The place for alternative investments in superannuation

Alternative investments should still represent a key allocation for superannuation fund trustees but, as Damon Taylor reports, finding the right mix is proving crucial.

As investments that are either untraded, or at least traded differently to those in listed markets, the traditional role of alternative investments has always been as a portfolio diversifier.

Yet the reality is that investment into infrastructure, property and even hedge funds and private equity, has become far more commonplace in recent years.

To a large extent, alternative investments are no longer quite so alternative and, as a consequence, this basket’s individual assets are increasingly being examined individually and in their own right.

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And rightly so, according to Fiona Trafford-Walker, managing director of Frontier Investment Consulting, who said that alternative investments’ recent performance had been as diverse as the asset class itself.

“As usual, their performance has been quite mixed in the sense that alternative assets are not necessarily a homogeneous group of investments,” she said.

“So what we’ve seen is that direct infrastructure has done reasonably well. They’ve recovered, for the most part, reasonably well following the global financial crisis.”

“Those higher quality assets that got pretty badly marked down have come back but anything that was not real infrastructure, which was peripheral or really more like private equity, some of those things have continued to struggle,” Trafford-Walker continued.

“But toll roads, airports, the more traditional infrastructure investment, have come back nicely and performed reasonably well.”

Private equity

Trafford-Walker said that private equity performance had probably been a bit more variable.

“The environment for exits has been a bit questionable,” she said. “And it’s a very expensive asset class so it really needs to deliver its 5 per cent above listed markets to be worth investing in.”

“So while the returns have certainly improved since the global financial crisis (GFC), its been complicated at the super fund level by a lot of the trustees looking at the sector in the context of the Cooper Review and its focus on fees,” Trafford-Walker added.

“We’ve seen a lot of clients be much more discerning about their private equity investments and tending not to go into the more generic fund of funds. They’re instead looking for something that’s less diversified and really focused at that pointy end to try to get the good returns.”

Also weighing in on private equity, Ken Marshman, Head of Investment Outcomes for JANA Investment Advisors, agreed that performance had been a mixed bag.

“It’s been largely dependent on the type of manager and the type of area that you’re looking at, but we do see that there’s some areas that look quite interesting,” he said.

“And that’s particularly within secondaries where some investors have had to off-sell their existing portfolios because of their own direct needs.”

“That might have been for liquidity purposes or balance sheet restructuring or something else entirely, but what it amounts to are some good opportunities.”

Hedge funds

In the case of hedge funds, Trafford-Walker said that super funds were similarly conscious of fees.

“They’ve improved too but hedge funds, within themselves, are a very heterogeneous group and again, they’re falling into this category with clients of being pretty expensive,” she said.

“There’s generally a lack of willingness to pay over the odds for these investments so they’ve probably been the biggest casualty of the Cooper Review and the GFC.”

“They really struggled through the GFC when people thought they would do a lot better and then, coming out the other side, many of them did do pretty well but the Cooper Review and the spotlight on fees has knocked them around a fair bit.”

Performance aside, the level of comfort many investors are reaching with alternative investments is interesting to note.

As mentioned previously, alternatives are no longer quite so alternative but according to John Paul, Chief Executive Officer of Asset Super, that does mean the asset class is one favoured by all investors.

“We went into this area later than some others but we had a program target of $160 million to invest across a range of alternatives and, within that basket, we didn’t restrict ourselves to a particular style of investment,” he said.

“If it was private equity or distressed property or opportunistic property or mergers and acquisitions, it was considered.”

“We looked at anything that was brought forward to us by our manager at that time, Quentin Ayers, and they had a three year program to find opportunities in what we saw as a market where we might have got a little bit of enhanced investment performance,” Paul continued.

“That was the logic behind it.”

Outlining Asset Super’s alternative investments experience further, Paul said that the process had lasted three years, but added that his fund hadn’t become fully invested to the $160 million that had been intended.

“And that was for a variety of reasons but primarily because good opportunities take time to find,” he said.

“But what I would also point out is that up until the time we took this particular path, we had basically been used to the standard manager approach where you go direct mandate and get some control over how the investments are done, or you go with tooled super trusts and you pay a management fee for that.”

“What we hadn’t had experience in was the fairly hefty fees that some private equity investments and alternatives do charge.”

Paul said that the experience of being charged for money committed rather than invested had also been new to Asset Super’s executive.

“So if there’s one lesson I learned from that exercise, and a word of warning I’d have for anyone, it is that I am philosophically opposed to taking on investments where you’re paying for the commitment rather than the investment,” he said.

“If someone has a $10 million investment, you put your hand up and say that you want to invest $10 million in that particular private equity fund, but what happens is they say that you’re paying fees on that $10 million from day one even if they only gradually draw down and don’t get the full $10 million for 12 months or 18 months or whatever.

“I have a lot of issues with that; you haven’t got the money in there earning but you’re actually paying a fee for it.”

For Marshman, this kind of experience is a large part of the reason why, despite the growing use of alternative investments within super fund portfolios, listed markets aren’t ever likely to lose their predominance.

“The liquid market is the least cost source of raising capital for most large businesses,” he said.

“We should also never lose sight of the fact that these markets only exist because people want to raise money to take on their entrepreneurial spirit, invest capital and produce a long term return.”

“Raising capital is a cost to those businesses and they’ll raise funds from the lowest cost source,” Marshman continued. “So you have to ask the question in these alternatives - why are they raising capital from sources that are not the lowest cost?”

“And the reason that they have to raise capital in from a source that is not the lowest cost is because there is another risk involved, a risk that the listed capital markets won’t take.”

Illiquidity

Marshman said that risk might be the risk of illiquidity, the risk of not getting cash flow back from an investment for a decade or longer, or it might be the risk of a corporate strategy which is about new technology or aggressive management.

“Those elements aren’t typically appealing to investors in the listed markets, the lowest cost source of capital,” he said.

“So that’s why shares will never go — they’re the lowest cost source of capital.

“So yes, allocation to alternatives investments may well rise and it may well be at the expense of listed assets, but the point I’m trying to make is that alternatives will always be alternative,” Marshman elaborated.

“They won’t ever be mainstream and that’s simply because of the higher cost of capital associated with them.”

On the other hand, Trafford-Walker suggested that the super industry’s increased use of alternatives would most likely be handled by looking to the individual assets, and the characteristics thereof, rather than the asset category as a whole.

“At Frontier, we tend not to call them alternatives as much as just give them their proper names,” she said.

“So we don’t talk about infrastructure as being an alternative asset anymore in the context of our own clients because, for many of them, it’s been one of their investments for nearly 15 years.”

“But in saying that, when we think about that grouping of assets and what the market still calls alternative, then we’ll still call them that so that clients can compare,” Trafford-Walker added.

“I think people will generally become more discerning about the investments they make, and what they’re called and how they fit in will probably be much less important than things like the capital structure, the performance expectations, the volatility and the real risks.”

“So maybe we’ll see more thinking around what you’re actually investing in, not just the name that something’s been given.”

Listed assets

Perhaps largely on the back of Asset Super’s alternative investments experience, Paul, like Marshman, said that listed assets would continue to be the dominant area of investment.

“I think it’s just the nature of the beast,” he said.

“There’s more opportunity in that space and, in some ways, it’s a little bit more transparent because of the way the market operates.”

“Private equity, distressed debt and infrastructure on the other hand, for all of those sort of things it’s quite often a case of being ‘in the know’ so that you can get on the bandwagon early and become an investor at the appropriate time,” Paul continued.

“And history is full of things like the Cross City Tunnel and the Lane Cove Tunnel where people have paid a price for going into things that though they may have been well researched, had some problems.”

“Having seen the events of the global financial crisis, I think a lot of funds have probably got a fairly healthy level of caution about the alternatives space and while that doesn’t mean people won’t go there or consider it, I think it does make investors pause and consider it very carefully.”

Importance of managers

Indeed, the key with alternatives, given their relative complexity and variety in terms of strategy and risk, seems to be choosing the right managers. And for those super funds seeking to differentiate the alternative investment managers out there, Marshman recommends looking to experience.

“I think in many of the alternate spaces, there is a pattern of people who can consistently manage and invest well over time,” he said.

“So looking at past performance is an important criteria, provided that the same people are in place.”

“The second element is one of a fair arrangement with the distribution of the benefits and the returns of investing,” Marshman continued.

“And that’s not only a question of fairness of who should get what and who’s taking the risk but, more importantly, it is one about setting the right incentives to attract the right sort of people into this game.”

“The final one, and quite possibly the most important one, is experience.”

Echoing many of Marshman’s keys for manager selection, Trafford-Walker said that super fund executives could not overestimate the importance of having the right structures in place for fees and investment ownership.

“When it comes to manager selection, we have a big long list of negative screens which we apply in the unlisted sector,” she said.

“But we have a much shorter list of negative screens in the listed sector simply because if you invest in something that’s unlisted or illiquid, you’ve got to work on the basis that you might be there for a few years.

“Those screens are very much around things like the quality of the people and the process, the quality of the assets that they buy, transparency, governance, and the right to terminate the manager is a big one,” Trafford-Walker continued.

“We’re very clear that the investors own the assets; the manager doesn’t own the assets, they’re just a temporary guardian.”

“So if the investors, who own the assets, are no longer happy with a particular manager, they ought to be able to terminate without being penalised.”

Speaking directly to fees, Trafford-Walker said that super funds should be looking to ensure that what they were getting was fair value.

“So we’re happy to pay what might be a pretty decent fee on the basis that what we’re receiving is a pretty specialised service, but we don’t want to be gouged by anybody,” she said.

“So there are lots of negative screens around the fee structures and how things get paid out and how much gets paid out.”

“It’s not anything that’s rocket science, a lot of its common sense, but I think the value in the process we have is the fact that we apply it,” Trafford-Walker continued.

“So whether it’s the good times or the bad times, we’ve learned our lessons on that stuff and we just apply it religiously.”

“You can get a bit slack in the good times and say ‘oh, its fine, I won’t worry about it because this manager’s really hot’ but if you do, at some stage it will bite you in the bum.”

Investment teams

The other side to picking the right alternative investment manager is a recent trend towards super funds employing larger internal investment teams.

In many cases, such moves are replacing alternative investment managers entirely as those same funds look to direct investment in various alternative assets and, for Marshman, it is often an understandable decision.

“There is no doubt that when you’re investing in some long term investments, the ability to ensure alignment of interest between the manager, the promoter, the sponsor and the investor is very difficult,” he said.

“And so the more those decisions are brought closer to the investor, the less likely it is that they’ll have troubles with misaligned incentives and motivations.”

“It’s not so much a matter of cost that is the driving force but one of ensuring that investments are made for the right reasons and for long term returns.”

According to Trafford-Walker, trends towards in-house investment teams and direct investment were also largely in response to experiences through the global financial crisis.

“I think the global financial crisis triggered a bit of a loss of trust in a number of the managers and also a sense of not being totally in control of the investments that had been made,” she said.

“So a lot of the big funds responded by saying ‘look, I want more control, I want more flexibility and transparency, I want to see if that particular manager might be investing in this particular investment but what if I don’t like that investment, what if it breaches my ESG (environmental, social and corporate governance) guidelines or what if I’ve already got enough toll roads?’

“It’s really around flexibility of their own portfolio and it’s around control and transparency, but it was triggered by the fact that fund managers really didn’t do what clients thought they would,” Trafford-Walker added.

“So clients looked to take a bit of control back and make sure that they’re happy with what happens next time.”

Scale and resourcing

Not surprisingly, John Paul pointed out that while there were significant advantages to direct investment into alternatives, its viability depended entirely on scale and resourcing.

“If you’ve got the scale, you can control the fees and control the process,” he said.

“But the biggest problem with alternative investments is the amount of time and energy and research that’s got to be committed to weed out the good from the bad, and it comes down to resourcing.”

“If you’ve only got a smallish super fund with one chief investment officer (CIO), that’s a big ask to expect that the CIO would have the capacity to properly investigate the market across all alternatives,” Paul continued.

“On the other hand, if you’ve got a fund like AustralianSuper with 25 or more investment professionals, that’s a fairly big team of people.”

“You can afford to engage people who are experts in particular areas like private equity, like opportunistic property, and you can then focus on those directly.”

In agreement with Paul, Trafford-Walker said that infrastructure was a perfect example.

“It’s definitely a big resourcing question for the fund,” she said. “Infrastructure managers, for example, have big teams with specialised knowledge and people who do dedicated work in particular areas.

“And its pretty hard for a fund to replicate that,” Trafford-Walker stated simply. “It would be expensive and it’s just not that practical.”

Trafford-Walker said that what most super funds tended to do instead was employ people who could work with those alternative investment managers or, in her example, infrastructure manager teams.

“So they don’t try to second guess them or duplicate their work, they just test that what they’re doing meets the needs of the fund,” she said. “They’re checking that the due diligence is done properly, that all the i’s are dotted, that the t’s are crossed and that the investment makes sense for the fund.”

Regulatory reform

Of course, any examination of alternative investments, despite, or perhaps even because of, their growing popularity, has to broach the topic of MySuper. Within MySuper and the Government’s Stronger Super reforms, costs, fees and efficiency are an acknowledged focus but the question is how alternative investment fit into that picture.

And the answer, according to Trafford-Walker, is one still being debated throughout the industry.

“Until there’s some resolution on what everything will actually look like under MySuper, that debate will continue,” she said. “But the downside is that the focus on fees comes, I think, at the expense of a focus on net returns.”

“And net returns, to us, are paramount,” Trafford-Walker continued.

“It doesn’t really matter what you pay, it matters what you get to keep.”

“So if you’re a member and you’re paying a particular fee, that’s important because you want to make sure you’re getting good value but, at the same time, if you’re getting a good return that you’re happy with, then its worth paying for.”

According to Trafford-Walker, the industry’s focus on fees has steered the debate too far towards the absolute level of fee rather than to what net return the industry needed to target.

“The problem comes when clients look and see that this alternatives asset class takes up 5 per cent of their portfolio but nearly 20 per cent of their fees and they say ‘is it worth it?’” she said.

“And then, on the other hand, we’ve had discussions around having more passive investments because that will bring fees down and yes, it will, but it will also bring returns down.”

“So what would you prefer?” Trafford-Walker asked. “There’s no doubt that some of the alternative investment fees are simply too high but that’s why structuring those fees is so important.”

Trafford-Walker said that it really was a simple equation.

“If a manager wants to get paid a lot of money, they need to have delivered very high returns for the client and we’re okay paying for that,” she said.

“But the biggest issue is around things like the fee structure, so if you’re paid performance fees, what’s your base fee?”

“And if you’re paying a base fee that’s high and a performance fee, well that’s a win/win for the manager and that’s just crazy,” Trafford-Walker continued.

“So the solution here is restructuring the fee, not necessarily reducing it.”

“It’s about making sure that if the manager delivers a pretty crappy outcome, they get a pretty crappy fee.”

Interestingly, Paul said that his own fund’s view on the fee debate was just as simple, even though it had a different focus.

“The mantra that I tend to speak to my board about is that the return you might get from investment is variable and not guaranteed,” he said.

“The cost that you pay for investments, on the other hand, is not variable and is guaranteed.

“So if you know what your costs are, then you’ve got a chance,” Paul continued. “But if you go into a high cost environment for the potential of outperformance, that outperformance may well be there but you also can’t guarantee it.”

“At the end of the day, superannuation is a conservative game; we’re looking after members’ retirement savings and we need to remember that.”