Superannuation funds forced into an asset allocation rethink

Asset allocation has been the key differentiator with respect to superannuation fund returns but, as Damon Taylor writes, the continuing fallout from the global financial crisis has caused many funds to re-examine their settings.

As Australia’s superannuation industry contemplates what will undoubtedly be a very different superannuation environment come July 2013, it seems the one certainty is that competition will continue to be a constant.

In line with that reality, funds’ asset allocations have evolved markedly in recent years and according to Frontier Asset Consulting managing director Fiona Trafford-Walker those funds seeking to differentiate must, and therefore will, evolve them further.

“Over a number of years there’s been a fairly natural evolution in asset allocations as people realised that reliance on equity markets to deliver the goods was probably going to give you a pretty bumpy ride,” she said.

“So the main desire is producing smoother and more diversified return patterns over time and, from that we’ve observed, an allocation to things like infrastructure and property and private equity are becoming key parts of what clients are doing to do that.

“There’s also been further diversification into investments like hedge funds and commodities,” Trafford-Walker continued.

“More global investments as well, and that’s not only in equities, because there are a broad range of asset classes that people are investing in overseas.

“But the key development in asset allocation is that there’s now far greater diversification in portfolios than there was ten years ago.”

Russell Investments director of consulting and advisory services Greg Liddell said that his main observation had been that many within the industry, Russell included, were moving away from growth/defensive splits in asset allocation.

“They’re looking at different markets now and having a different nomenclature for defining the characteristics of their portfolio building blocks,” he said.

"So at Russell what we’ve done is move to five buckets, those being equities, fixed interest, other real assets like commodities or property or infrastructure, alpha-driven or skill-based strategies and finally opportunistic investments.

“So in the case of the latter, those are things that you don’t necessarily want to have a permanent exposure to, through a full market cycle,” Liddell added.

“That said, there are going to be times when the risk/reward to be had from those asset classes or investment strategies is going to make them attractive.”

Like Trafford-Walker, Liddell said that he had also seen moves towards less reliance on equity risk premium to drive returns.

“Equities are still very substantial components of asset allocation in most funds, particularly most default offerings, but over the last few years there’s been a trend to move more into alternatives,” he said.

“For instance, the Chant West numbers show that at the end of 2007 the overall average for alternative asset exposure was 6.2 per cent.”

“Contrast that to the end of 2010 and it had increased to 10.2 per cent,” Liddell continued. “So people are clearly buying more infrastructure; they’re buying more hedge funds and that certainly seems to be a global trend.

“So, just the way that funds think about asset allocation has changed and, within that, there’s been small but significant movement at the edges in terms of asset exposures.”

Dynamic asset allocation

Yet while investment into alternative assets has undoubtedly become more common, following on from times of uncertainty, Liddell’s opportunistic investments category is arguably as favoured.

For some time now, the industry has had a number of proponents of dynamic asset allocation or strategic tilts and according to the head of Mercer’s Australia and New Zealand dynamic asset allocation team, David Stuart, such strategies remain well used.

“This was probably a trend in place before the global financial crisis (GFC) and, to be fair, some funds have been adjusting their asset allocations for quite some considerable time,” he said.

“But around the middle of the last decade I think it began to get more impetus and, following the GFC, I think those that were still standing by static asset allocations wondered whether it was the right thing to do, given the sheer scale of the market moves around that time.

“There certainly seems to be a strongly increasing trend towards varying your asset allocation through time, in response to perceived valuation anomalies in markets.”

Trafford-Walker said that dynamic asset allocation continued to be popular, simply because the thing that most determined the future performance of an asset was the price at which it was bought.

“Obviously the environment that you end up having is important but if you can buy high-quality investments at good, cheap prices then that should set you up for a pretty good return over the life of that investment,” she said.

“That’s the heart of dynamic asset allocation; it’s trying to find investments that are good quality but a little bit out of favour, and therefore cheap.

“Secondly, it’s about identifying risks so that if something is very expensive and you’ve made a lot of money on it, it’s time to move on,” Trafford-Walker continued.

“But the difference between strategic asset allocation (SAA) and dynamic asset allocation is really a willingness to look at how much you pay for something.

“The old SAA approach was basically ‘set and forget’ and we just think that that sets you up for a pretty rocky ride.”

Of course, the key question here is not about the popularity of dynamic asset allocation but rather whether the strategy’s effectiveness has been borne out in superior returns over time. Stuart said that the aim was not just return-enhancing but risk-dampening as well.

“We do measure the performance of our own recommendations and obviously we believe that our tilts have added value but we also educate our clients not to expect it to add value in every short-term time period,” he said.

“So that may include a year in which you adopt a position and the markets continue to move against you.

“The other thing we would stress is that not only would we hope to add value by enhancing the returns of the fund but we’d also hope to lower the overall risk of the fund and I think that did come through in the GFC,” Stuart continued.

“We felt that a variety of assets had become quite expensive and, of course, they tended to fall significantly, so those who were adopting a more dynamic approach probably cushioned the scale of the falls.

“And that’s really one of the most important things for super funds — to realise that avoiding really poor returns is just as crucial as enhancing returns over time.”

According to Trafford-Walker, the return advantage yielded by dynamic asset allocation was most noticeable when viewed over longer time horizons.

“We look at how our clients have performed and the clients that we’ve had for a long time — say more than ten years — and we see about a one per cent excess return above the average fund,” she said.

“And when we look at what has led to that one per cent, the asset allocation positioning has been a key part of it.

“We think it works and, if you look at the market, you know that there are other funds that follow the same process and you can see that they’ve done pretty well over time as well,” Trafford-Walker continued.

“The important thing is not to look over the short-term but to look over the medium- to long-term.

“That’s how you can know that this stuff works and our strong view is that it’s a very important way to manage the portfolio, a very good source of value over time and we feel that fact is well borne out in the numbers.”

Working population changes

The one issue that has yet to meaningfully impact super funds’ asset allocations, but one that has been flagged by a number of industry pundits, is the impending retirement of an ever-increasing number of baby boomers.

The premise is that as this demographic enters retirement, they will be in need of income-generating assets rather than the growth assets which now dominate super fund allocations. But for Stuart, the issue isn’t that straightforward.

“The first thing to point out is that demographics, although they’re imminently forecastable compared to most forecasts that we make in economic markets, do change pretty slowly,” he said.

“They’re very gradual changes, almost glacial [in speed].

“So, in Australia, while there is this retirement of baby boomers, we’ve also got positive immigration that tends to be of a lower age range,” Stuart continued.

“And Australia is like the rest of the developed world, in that it’s going to see changes, particularly in the size of its working population relative to the retired population, but it isn’t going to happen overnight.”

Stuart said that when it came to moves towards income-generating assets like bonds, again it would not happen overnight.

“But the other thing that will hold it back is the fact that life expectancy is now getting longer and longer,” he said.

“When people retire, typically they’ve probably got a life expectancy of at least another 20 years and that’s actually a time horizon which we would say most normal balanced funds are probably quite good for.”

“If you switched immediately into a substantially fixed income-focused portfolio upon retirement, the risk is that you will run out of money before you run out of life,” Stuart continued.

“So we would say that you still need a fairly balanced mix and, again, the income requirement may mean that you make different changes.

“You might change your growth assets to higher income-producing assets but still potentially retain a reasonably significant weighting to growth assets.”

Similarly, Trafford-Walker said that the big picture issue wasn’t as much about increasing allocations to income-generating assets as it was about what asset allocations in retirement ought to be.

“That’s the dilemma here — what asset allocations ought to be in the retirement phase versus the accumulation phase, because there’s no doubt that they should probably be different,” she said.

“There also ought to be some consideration given to the tax position because that’s obviously vastly different in those two phases as well.

“And this is probably a key thing that funds learned out of the global financial crisis — that you do need to build tailored options for people in that phase,” Trafford-Walker continued.

“They could well be balanced options or growth options but consideration needs to be given to offering the products that people want to buy that give them that comfort in retirement.

“For a lot of people, that will be something that’s lower-risk, maybe more of a guaranteed-type structure. Maybe it’s more bond-type investments, maybe it’s more floating rate-type investments but whichever one it is, making sure people have effective allocations in retirement is rapidly becoming a priority.”

Naturally, the asset allocation issue waiting in the wings for all super funds relates to how fees will enter into the allocation equation.

The upcoming MySuper environment has put fees centrestage and front of mind, so it will undoubtedly be interesting to see how allocations develop as a consequence.

The simple view

“I have the view that all assets should be justifiable on an after-tax, after-fees basis,” said Liddell.

“What’s important is the net return in the pocket of the member and I think that all investment strategies should be predicated on that basis.

“In saying that, I think as result of the Cooper Review and MySuper, there certainly seems to be a push for MySuper funds to be more cost-conscious, more cost-aware,” he continued.

“And the response from a number of the retail houses has been to come out with superannuation offerings that are largely passive with few, if any, alternatives.”

Liddell claimed it would be interesting to see how such passive options fared when compared to funds employing property assets, private equity or similar illiquid alternatives.

“Because if the fee is appropriate, they do bring diversification benefits to portfolios,” he said.

“Sometimes the fees are too high but, at the end of the day, a premium is warranted for exposure to good assets in that space.”

Trafford-Walker said while fees were definitely a hot topic, Frontier clients had been negotiating with managers, both in the unlisted space and with listed managers as well.

“It’s really just about making sure that you pay what’s a fair price for a fair service and you’re getting decent value,” she said.

“In fact, the reality is that some listed managers are really bad value and some unlisted managers are really good value. So, while unlisted and alternatives for the most part will be more expensive, there’s no hard and fast rule here.”

Consolidation continues

“From a helicopter view, this issue of fees is definitely ongoing and it is definitely gaining momentum with a lot of funds, especially the big funds that are really looking to benefit from their scale,” Trafford-Walker continued.

“So what we’ve said to the funds management community is that you need to be innovative with how you think about your fee structures because the consolidation that’s occurring in the superannuation industry today is just going to continue.

“We’ve made it clear that there are going to be fewer and fewer mandates for them to fight over and that they need to think carefully about how they want to be paid and, more importantly, how they want to be rewarded in terms of performance fees.”

Looking specifically at the focus on investment fees that would result from MySuper, Trafford-Walker said that whatever fee guidance was provided had to be practical, implementable and had to reflect the nature of the businesses that offered these products.

“There are some small businesses which manage very small amounts of money and charge higher fees because they need to have a certain amount of dollars coming in the door,” she said.

“If that protects the ability of that manager to deliver excess returns to clients — well you might consider that that’s worth paying for.

“But if there was some prescription around what the fee could be, then those sort of products will become much harder for the funds to access,” Trafford-Walker pointed out.

“In terms of any likelihood that there will be greater allocations to passive investments, one of the big reasons behind why our long-term clients have done pretty well is that they’ve had good asset allocation but also they’ve tended to use active managers — not for the whole portfolio but for most of the portfolio.

“Good manager selection can add quite a lot of value, so if it’s just for cost reasons that people start to say ‘no more active management’, then there is definitely a risk that returns will be lower.”

Yet when it comes to asset allocations, the constant question lies in what constitutes the yardstick by which their efficacy can be measured.

Within the industry, there is often talk that research house ratings on super fund performance are of limited use, since past performance is no measure of what a fund’s returns will be like in the future.

If that’s the case, what dictates whether a given asset allocation has done its job and fulfilled a trustee’s objectives?

Trafford-Walker said that it was a question to which there was no easy answer.

“The way that I think about it is that the market gives you what the market gives you,” she said.

“It’s like there’s the god of the market and he wakes up one morning and says, ‘it is going to be this today’.

“Most people have no control over what that number is, so the inclination is for people to try to change the things they can control — fees and things like that,” Trafford-Walker continued.

“But when you look at asset allocation, you can have the best faith in the world in what you think is a good asset allocation and in any one year it might not perform very well at all.”

For Trafford-Walker, if a client gets a good return over seven-to-10 years, that’s telling you something.

“So you then have a look at what makes up those numbers, have a look at the shorter-term numbers and see whether it was just one year where they’ve shot the lights out, or was there a steady pattern of doing okay year after year, with the odd good or bad year?” she outlined.

“It’s really about trying to pull apart the numbers to see where they come from and what they can teach us.”

Peer comparisons

Looking at the issue of peer comparisons in the super industry and how it related to asset allocation decisions, Stuart advised funds to be very careful about focusing solely on relative performance.

“One thing we will do is look at where a client fund’s nominated peer group may have different allocations to them and we’ll assess why it is they may wish to retain their points of difference or maybe converge more,” he said.

“But ultimately the danger is that whoever is at the top of the table will be in the assets which performed best most recently and to have a policy whereby you constantly chase the table-topping fund is a dangerous chasing-tails type of approach.

“We constantly look at whether there are new ideas which maybe this fund hasn’t taken onboard and, if we think that they’re long-lasting and durable, then potentially the fund should incorporate them,” Stuart continued.

“But that shouldn’t be just because they’ve done well recently.”

“That’s really the source of most market misevaluations — people start chasing assets that have gone up and, to some extent, chasing the funds at the top of the table makes for a risk that you’re doing exactly that.”

According to Trafford-Walker, peer risk and peer competition was one of the biggest negatives to come out of fund choice.

“It creates this continual ‘looking over the shoulder’ by some funds at what other funds are doing and the reality is that they’re looking at a number of funds that have nothing to do with their industry or business,” she said.

“You have to say to yourself, ‘this is what I’m going to try to achieve for my members, this is my philosophy, this is how I’ll invest and this is my roadmap for investing’.

“That way, when things get a bit tough they can go back to their roadmap and say, ‘why am I doing this? Okay, yep that’s right. Do I still want to do that? Yes, let’s press on’,” Trafford-Walker said.

“And you tend to find that those funds doing that are the ones that do better over time. They don’t get sidetracked by noise in the market or noise from competitors.”