Superannuation funds redouble efforts to get asset allocation balances right

Asset allocation has emerged as the key differentiator in superannuation fund performance and, as Damon Taylor writes, trustees are looking increasingly critically at which advisers have done best.

Faced with an increasingly competitive operating environment, the super industry often talks about points of differentiation.

Insurance, member communications and even access to financial planning are all pointed to as providing that point of difference and, fortunately, the global financial crisis has done little to alter that fact.

Yet when the chips are down, asset allocation provides funds with the most vital competitive advantage, and Warren Chant, principal of specialist superannuation research and consultancy firm Chant West, believes the relative performance of those allocations continues to be differentiation’s bottom line.

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“Asset allocation undoubtedly provides the biggest point of difference,” he said. “It’s not about fees and it’s not about governance.

“When the rubber hits the road, it’s all about performance.”

At the fund level, Damian Hill, chief executive officer of the Retail Employees Superannuation Trust (REST), said fundamentally, asset allocation was the most important decision made by trustees.

“So from that point of view, asset allocation has to provide a point of differentiation,” he said. “Ultimately, super funds are trying to provide growth in their member’s retirement income that is above inflation.

“Broadly speaking there will be common themes, but there are certainly opportunities to differentiate.”

For Maggie Callinan, head of ING research house Financial Facts, asset allocation maps directly to performance.

“An optimal allocation will obviously yield the best performance,” she said. “But asset allocation maps to liquidity as well.

“When asset classes perform very differently, as they have been recently, the decisions super funds make can yield very different results,” Callinan continued. “Direct property versus listed property is a perfect example.”

Pointing to recent returns as evidence, Callinan said the consequences of a super fund being strongly invested in direct property, where revaluations were rare, would have been very different to those worn by a super fund invested in listed property, where revaluations occurred every minute of every day.

“With listed property currently down 50 to 60 per cent,” she said. “And with direct property, which according to some hasn’t budged, the impact would have been very different.

“The same thing happens in other spaces as well,” Callinan added. “It happens when weighing up small companies versus large companies and alternative investments versus equities.

“These are decisions that can achieve very different outcomes.”

Examining allocation decisions as they relate to industry super funds and their peers in retail master trusts, Nathan MacPhee, chief operating officer for SuperRatings, said allocation trends were what dictated the industry and retail returns differential.

“The key difference in terms of not-for-profit and retail super fund allocations lies in their exposure to alternatives.”

MacPhee added that not-for-profit super funds had gone to alternative assets sooner and that they continued to have a much larger presence in the alternative space.

“Not-for-profit funds have up to three times as much invested in alternatives,” he said. “Whereas master trusts tend to have a greater allocation to listed equities.

“Clearly that’s a significant point of difference.”

Of course in recent times, an individual fund’s asset allocation will have been skewed significantly by the influence of the global financial crisis.

Yet while MacPhee admitted that it had been a major change to the financial environment super funds were enjoying three years ago, he said most funds had stuck to their strategic allocations.

“There has been a switch to alternatives for many funds over the last three to four years,” he said. “But while super funds monitor their long-term strategies closely, switching is rare.”

MacPhee added that any shifts that had, in fact, occurred had been on the basis of domestic equities performance.

“Funds have different ways of rebalancing their strategic allocations,” he said. “They can sell liquid assets or they can rejig portfolios.

“But the problem recently has been that some funds have found themselves a long way from their strategic allocations,” MacPhee continued. “They may have sought a 20 to 30 per cent weighting to alternatives, but have instead gone to 30 or 40 per cent.

“There have been shifts to cash as well, but we’re seeing some of that flow back into equities now.”

By contrast, David Stuart, head of dynamic asset allocation for Mercer Investment Consulting, said there had been substantial shifts to fund allocations compared to two years ago.

“Most funds have significantly lowered their allocation to equities and credit,” he said. “Though lower credit weightings may be hidden within fixed interest portfolios.

“Unlisted assets have also risen quite significantly for some funds,” Stuart continued. “And while these allocation changes may have happened in a passive manner due to changes in valuations, there will be funds that have seen a 5 to 10 per cent rise in their unlisted asset weighting.”

According to Stuart, building up cash was another common theme, but he added that it had been offset by a number of members moving their superannuation into cash options.

“We’ve seen many funds trying to raise cash,” he said. “But we’ve now seen a two-month rally in equities markets.

“Some of what’s been seen in the last 12 months is starting to reverse,” Stuart continued.

“Listed markets are coming back and unlisted assets are fading. There’s a lot of that cash going back in.”

Reflecting on what allocation changes had occurred as a result of recent uncertainty, Hill said there wasn’t anyone in the industry who had seen the global financial crisis coming to the extent that it did.

“But there were signs in some markets that things were becoming overheated,” he said. “And we felt that valuations weren’t being based on asset fundamentals.

“REST reacted by building up our assets, particularly with respect to cash,” Hill continued. “And while you can argue that our cash build up occurred too early, we felt that it was the prudent option.”

Hill said the byproduct of the financial crisis had been that there were now opportunities emerging in various asset classes. He pointed to the low prices currently available in credit and alternatives as an example.

“There are low prices in those assets for what are long-term opportunities,” he said. “And the trustee hope is that we have sufficient flexibility to take advantage and to lock in good long-term returns.”

Agreeing that cash build-ups had been the common reaction to the financial crisis impacting all markets, Chant said those funds advised by Frontier Investment Consulting and JANA Investment Advisers through 2007 had been using their available cash flow to grow their cash reserves.

“They began moving away from their strategic allocations over concerns that equities were becoming overheated,” he said. “So when the crisis became evident at the end of 2007 and things nosedived, they were relatively prepared.

“For the last 18 months, among considerable volatility and considerable uncertainty, there’s been a freezing up of credit,” Chant continued. “And funds have found themselves reasonably restricted in what changes they could realistically make.

“The difference now is that funds are looking very closely at their strategic allocations and whether their traditional approach is what they want going forward.”

Yet if superannuation allocation shifts were made, the assumption is that they took place on the basis of the good or bad performance of individual assets and, according to Chant, hedge fund investments took a great deal of the spotlight.

“Everyone was disappointed with the way hedge funds performed,” he said. “They were meant to give support during a down market and they didn’t.

“Everyone expected equities to get hit, so there were no surprises there,” Chant continued. “Listed property trusts (LPTs) were hit pretty hard when credit dried up and various companies had refinancing issues, as were highly geared managed funds.

“The worst performers were undoubtedly those assets with high levels of leverage.”

Similarly, Stuart said the disappointing assets had been those funds chosen specifically for diversity.

“Given the nature of the economic environment, which itself was a surprise, the scale of the economic downturn could not have been predicted substantially in advance,” said Stuart. “So given that, most asset classes performed as expected.

“The disappointments were those assets funds held in alternative areas for diversification,” he continued. “Hedge funds, for example, performed almost identically to other asset classes.

“The diversification benefits disappeared as all markets felt the crisis’ impact.”

Asked whether any asset class had been hurt enough to alter the role it played within superannuation portfolios, Stuart said there were definitely some big question marks out there.

“In the case of hedge funds, they have what are relatively high fees and were among the weakest performers,” he said. “And you will find many investors reassessing their role.

“But I think there’s been a reconsideration of all asset classes because at a time when funds wanted diversification most, it simply wasn’t there.”

Providing an alternate perspective, MacPhee pointed to the biggest performance divide being between listed and unlisted property.

“That divide was around 60 per cent,” he said. “But we’ve seen falls across the board, except perhaps in cash.”

MacPhee added that while there were some obvious issues in listed property, it was unlikely that super funds would shy away from its investment in the future.

“For most funds, the number of asset classes they can invest in is relatively limited,” he said. “Most variations will be in listed versus unlisted property and their exposure to alternatives.”

On the super fund side of the fence, Hill argued that allocation changes had been driven by asset positions with respect to their fundamentals and not as much by their individual performance.

“Government bonds, for example, performed well, but if funds are looking to the future and the likelihood of good returns, there are better opportunities available,” he said. “And that’s why it’s so important for funds to have sufficient liquidity.

“That cash flow allows them to cover redemptions and take advantage of opportunities as they come into play.”

Looking ahead, Hill, like Stuart, suggested that the global financial crisis would lead to a number of reassessments.

“There’s likely to be a reassessment of how we measure risk and whether portfolios have been truly diversified,” he said.

“Expect a re-examination of the correlations between various asset classes and a rethink of individual asset roles.”

However, the allocation rethink caused by this financial crisis goes beyond poor performing assets and the roles they may have played. Concerns over liquidity have been a feature of this uncertainty and, according to Callinan, its possession has had a long list of advantages.

“The more liquid assets are, the more accurate prices are,” she said. “And in this sort of environment, having good liquidity means that you aren’t going to get into the situation where the fund could close due to redemptions.

“Most importantly, those funds with the advantage of liquidity have been able to maintain their asset allocations without going overweight to illiquid assets.”

From the outside looking in, Chant’s view was that most funds had had very few liquidity concerns.

“There’s been a lot of discussion about liquidity and it has certainly dried up,” he said. “At the end of 2008, as funds were looking to cover their hedge positions, they took away a significant amount of liquidity, and they also had people transferring from aggressive options to options that were far more conservative.

“But by and large, I don’t think there’s been any funds that have been adversely affected by liquidity,” Chant continued. “There haven’t been people changing funds en masse and there haven’t been huge shifts in investment options either.

“Liquidity has been tight, but I think the system has held up pretty well.”

Stuart said in this kind of environment, liquidity and cash were king.

“We’re moving out of that situation slowly, but there continues to be assets for sale at very distressed prices,” he said. “So if funds have had liquid assets, they’ve been able to pick up some real bargains.

“Liquidity has been a very important factor for those funds looking to take advantage of this financial environment,” Stuart continued. “And the reverse has been true in that a heavy exposure to illiquid assets has placed significant restraints on some funds.”

Stuart stated that last year, highly illiquid assets had performed well but pointed out that as markets were rebounding, that strong performance was turning around.

“To date, there’s been a performance advantage in unlisted assets, but it’s generally accepted that unlisted valuations lag listed valuations by a fair margin,” Stuart said. “So the performance we saw in listed markets last year could still follow through.

“I’d say that one of the longer lasting impacts of the global financial crisis will be a more careful analysis of liquidity needs,” he continued. “Super is about long-term investment strategies and long-term needs, but fund executives need to remember that member switching can create a short-term liability.”

According to Hill, liquidity gives trustees options.

“Those options may be in the form of short-term opportunities or they may be in the form of reducing risk,” he said. “But good liquidity ensures trustees can remain in charge of their asset allocation decisions.

“If those decisions are impeded by liquidity concerns, it can make the risk/return trade-off that much more difficult.”

However, the obvious question around liquidity is whether preparation for the recent financial turbulence was possible and whether Australian superannuation funds were savvy enough to manage their cash flow and increase their exposure to unlisted alternative assets in the lead up to the crisis.

Stuart said while preparation for the financial crisis had been possible, it probably hadn’t paid the same size dividends as funds had originally hoped.

“The bear market of 2001 and 2002 was relatively mild here in Australia,” he said. “And following that, we saw a lot of super funds deliberately reducing their listed exposure as they moved into alternative assets.

“But this time around, there have been some alternative assets that have mirrored what has happened in equities,” Stuart continued. “Hedge funds and commodities are a good example of that.

“So going forward, I expect funds will conduct a continuing search for the drivers of performance and for those uncorrelated assets that are likely to survive an economic collapse.”

Chant said while Australian super funds had indeed made attempts at preparing for a financial downturn, he had seen flows to cash being much more popular than flows to unlisted alternative assets.

“I think funds were putting their money into cash rather than unlisted alternatives,” he said. “Most funds haven’t actually increased their weightings to unlisted alternatives, but they’ve gone up as their listed equities have been written down.

“But in saying that, the heavier weighting of industry super funds into unlisted alternatives has helped them significantly,” continued Chant. “It’s meant that up to 20 per cent of their portfolio hasn’t been hit as hard and that their overall performance has been stronger.

“The result was that for the 2008 period, the gap between industry and retail funds went from where it is normally — 2 per cent — and blew out as far as 6 per cent.”

For Hill, preparation was possible, but not to the extent that was necessary.

“No one can consistently pick the tops and the bottoms of markets,” he said. “And the reality is that that kind of preparation and undertaking those sorts of allocation shifts isn’t an easy exercise.

“You have to be prepared to take short-term pain for long-term gain.”

Taking a step back from the global financial crisis and the impact that it has had upon superannuation asset allocation, the guarantee is that the downturn will eventually end and that those super funds left too strongly in defensive assets will be left behind.

And when asked how funds should avoid that happening, Hill said there were no easy answers.

“That’s a difficult question at the moment,” he said. “The question of how soon you should start reinvesting.

“I think it has to be based on the fund’s view of their liquidity position and the sort of cash flow they can guarantee,” Hill continued. “It’s important for funds to be doing even more work on their prospective cash flows now.

“The bottom line is that those funds unable to produce good long-term returns are those that will be left behind.”

Taking an altogether different view on questions of market timing, Stuart said Mercer encouraged its clients to allocate according to the economic conditions.

“And at the moment, our advice is that funds should be building their positions,” he said. “For us, market timing is trying to pick the bottom of markets, and that can be dangerous.

“But when there are excess returns available and when markets are trending below their equilibrium value and below fair value, there’s no reason funds shouldn’t be taking advantage,” Stuart continued. “And I think funds are much more aware of that now.”

According to Stuart, it is no longer appropriate for funds to have a ‘set and forget’ long-term strategy formulated by an actuary.

“We think the days of sticking to that sort of long-term strategy through thick and thin are well and truly over.”

So with an eye to the future, it is clear that super funds have learned a number of lessons throughout a financial crisis that has drawn repeated comparisons with the Great Depression.

Yet it is MacPhee’s belief that there have been few, if any, long-term changes to funds’ asset allocations.

“Things typically move quite slowly within superannuation investment,” he said. “Funds are limited as to where they can allocate.

“Many alternatives can now be considered quite mainstream and well suited to super,” MacPhee continued. “And provided funds pay attention to liquidity, they’re likely to perform well.

“But I don’t expect funds will make any long-term changes to their strategic allocations.”

For his part, Stuart said while he had seen funds learn a great deal in the last 12 months, he had doubts about how long their memories would last.

“Funds will have learned a number of lesions, but the last cycle proved that memory can be short,” he said. “So whether these lessons will be remembered in another five years is an altogether different matter.

“More immediately, I think we’ll see a reduction in the very large allocations to unlisted assets that some funds have undertaken,” Stuart continued. “Many will have been chastened by the need for liquidity.”

Stuart said he also expected continued moves by super funds to reduce their direct equities exposure.

“Our advice in the short-term is to increase that equities exposure, but that will settle down in the next three to five years.”

Examining the lines separating industry and retail funds once more, Chant suggested that investment habits might be changing.

“In the past, retail funds have been reluctant to go to unlisted assets because of the importance they’ve placed on liquidity,” he said. “But they’ve had too little exposure to unlisted markets and I expect that we’ll see that increase in the next 12 to 24 months.

“Industry funds have also been much more prepared to adjust their strategic asset allocation over the medium-term if circumstances have warranted the change,” Chant continued.

“All funds would like to have less reliance on equities markets, but retail funds may have learned a thing or two from their industry counterparts.

“So across the board, medium term strategic tilts and higher exposures to unlisted assets are likely to become far more common.”

But the superannuation reality, according to Hill, is that funds are continuously learning.

“At times like these, it’s detrimental to be purely reactive,” he said. “Funds need to avoid knee jerk reactions and that requires thinking and contemplation.

“It’s important not to throw the baby out with the bathwater and to understand why investment philosophies might be changing.”