Asset allocation: are superannuation funds looking in the wrong direction?

With a number of superannuation funds having gone from hero to zero on the back of unwise asset allocation calls, Damon Taylor reports that reliance on past performance represents a foolish strategy.

Since the inception of member choice, the Australian superannuation industry has broadened and improved its skill set.

From insurance offerings to access to financial planning, members have any number of ways to differentiate individual funds, and yet the reality is that for many, asset allocation and the returns it yields represents the ultimate measure of a fund.

Like it or not, an increasingly competitive superannuation environment means that performance continues to be on peoples’ radars, but according to Mike Wyrsch, senior consultant at Frontier Investment Consulting, it isn’t past performance that’s important.

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"Clearly, asset allocation explains the bulk of returns but what we’re also seeing now is an environment where you have member choice," he said. "And broad asset allocation calls aren’t always made by trustees.

"But the question here is what past performance tells you about future performance," Wyrsch added. "Some funds have gone incredibly well for a period of time and then subsequently gone incredibly poorly.

"You really have to understand how these funds have set their asset allocation and what flexibility they have to change them if conditions alter, because it’s what happens in the future that actually counts."

Simon Eagleton, business leader for Mercer’s Investment Consulting business in Australia and New Zealand, said a focus on short-term performance was one of the more unfortunate by-products of increased competition in Australia’s super industry.

"Obviously there is evidence of more and more short-term perspectives on performance," he said. "It’s disappointing though and clearly not in the best interests of long-term retirement savings.

"Fortunately, I’m not seeing a lot of evidence that super funds are overly sensitive to the trend," Eagleton continued.

"Most adhere to well diversified long-term strategies, but focusing on short-term numbers is always a danger, particularly in a highly competitive environment."

Of course, a focus on short-term performance has not come solely from increased competition.

The massive market upheaval seen through the global financial crisis (GFC) has had all investors on edge and had an impact on superannuation account balances that many members have been unable to ignore.

Yet while the impact upon super funds’ investments and returns was significant, Wyrsch said that most super funds had been cautious in making significant shifts to their strategic allocations.

"I think people have been aware for some time that markets aren’t efficient and that there are times when they’re going to be better value than others," he said.

"But there are always lessons in these things, and there were certainly lessons from the GFC.

"Many are probably still mulling over and reviewing those lessons and how they might better go about things, but I think that a lot of people actually saw this coming," Wyrsch continued.

"Sub-prime was something that was pretty clear fairly early and most investors made sure they weren’t exposed to it.

"It certainly spread further than most people thought it would and I think there were definitely lessons around how quickly these kinds of events can move and exactly how much they can impact."

Liquidity mismatch

In line with Wyrsch’s sentiments, Eagleton said that one of the key lessons of the GFC had been in liquidity mismatch.

"A lot of funds have seen that running at a huge liquidity mismatch was a dangerous thing to do," he said. "So many will have rethought their entire portfolios in that area.

"There would also have been lessons in terms of diversification," Eagleton continued. "There would be funds out there which thought they were diversified but then saw everything go to custard at the same time.

"Investors have to look underneath asset classes because assets like fixed income, which they might have thought of as defensive, had become more and more exposed to credit and in that kind of environment, of course it was going to go down."

According to Eagleton, in addition to super fund investment teams rethinking the roles of specific assets, he had also seen a lot of interest in genuinely alternative strategies. "So investments that are truly diversified and assets that have nothing to do with capital markets," he said.

"Those hedge funds where the returns are coming from manager skill have also garnered increased interest, but overall there seems to be a lot more consideration of operational risk.

"Trustees are looking very carefully at what is happening where the rubber hits the road and realising that they just haven’t done enough work there."

Commenting on whether there had been assets that had failed to deliver the diversity expected through the financial crisis, Nicole Connolly, director of alternatives consulting for Russell Investments, said funds had certainly been looking very carefully at asset correlation.

"Without a doubt there’s been closer scrutiny of a number of asset classes that perhaps were more highly correlated than was expected or anticipated," she said.

"You could say that hedge funds fell into that category, but if you look back at hedge fund returns over the last couple of years, the reality is that they have provided a superior risk adjusted return compared to many other risky assets such as equities or property.

"They did fail to deliver on an absolute return basis over 2008 and that was certainly disappointing for some investors, but hedge funds shouldn’t be expected to deliver absolute returns every single year," Connolly added.

"Over the longer term they’re designed to give a cash-plus return, but there will be years where they will produce negative returns, and obviously 2008 was an example of that."

Alternatively, Eagleton said the problem lay in the fact that hedge funds did not always rely on their managers’ skill.

"The ones that do are the ones we like but they aren’t all like that," he said. "Many held large exposures to risky assets during the GFC, large exposure to directionality and gave what was illusory diversification," he said.

"It’s proof that there’s just no substitute for good detailed manager research.

"To some extent, it’s simply about being more discerning."

Asked whether she felt trustees were re-examining hedge funds on the basis of what had occurred through 2008, Connolly said that many probably were, but not on the basis of the returns that they provided.

"It relates more to the structural issues of the intermediaries or the hedge fund of fund managers," she said.

"Often there was a mismatch in terms of liquidity, so the fund of fund was offering liquidity provisions that didn’t match the liquidity provisions of the underlying managers.

"There were also extreme currency movements late in 2008, which meant that fund of funds often had to raise capital within their structures by selling down highly liquid and often more profitable managers," Connolly continued.

"So a lot of people were unable to get their money out of fund of fund hedge funds during that time, and that caused concern for investors.

"It’s not necessarily that they were disappointed with hedge funds per se, it was the access mechanism to hedge funds that was the problem."

Of course, hedge funds are just one part of the alternative investment picture. For the last few years it seems exposure to alternatives has become increasingly popular for super funds, but while Wyrsch said he hadn’t seen any evidence of the trend altering, he warned there were lessons to be learned here as well.

"Our clients have been well set in alternative options for quite some time, so it’s not something we’re particularly increasing our focus on," he said.

"But there does seem to be a greater focus on alternatives within the industry and a realisation that, as with any other asset class, you have to look through at what the value is and understand what you’re investing in.

"This is probably yet another lesson out of the GFC," Wyrsch continued.

"And it’s about how important the capital structure is and, regardless of what investment you have, if you gear it too highly you’re going to have problems in a distressed environment.

"It really doesn’t matter how defensive it is or how strong the earnings are or how impervious the revenues are to economic downturns, if you’ve over-geared it then you’re going to be in trouble."

In saying that she saw investment into alternatives continuing for super funds, Connolly pointed out that the asset class held clear diversification benefits.

"For instance, if you look at strategies on an isolated basis, private equity is a clear return enhancer for any portfolio where you expect a listed equities return plus a premium," she said.

"Alternatively, hedge funds are designed to be a volatility dampener where you’re targeting a more consistent return over time, and then there’s infrastructure investments that provide a yield driven return, and in some cases are linked to inflation.

"There are a number of options available in alternatives and I think a lot of trustees have recognised that."

Socially responsible investment

But with respect to what seems to be an increasing propensity towards environmentally and socially responsible alternative investment (SRI) on the part of institutional investors, asset consultants seem to have mixed views.

"There’s a feel-good element to investing in these types of strategies but increasingly there’s an investment case as well," she said.

"And certainly the Government’s target to have 20 per cent of electricity supply coming from renewable energy sources by 2020 is a large part of it."

Similarly, Wyrsch’s take on SRI investment was that while funds were open to them, they had to stack up on investment grounds.

"It’s an area that will be ongoing for many investors," he said. "But ultimately, it will be subject to exactly the same disciplines as any other investment."

Eagleton said that while Mercer had clients with exposure to what was broadly referred to as responsible investments, he didn’t see any widespread increase in demand from the super industry.

"It’s more about product availability and picking up the right opportunities as they arise," he said. "But we are seeing increased interest in the policy aspects of investment."

The unlisted assets that had been the bread and butter investments of industry super funds for so long might also find their place in portfolios questioned this year.

With valuations lagging the listed markets, they are an asset class that still seems to be in a recovery phase, but within portfolios Wyrsch said he could see trustees having a greater appreciation for why an illiquidity premium existed.

"I think people have now got more appreciation for why you have an illiquidity premium," he said.

"But what I would also say is that the unlisted asset class was a real standout in the way they were managed during the GFC because they didn’t typically raise money.

"Equity was at its most expensive, but they didn’t flee from investments and they didn’t favour some investors over others," Wyrsch continued. "I actually think that the GFC was a real advertisement for the benefits of unlisted assets and unlisted funds.

"On the one hand, yes there’s a cost to liquidity, but on the other hand, in terms of governance and the way these funds behaved, there were some real benefits in comparison to the listed market."

Connolly said that while the GFC had highlighted the problems with illiquid investments, most super funds had managed their unlisted exposures well.

"Most trustees and investment teams managed illiquidity within their fund by targeting no more than perhaps 30 per cent exposure to unlisted assets," she said.

"And while that was stretched and pushed to its limits during the crisis, most funds managed to get through that period relatively well.

"Funds are looking closely at the type of illiquid investments they have within a portfolio, but the diversification benefits of having an illiquid exposure is still very relevant."

Ultimately, there is no doubt that there will always be common themes within super fund allocations. They are, after all, put together to foster the best possible retirement income for members, but while investment choices are bound to reflect that, Connolly said there were points of difference.

"It would probably be in the alternative investment strategies that asset allocation differs the most," she said. "For example, private equity, infrastructure, hedge funds, commodities, active currencies — it’s whether or not super funds or investors consider these strategies within the broader asset allocation framework or as a separate allocation.

"Most do to a certain degree, but I think that it is within those strategies that you’ll see the most divergence in allocations."

From the Frontier perspective, Wyrsch said that the variation to be found within Australian super fund asset allocations had a lot to do with how well the local market had performed in recent years, but he added that asset consultants could only work within the objectives that trustees had set.

"That has a big bearing on where asset allocations might be," he said.

"But things are pretty good in Australia compared to most of the world, and I think Australian funds have probably been able to take more positions in risk than we’ve seen offshore, both psychologically as well as physically.

"That fact certainly helped in the last year but I think there’s also different views on how much illiquidity you want to take as risk," Wyrsch continued.

"Clearly some people are of the view that the world is always ending whereas others simply see opportunity.

"But the key difference is in how much risk people are wanting to take at the moment, and there’s different views on that and different timeframes."

And adding yet another perspective to the mix, Eagleton said that he saw the bulk of allocation variation in unlisted investment philosophies.

"So that’s mainly funds’ tolerance to unlisted property exposure, infrastructure exposure and so on," he said.

"But there are also differences in funds’ preparedness to diversify globally, and that’s something Mercer is a strong proponent of in terms sourcing alpha as well as exposure to different underlying asset classes.

"The one other point of difference is in super funds’ preparedness to deviate and shift their allocations in response to medium-term risk or opportunity. In an increasingly competitive industry, like it or not, trustees need to have some regard for medium-term performance.

"They need to be aware of the need to rebalance."

On the topic of dynamic asset allocation or medium-term portfolio tilting, Wyrsch said it was a strategy Frontier had advocated for some time, but that he also saw trends towards it growing.

"We’ve done it for some time and I think there is probably a greater focus on it, but it’s about how you execute these things," he said. "I’d say there’s a theoretical advantage in doing it at times but you’ve got to be able to actually do it, and it’s not always easy.

"You’ve got to put the tilt on when markets are about to outperform and then take it off when they’re about to underperform, and that can be easier said than done."

When all is said and done, though a super funds’ returns and the asset allocation that yields them might have the most significant bearing on members’ retirement savings, the reality is that there are very few ways by which this can be measured.

Various research houses provide fund performance figures periodically, but for Eagleton, those figures can not reflect all of what makes up an investment strategy.

"There are a lot of things going on in a super fund’s investment strategy," he said. "Part of it is asset allocation, part of it is their active strategies, part of it is recognising opportunities to shift, part of it is the cost of implementation, part is tax management and so on.

"So looking at any particular fund’s performance over the long term is difficult, and in the short term, people should realise that a lot of what is measured is noise — it can have more to do with luck than skill," Eagleton said.

"Of late, I think there’s been too much focus on relative performance and not enough on whether a fund is achieving what it has set out to achieve and provide for members.

"Thankfully the industry has done a pretty good job of achieving those outcomes, but if people are going to draw any conclusions over whether one super fund is better than another, it has to be done over the long term."

Measuring performance

With regard to the return figures released by research houses, Connolly said that super funds could not help but be aware of their own relative performance.

"I used to work at a super fund and we certainly looked at the super returns on a monthly basis," she said. "You do look at them and you do compare yourselves to them.

"You certainly know which funds you’re going to see at the top of the charts in certain environments and you know that there’s going to be others at the bottom of the charts when that environment changes.

"It’s probably something members shouldn’t be looking at on a monthly basis and, to be honest, we as an industry probably shouldn’t be looking at them either."

Reiterating his point that past performance had little to do with future performance, Wyrsch said that providing members with the retirement benefits they would at some point rely upon was what counted.

"When it comes right down to it, funds are interested in retirement benefits for members that are a consumer price index [CPI] based measure," he said. "The trouble is, you really can’t invest in CPI plus 3 per cent, at least not directly.

"So when these figures come out and people measure themselves against them, all things being equal, it’s better to be at the top than the bottom," Wyrsch continued. "But at the end of the day, it’s about providing retirement benefits for members.

"That’s what’s got to count."