Balancing risk and return
Our Act requires us to "maximise returns without undue risk to the Fund as a whole".
The key decision for our portfolio is to determine what balance of risk and return is appropriate. The long horizon and mandate of the Fund mean that it should be weighted towards growth assets in order to have the best chance of maximising returns without undue risk. This decision establishes the ratio of growth to income assets in our portfolio.
The expected financial benefit of growth assets such as equities derives from their value increasing over time and is primarily realised when we sell. There is a greater risk in such assets as their value can increase and decrease - sometimes markedly - depending on what happens in investment markets. To accept that higher level of risk, we require a greater return.
The expected financial benefit of income assets such as bonds derives from gaining a share of stable and predictable cash flows and is realised the entire time we hold the investment. Such assets have less risk as the income stream is agreed in advance. The returns we expect are therefore lower.
Deciding between growth and income assets
More growth assets means more risk and more likelihood of variations in the value of the portfolio in the short-term. Over the longer term, however, when the pattern of volatility tends to even out, growth assets are expected to produce a higher return.
Choosing a mix between growth and income assets is therefore a trade-off between the returns you want and the certainty of outcomes that you need.
For us, the starting point and key decision is therefore the mix of assets in the Fund's Reference Portfolio.