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Bigger and Better than Beta? The challenge of finding alpha at scale
Outperforming the market is tough, particularly when an investor owns most of the market. As the scale of assets under management in the Australian superannuation system grows and the number of entities responsible for managing it shrinks, is it going to be harder for trustees of large superannuation funds to outperform?
It stands to reason that as the scale of managed assets increases relative to the size of the markets invested in, that alpha could regress to the performance of the market.
The prospect of such a diseconomy of scale may not be immediately apparent, yet it is important for trustees of large superannuation funds, and policy makers, to start to think about how we set and measure investment performance.
Super big
The value of assets in the superannuation system continues to grow in real terms but also relative to national wealth. Advisory firms Deloitte and Rice Warner have both forecast the value of assets in the superannuation system to grow to $4 trillion or more by 2025 and $10 trillion by 2040.
While commentators often like to compare the value of assets with gross domestic product (GDP) – 150 per cent of GDP sounds impressive - a better comparison is national wealth. While GDP is a measure of flow, national wealth measures value - including the value of assets which are fenced into our concessionally taxed superannuation system.
The $2.6 trillion of assets as at June 2017 represented about a third of the $7.4 trillion in Australian national wealth. The projected growth in the superannuation system is largely unleveraged and the product of a higher rate of savings because of mandatory contributions by employers.
This is likely to not only increase national wealth, but also increase the relative proportion of the superannuation system to national wealth, and all the markets in which assets are invested.
Let’s concentrate
Concurrently, we’re seeing a push for consolidation in the number of trustee entities responsible for the management and stewardship of these assets.
Over the past decade, we’ve seen the number of superannuation trustees on funds with more than four members contract by 62 per cent. This concentration is expected to continue and focus the management of a growing pool of assets with a smaller number of trustees.
The importance of this shrinking group of growing superannuation trustees over the coming decade is difficult to overstate, and the manner in which they prepare for performance at scale over the coming decade will be telling.
While alpha, or outperformance, may become more challenging as the assets under the stewardship of superannuation trustees grows, there will still be abundant opportunities to outperform at scale for trustees positioned to perform at scale.
Preventing growing pains
What then, can trustees of large superannuation funds consider when positioning for long-term performance at scale? I believe that there are four important factors which are the starting point:
1. internalising investment management
2. holistic portfolio view
3. a global approach to investing; and
4. low-cost market exposure.
Insourcing investment management?
The use of investment managers to manage portfolio mandates is common in the management of superannuation funds, and there can certainly be benefits in the expertise and scale that an investment manager can provide to some asset owners.
Internalisation of the investment management function involves portfolios of assets being managed on a discretionary basis by the employees of the superannuation trustee. It isn’t merely the selection of investment managers and balancing strategic allocation.
There is nothing novel about internalising management of some portfolios, with Australian superannuation funds and large international pension funds both bringing some investment management in house.
When considering internalising investment management, attention is needed to understand which asset classes have a strong business case for insourcing and those which don’t. While the case for insourcing real property and infrastructure might be strong, the costs and risks associated with bringing cash management of bonds and fixed interest in house may not stack up.
Ongoing review of internalised functions is important to ensure that the internalised function remains the best strategy. The use of a subsidiary can make the process of objectively assessing performance of internalised functions against alternatives much easier and more reliable.
Holistic portfolio view?
The attraction of a holistic portfolio view to large superannuation asset owners has contributed in part to the trend towards the internalisation of parts of the investment management function of superannuation trustees.
Individual managers often don’t have visibility of the positions and investments taken in the mandate of other managers investing in the same or related markets. This can lead to the creation of positions which offset or compound exposures.
As the scale of assets being managed grows, the importance of ensuring that the trustee has a holistic view of investments can assist in ensuring that the costs associated with active managed positions aren’t inadvertently offset by the mandate of another manager.
A global view
As the scale of assets managed in superannuation funds continues to grow relative to Australian investment markets, a pivot away from a home bias will be important for large superannuation funds.
Combined with a trend towards partial internalisation, we’re already seeing large superannuation trustees start to develop an international presence and seek to attract the best and brightest talent from across the globe.
Performance at scale is likely to involve the establishment of highly skilled investment teams with local expertise in the key economic hubs around the globe. Performance might not be as easy to find; however, the opportunities will exist for those funds best positioned to seek them abroad.
Running a tight ship
As the scale of assets to be invested in some markets grows large that exposure is bound to be very diversified. Low-cost management via smart beta, exchange-traded funds (ETFs), and index-tracking funds does represent an important component of position to perform at scale.
In an environment of uncertain performance, costs are certain and increasingly important to minimise wherever possible. The saving on costs which scale up as the value of assets increase should form an important component in positioning a large superannuation fund with diverse investments to perform at scale.
A better beta?
Objectives and performance benchmarks may need to shift from alpha, to a better beta.
The responsibilities of superannuation trustees as stewards of such large amounts of capital should see the promotion of better practices in areas such as environmental, social, and governance (ESG) practices.
Improved integration of ESG and similar factors might not only be a source of performance, but also as a means to a better beta by improving the performance of the market as a whole.
Jonathan Steffanoni is QMV's principal consultant, legal and risk.
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