The superannuation landscape is in the throes of some dramatic changes. The release of Jeremy Cooper’s Super System Review – hot on the heels of the Ripoll and Henry Reviews – means it is interesting times for an industry that manages assets in excess of Australia’s gross domestic product (GDP). Given the near-universal coverage of superannuation in Australia, the issues raised in the Cooper Review have broad political, social and economic implications. This article will focus on one of the main reforms that the Government has indicated it will pursue, MySuper, and how it mostly serves to highlight the many misconceptions about investment management.
The Cooper Review Recommendations: A Mixed Bag
After making a number of fairly inflammatory remarks throughout 2009–10, covering everything from scale and size of super funds, fees and charges, through to inefficiencies of the administration process, the Cooper Review Panel issued its final report, which was released by the government on 5 July 2010.
The final report settled on two main proposals:
- SuperStream, which is concerned with fund administration.
- MySuper, a more fundamental overhaul of the default fund offering.
Anyone who has attempted to rollover a benefit from one provider to another will recognise that, at present, this is a cumbersome process. The intention of SuperStream is to set standards that will help bring the industry out of its paper-based, pre-computer era and into the 21st century. Most members and industry participants should welcome this move, as it allows for a step-change in efficiency that ultimately means more transparency, lower costs and quicker response times for members. While the devil is in the details, SuperStream looks like a welcome step forward.
However, in the perennial sign that a little bit of knowledge is a dangerous thing, the second broad proposal which recommends a particular default fund choice for members – MySuper – has, in my view, widely missed the mark.
One of Cooper’s concerns is that the current complexity of investment choice and the underlying investments in superannuation are expensive and baffling for consumers – a simpler structure is needed; while on that score he is right, unfortunately the critical mistakes of the current system are unlikely to be resolved by the MySuper proposal. Indeed, in imposing more rules around the structure of what makes a good default fund, and embedding a basic single choice asset allocation framework at the heart of the system, this is likely to make the situation worse. In addition, Cooper fails to address a real issue: many members have no choice, as default funds are mandated in awards.
A better starting position would be to understand the objectives of superannuation from the consumers’ perspective and what the industry could do to improve its delivery versus those objectives.
Investment Management: Popular Misconceptions
For most investors, the investment management process follows a relatively prescriptive formula. While clearly an oversimplification, the thrust of the process is to profile investors according to their return objectives and tolerance for risk, and place them into broad investment groupings defined along the lines of ‘conservative’, ‘balanced’ or ‘growth’ definitions. Each grouping then invests according to a well-defined model based around relatively static allocations to growth assets (read: equities). This model has been the basis for portfolio construction for at least the last 30 years.
There have been several flirtations at improvement:
- The shift towards alternative investments (e.g., private equity and hedge funds).
- Stable risk (or risk equalisation) portfolios.
- Life cycle funds.
More recently, the re-emergence of active management of asset allocation (reincarnated as Dynamic Asset Allocation, or DAA).
However, none of the above methods have fundamentally addressed the basic shortcomings inherent in the current portfolio construction model or process.
Moreover, the MySuper proposal would effectively embed these shortcomings in legislation.
Welcome to the ‘Real’ World of Investment Management
Investor disappointment and the increasing disillusionment with the existing portfolio construction model are understandable. It is also well grounded in fact, given the poor performance of most diversified portfolios over the last decade. For example, the median ‘growth’ manager1 returned 3.8% over the 10 years to June 2010 – well below the required 8.8% needed to achieve a return of 5% above Australia’s inflation rate2 over this period.
The underwhelming performance of what is, in effect, a proxy for the industry standard model can be traced to its dependence on a questionable series of assumptions.
- The Strategic Asset Allocation (SAA) will meet our objectives over time,
- Valuations do not matter in the long run.
- Volatility is a good indicator of risk.
- The order of returns does not matter.
- The SAA will meet our objectives over time.
- The fixed SAA model implicitly assumes that a) equities will outperform bonds over the medium term and b) the difference in risk between equity and bond returns is sufficient to warrant holding a substantial exposure to equities at all times.
This assumption has been severely tested over the last two decades, with bonds outperforming global equities over the last 10 and 20-years respectively. While Australian equities have performed better, the gap between Australian equity and bond returns is relatively small when compared to the additional risk.
Figure 1: Bonds Outperforming Equities
Figure 2 also shows the gap between the typical assumptions used in the SAA process compared to the actual return over the last decade.
Typical Assumed vs Actual Returns
Source: Schroders, Datastream, Actual Returns based on 10 years to June 2010.
UBS Composite Bond Index, MSCI Australia (AUD), MSCI World – ex Australia (AUD). Typical assumed returns based on Schroders’ experience.
Several points can be gleaned from this:
The difference between expected and realised returns is substantial in global equities – both in magnitude and direction.
The difference between realised bond returns and realised equity returns shows that investors would have been better served by owning more bonds than equities (even before any allowance is made for risk).
The end result was that investors held both too much equity and too few bonds, leading to substantial underperformance against objectives.
Valuations do matter
The substantial gap between expected and realised returns for global equities can be attributed to valuation being ignore – not that returns were unpredictable.
While not perfect, a strong relationship has been found between the Shiller PE and subsequent 10-year (or long run) equity returns3. The Shiller PE uses the inflation adjusted average from the previous 10-years’ earnings to calculate the PE ratio. As Figure 3 shows, the extent of the overvaluation in the global share market on this metric accurately foreshadowed a decade of very weak (on average) equity returns.
US Equity Market and Shiller PE
Source: Schroders, Campbell and Shiller.
Risk premium (and therefore prospective returns) can and do change, often markedly. This has been particularly apparent in credit and equity markets over recent years. Clearly though, this point was ignored by investors who, by and large, made very little change to their asset allocation – persisting with the belief that equities would deliver for them.
Risk is not Volatility
If the proposition that investors want real outcomes is correct, then risk, too, is misconstrued. The concept of volatility (or standard deviation) as the market’s default risk metric assumes that short-term variation in returns matters. For most investors, ‘risk’ can be better described as:
The risk of losing money – either permanently or over a timeframe relevant to the investor’s investment horizon.
The risk of not achieving a return sufficient to meet liabilities (be they defined as either actual liabilities or a specific return target).
Against this definition, volatility and risk are inversely correlated.
Volatility and Risk
Source: Schroders, Datastream.
Volatility typically declines as the price of ‘risky’ assets (such as equities) rise and is often at its lowest in the later phases of a bull market, which usually coincides with extremes of valuation. Expensive markets expose investors to substantial downside price risk, meaning that despite low volatility, the risk of losing money (either temporarily or permanently) is highest. Conversely, high volatility is typically associated with falling markets, which, all else being equal, improves valuations and thereby reduces the risk of loss over the medium term. Consistent with the analysis on the Shiller PE above, there is a strong correlation between market valuation and future returns – both positive and negative – and a stronger correlation to risk than volatility.
Order of returns matters
Implicit in the fixed SAA model is an assumption that volatility is a necessary price to be paid for return. In other words, the return dispersion generated by the fixed SAA model is inconsequential to investors, provided their investment horizon is sufficiently long enough that their realised equity returns equate to expectations.
However, practical application of this model falls well short as the following case study will illustrate.
Consider the case of two employees (Linda and Glenn) who make regular Superannuation Guarantee (SG) contributions of 9 per cent over their 40-year careers. Now assume Linda earns 7 per cent per annum for 20 years then 10 per cent per annum for the next 20 years, while Glenn earns the reverse.
The industry would report both employees as having ‘earned’ the same return over the 40- year period of 8.49 per cent per annum. The reality, given the changing account balance via contributions over the period, is that Linda finishes 35 per cent better off than Glenn.
The difference in return outcomes vis-à-vis objectives is simple. Large returns (plus or minus) have a much more substantial effect on outcomes for the investor if they occur towards the end of an investment horizon rather than towards the start when the account balance is low. Clearly, statistics based on ‘averages’ are largely irrelevant to individual investors whose circumstances, objective and investment horizons vary substantially.
Building a Better Portfolio
The ideas above highlight some substantial shortcomings in the way portfolio construction has been approached for at least the last three decades – an approach which will effectively continue with the introduction of MySuper. An alternative is therefore necessary to overcome these constraints and deliver to clients the sorts of outcomes they genuinely crave.
A more satisfactory alternative model would satisfy several important criteria:
Focus on the delivery of real outcomes, not relative ones.
Recognise that risk premiums are dynamic, and use them.
Recognise that the path of returns is important.
Manage the risks that matter, not the ones that are easiest to measure.
Hold the manager accountable for the delivery of ‘real’ not ‘relative’ outcomes.
To achieve these goals, a fundamental change to the way portfolios are constructed and reported on is required. Central to this change is a shift away from a redundant fixed SAA approach to an objective-based asset allocation model.
Principally, funds should be able to:
Offer a real risk profile that matches the clients’ requirements (that is, not ‘balanced’, ‘growth’, ‘conservative’, but options that reflect real risk and return outcomes).
Be easily understood – both in terms of what they purport to deliver and what they actually deliver.
Real Naming Conventions and Objectives
For a start, current industry naming conventions – ‘conservative’, ‘balanced’, ‘growth’ and ‘high growth’ – mean little to the average person and, worse, are probably quite misleading. MySuper does nothing to address this; indeed, it lends these terms regulatory credence.
A better move from the Cooper Review would have been to encourage a wholesale change in reporting (and managing) of existing fund options, not create a new fund that embeds the problems of the existing structure. Instead, label fund choices by what they actually aim to achieve (e.g. Consumer Price Index + 4, 5 etc.) and the real risks, then spend more time describing to members how this objective could be achieved.
In particular, funds should be required to:
Outline their real return objectives in detail.
Present performance against those real return objectives, not artificially created benchmarks.
This step alone would serve the purpose of shifting the emphasis from a fixed SAA benchmark model, as proposed by MySuper, to one that better aligns superannuation funds with member requirements.
It would also assist in de-emphasising the increasing and worrisome level of short-term performance comparison amongst funds – an issue that will only get worse under a legislated MySuper regime.
Another expectation arising from Cooper’s recommendations is that the delivery cost of MySuper should be cheaper than the existing industry offerings.
As a result of all the hoopla and headlines from Mr Cooper over the course of his review, one could be forgiven for not realising that average costs across the industry have already come down substantially over the last five years for all fund types. More interestingly, Mr Cooper seems to be enamoured with ‘bigger is better’ as far as funds go, but at the same time thinks Self-Managed Superannuation Funds (SMSFs) are the ultimate model
From an investment perspective, there are three key strategies that funds could be using to bring down costs further:
There is a simple relationship between larger funds under management and reduced fees (which is why SMSFs are so expensive). Traditionally, when super funds find that their funds under management (FUM) have grown, rather than taking these scale benefits with existing managers, additional managers are added to the line-up.
The financial situations of super funds have been made significantly worse by adding expensive and complex ‘new’ asset classes, such as private equity, infrastructure and hedge funds. The end result has been higher costs, less transparency and poorer return outcomes. While MySuper may affect the use of these alternatives and subsequently affect investment costs, the additional administration and operational structure will more than likely increase costs across the industry. In any case, it misses the key point; it will not improve the focus and accountability for delivery of real outcomes.
Lengthen Time Horizon
We know intuitively that the most skilful of investors can appear to be wrong for multi-year periods. Yet the industry, egged on by the media and the ‘rating’ agencies, is fixated on short-term performance comparisons. In investment, a longer time horizon is in increasingly short supply, meaning the rewards for taking it are increasingly large.
MySuper completely misses all of these points.
Objective-Based Asset Allocation
An ‘objective-based’ asset allocation approach focuses on the application of investment capital to those areas where risk is rewarded (via an appropriate risk premium) and where the expected return matches/exceeds the investor’s real objective. It entails a continuous assessment of risk premium (and, therefore, prospective returns) to continually allocate the risk budget to those assets which, in combination, meet the underlying performance objective with the greatest certainty.
The approach described above effectively positions each asset on the risk distribution. This gives the portfolio constructor a strong indication of both absolute and relative returns but also the proximity of the return to the tails of the return distribution. In an objective (or real return) environment, this is critical as the portfolio should be constructed around those assets offering the greatest potential for returns around/exceeding the target. In other words, it is important to avoid assets where the risk of a return substantially below target is high.
Figure 5: Objective-Based Asset Allocation
The need for normal portfolio management techniques is not obviated by this methodology, merely premised around return and risk expectations that better reflect the outlook. Another important point of differentiation is that the portfolio should be constructed around maximising the prospect of achieving the return outcome, rather than simply maximising the return on the portfolio for a particular level of risk (defined as standard deviation). Correlation is still highly relevant, but downside risk (or risk of underperformance versus the return target) is critical. As shown previously in this paper, the path of returns does matter.
The importance of achieving ‘real’ not ‘relative’ outcomes cannot be underestimated. In the traditional fixed SAA model, manager focus shifts almost entirely to ‘relative’ performance – after the SAA is assumed to deliver the target ‘absolute’ outcome over the investment horizon. In an objective-based framework, the portfolio constructor is effectively holding himself accountable for the absolute return achieved by the portfolio and the path taken to achieve it. This is an important difference between the two frameworks. The SAA is not the objective, and assuming it will meet the objective over time accepts some very large basis risk predicated on very long-term equity data. Yet, adopting this model effectively obviates responsibility for what matters most: the real outcome. Objective-based investing holds someone accountable for this.
Investment is not a complex field; those who seek to make it complicated usually have their own objectives, which are not necessarily aligned with putting the client first. Clients’ objectives are fairly simple: real wealth generation with the lowest level of absolute volatility possible.
While the bureaucrats and their inquiries will run their merry course, our industry would be best served by taking a step back in time, when many of the characteristics we seek today were more prevalent in the balanced funds of yesterday.
Some final points to consider:
Be clear to clients about what you are really aiming to deliver.
Take the easy wins in portfolio structuring – reduce complexity, embrace scale, lengthen time horizon.
Manage portfolios with a view to achieving the real objectives clients want.
Require funds to report performance over the longer term against these real return objectives, not against self-selected or industry average benchmarks.
1Based on Morningstar Multi-Sector Growth Survey – Median Manager (post fee).
2The Reserve Bank of Australia’s (RBA’s) trimmed mean inflation measure.
3John Y Campbell and Robert J Shiller, Valuation Ratios and the Long-run Stock Market Outlook: an Update, Cowles Foundation Discussion Papers 1295, Cowles Foundation for Research in Economics, Yale University, 2001, <http://ideas.repec.org/p/cwl/cwldpp/1295.html>, accessed 13 November 2010..
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