credit Institutions (Stabilisation) Act 2010 which was enacted in December 2010 give the Minister for Finance significant powers which effectively dilute rules in relation to contributions to and drawdowns from the Fund. The implications of these developments for the Fundís operations are being considered by the NPRF Commission.

Note: the Investment Strategy below applies to the Discretionary Portfolio only1


Investment Objective

The Commissionís Mission Statement as adopted in 2001 is:

To meet as much as possible, within prudent risk parameters to be agreed by the Commission, of the cost to the Exchequer of social welfare and public service pensions to be paid from the year 2025 until the year 2055, as provided for in the National Pensions Reserve Fund Act, 2000.

In March 2010 the Commission agreed that this primary objective remained valid but that it should be modified to include a supplementary objective of seeking to outperform the cost of government debt (debt service costs) over rolling five year periods at a defined probability level as follows:

To maximise the terminal wealth of the Fund over the time scale as laid down in the Act through an investment strategy which has due regard to the purpose of the Fund as set out in Section 18 of the Act and the payment requirements as set out in Section 20 of the Act; a supplementary objective will be to outperform the cost of five year government debt over rolling five year periods at a 75% probability level.

While the Commission has always set investment strategy on the basis that the NPRFís strategic asset allocation is likely to outperform the cost of borrowing over the NPRFís long investment horizon, it has decided that the costs of borrowing should now be formally recognised in its investment objective and explicitly factored into the level of risk it is satisfied to take with regard to the NPRF. The supplementary objective set out above was adopted on the basis that it represents a reasonable balance between maintaining a long-term investment perspective and recognising Irelandís changed fiscal position and the increased budgetary impact of debt service costs.


Strategic Asset Allocation

When reviewing the Fundís Strategic Asset Allocation in late 2009 and early 2010 in light of the Investment Objective set out above, the Commission utilised a twin track approach combining asset allocation modelling on one hand with its own investment judgement and its analysis of the allocations of peer international funds on the other. It is important to emphasise that asset allocation modelling has limitations. These include the difficulty in specifying inputs (for example, expected returns and volatility for each asset class and expected correlations between asset classes), its extreme sensitivity to small changes in expected return, the way it strongly favours asset classes with high estimated returns and/or low estimated volatility and its difficulty in dealing with factors such as illiquidity. As a result of these limitations, modelling can only ever act as a guide to investment strategy and needs to be supplemented with qualitative considerations. Arising from this twin track approach the Commission agreed the following Strategic Asset Allocation as set out in table 1.

The Commissionís asset allocation strategy remains focused on investment in real assets and on maximising return within acceptable risk levels over the long term, given that the purpose of the NPRF remains to meet as much as possible of the costs of social welfare and public service pensions from the year 2025 until at least 2055.

The investment drivers behind the principal changes in asset allocation compared with the Fundís previous asset allocation strategy are:

  1. Diversification: allocations to bonds and absolute return funds and a reduction in the allocation to quoted equities.
  2. Growth: within equities, an increased allocation to Emerging Markets, Small Cap and Private Equity.
  3. Inflation protection: increased allocations to assets that are more likely to protect against longer term inflation Ė inflation linked bonds, commodities and infrastructure.

Table 1: NPRF Discretionary Portfolio Strategic Asset Allocation
 
Current Target Asset Allocation
 
%
Quoted equity
 
Global large cap
29
Global small cap
10
Global emerging markets
10
Total quoted equities
49
 
 
Fixed income
 
Eurozone government bonds
6
Eurozone corporate bonds
6
Eurozone inflation linked government bonds
5
Cash
1
Total financial assets
18
 
 
Alternative assets
 
Private equity
10
Property
8
Commodities and forestry
5
Absolute return investmentsNote 1
5
Infrastructure
5
Total alternative assets
33
 
 
Total Discretionary Portfolio
100

Note 1: 5% is an initial target. When this has been completed the Commission will consider if an allocation of a further 5% to absolute return (out of large cap quoted equities) is appropriate.

The Commissionís revised Asset Allocation includes investment in a number of new asset classes:

Dynamic Asset Allocation

As part of the investment strategy review the Commission also agreed that, while the NPRF retained the capacity to bear short-term volatility (and maintain significant exposure to real assets), the consequent risk should be managed more actively on an ongoing basis by varying the NPRFís asset allocation around strategic levels (dynamic asset allocation) and that it would delegate authority to the NTMA to vary asset allocation around the central levels as set out in its investment strategy within the following ranges:


 Table 2: Asset Class
Range (% of Discretionary Portfolio)
Quoted Equity
+/- 10%
Nominal and Inflation Linked Bonds
+/- 10%
Cash
+/- 10%
Property / Private Equity
+/- 2%
Commodities
+/- 2%
Infrastructure
+/- 2%

These ranges are based on the belief that dynamic asset allocation movements should be large enough to have a material impact on Fund risk and return while not being so large as to make the strategic asset allocation meaningless or to compromise the Commissionís fiduciary role with regard to the NPRF. The dynamic asset allocation policy is based on taking significant positions if and when market positions move to extremes rather than on taking small positions on an ongoing basis or attempting to time the market, and will only be implemented where suitable liquid investment instruments or vehicles are available.

Allocation to Irish Assets

As noted in the National Recovery Plan 2011-2014, the Commission agreed to invest in the following Irish assets:

Water Metering Investment in Ireland

The NPRF Commission agreed to support the domestic water metering programme on commercial grounds.

Irish Infrastructure

In May 2010, the NPRF Commission agreed to allocate 5% of the NPRF Discretionary portfolio to infrastructure investment, an increase from the initial strategic allocation of 2%.

The sectorís typical investment characteristics of long duration assets with stable yield returns make it highly compatible with the cash flow requirements of a reserve fund such as the NPRF. Operating within the commercial mandate prescribed by its statutory remit, the preferred initial approach of the NPRF is to invest up to €500 million alongside third party institutional investors in infrastructure assets in Ireland.

1The Investment of the National Pensions Reserve Fund and Miscellaneous Provisions Act 2009 disapplied Section 19(1) of the National Pensions Reserve Fund Act, 2000 Ė which sets out the NPRFís statutory commercial investment policy - from the NPRFís Directed Investments and the Commission is not responsible for the risk taken and return earned on these investments