In recent years it seems that market sentiment is shifting more rapidly than ever. We saw this earlier this year when the US Federal Reserve flipped on its monetary stance from a tightening stance to a “let’s take pause and see how things pan out” position.  In August we saw the yield curve invert meaning that long-term bond yields were lower than short-term bond yields. The most common measure of this is the difference between 2 and 10 year government bond yields. Markets reacted negatively to this as an inverted bond yield is typically an indication that investors are concerned about the economy. It has also been a good predictor of a looming recession with an inverted yield curve preceding every US recession since the 1970s. Interestingly, the time between the yield curve inverting and a recession is highly variable and equity markets have historically performed strongly until a recession has hit. For example, in 1988 the S&P 500 rose by over 30% prior the recession and in 2006 it rose approximately 16%. The yield curve has since steepened and is no longer inverted. So does this mean we are out of the woods?

From our perspective the economic news is mixed. Indicators such as manufacturing data have been trending down, however housing has been strong in the US and has improved in Australia. Consumers are also holding up in the US. Geopolitics continue to be an X-factor with news regarding US – China trade talks continually shifting, whilst the prospect of further quantitative easing is certainly plausible. From a bottom-up perspective, many of the professional investors Lonsec speaks to are indicating that they don’t expect a recession within the next 12 months but over a 2 year timeframe the risk of recession rises.

Amidst this uncertain backdrop, from an asset allocation perspective we have retained our slight defensive bias holding a greater exposure to real assets and focusing on diversification via uncorrelated assets such as alternatives.

Financial advisers are operating within a paradox. On the one hand, the industry is still reeling from the blow of the Royal Commission and the high levels of mistrust within the community towards the financial services sector. On the other hand, there’s every sign that demand for quality financial advice is growing – to the extent that some advisers may find themselves on the back foot when it comes to putting in place the necessary capabilities to deliver tailored advice solutions.

It seems that, if anything, the media coverage of the Royal Commission has only raised in people’s minds the inadequacy of their own financial knowledge when it comes to managing and growing their wealth. According to the most recent survey conducted by ASIC in August this year, 79% of participants agreed that financial advisers had expertise in financial matters that the participant did not have. Even after being exposed to the negative headlines, 75% agreed that financial advisers could recommend products that they normally could not find on their own, and 73% agreed that advisers could introduce them to good ideas they might not have thought of on their own.

So the need and desire for financial advice remains in place, but consumers still face a knowledge problem when it comes to finding an experienced adviser who they believe can genuinely help them achieve their objectives. It’s clear that the main reason people seek financial advice is to benefit from the expertise of the adviser, who they believe can provide recommendations that will improve their financial wellbeing and help them prepare for major life events. What it comes down to is not the overall perception consumers have of financial advice, which remains positive, but the way in which they discern the quality of individual advisers.

When it comes to demonstrating quality, advisers need to be able to show clearly how their advice adds tangible value to the client. Once a positive first impression is made, advisers must then follow through on their value proposition with a roadmap for success that the client can understand and that makes intuitive sense. Breaking down what are inherently complex topics can be a challenge, but it’s critical to ensuring clients are fully engaged in the process and can see for themselves how your advice is helping them build their wealth and meet their objectives. High-quality investment research can play a key role in supporting this process by giving advisers the information, visual data, and easy-to-use reporting tools they need to have deeper conversations that speak directly to their clients’ needs.

The Royal Commission has not spelled the death of financial advice, but it has made it harder for advice that can’t draw a direct link between the client’s individual needs and the investment decisions of the adviser or portfolio manager. We are entering a new age of financial advice that is seeing the role of the adviser shift from that of administrator and stock picker to someone who can deliver a holistic advice experience by showing that they have a deep understanding of their client’s position and can recommend high-quality investment products that support the client’s needs. This means having a thorough understanding of the qualitative aspects of different products, how they compare, and they can be used as part of a tailored investment solution.

The results of the ASIC survey support this, and while some of the survey findings may come as a surprise, many advisers will see this as old news. When it comes to choosing an advice provider, communication is one of the most important factors customers look for and anticipate in their interactions with advisers. Experience and reputation are obviously important, but a key differentiating factor is the way advisers talk to and engage with their clients. The ability to talk to clients in a way they can understand is just as important as an advisers reputation (38% versus 36%), while taking the time to understand their client and their goals is also one of the top attributes (32%).


Source: ASIC

What’s also interesting is that, for those respondents who had received financial advice (Group A), low cost became far less of a determining factor. For advisers who are successfully able to demonstrate the value of their advice, clients are more willing to pay because they can see how the advice they receive results in superior outcomes. That’s why it’s important to have not only high-quality investment research, but the right platform and tools that can deliver this research in a way that allows you to present complex information, including in-depth product comparisons and portfolio reports, clearly and concisely.

It’s also why we’ve continually evolved Lonsec’s iRate platform to ensure it’s more than just a place to access research, ratings and data. We give you the tools you need to get a more complete picture of your client’s portfolio, analyse and compare products across a range of qualitative factors, and demonstrate how your advice is contributing directly to their investment outcomes. For advisers looking to win the conversation game, a high-quality research provider can give them the edge they need.

Private markets have long been the domain of institutional investors. With benefits such as higher return potential, lower volatility, lower correlation to traditional listed assets, and enhanced diversification, it’s not hard to see why they are so attractive. Institutional investors such as super funds have been steadily increasing their exposure across the private market spectrum, which includes equity, real estate, infrastructure and debt.

Private markets by their nature require significant long-term commitments (in some cases capital can be locked up for ten or more years) and have significant barriers to entry given the large amounts of capital required. Both factors have traditionally made it difficult for retail investors to access the benefits of private markets, but this is quickly starting to change.

Private asset managers are exploring ways to make investing in private markets more accessible to retail investors by introducing greater liquidity and reducing minimum investment sizes. Along with slowing economic growth and the continued hunt for yield, this is making private markets an increasingly viable and attractive opportunity for retail investors and SMSFs seeking greater portfolio diversification.

Lonsec has seen an uptick in private market vehicles targeting retail investors coming to market over the last 12–18 months. Of particular note is the increased interest in private market funds (both equity and debt) being offered under ASX listed structures such as Listed Investment Trusts (LITs).  Such structures have been common in the UK and the US for some time but are a relatively new development in the Australian market.

Offering private assets through a LIT structure provides several benefits to retail investors, including:

  • The ability to create a diversified portfolio of unlisted assets with no minimum investment size;
  • Access to private markets in a more liquid investment structure, with investors able to buy and sell units via the ASX;
  • A greater focus on the long-term investment strategy. Because LITs are closed-end vehicles, managers are less concerned about funding applications and redemptions, which has the potential to boost returns compared to an open-end pooled vehicle;
  • No requirement to manage commitments to fund future investments. Capital is paid upfront and invested in the LIT from day one, so there are no additional capital calls for the investor.

However, as we all know, rarely do investors come across a free lunch, especially in the retail world. Trade-offs must be expected and managed in order to get the most value out of any asset class, and private markets are no different. When including private market assets in a portfolio, it’s important to think about the following:

Private market assets are illiquid

Private assets are by their nature highly illiquid, and investors wishing to redeem may have to do so at a discount to Net Asset Value (NAV). It’s important to treat an investment in private markets as a long-term investment, irrespective of the structure in which it’s offered. Investors wanting (or worse, needing!) to sell LIT units in periods of market stress, when many investors are heading for the door, may face significant discount to NAV. It’s important to ensure the private asset manager has policies in place for managing these discounts should they arise.

Expect some volatility along the way

Private assets offered in LITs will have a higher correlation to the broader equity market and are more volatile than traditional private asset investments. By offering private assets in a listed structure, market beta is introduced, exposing investors to swings in sentiment in a similar manner to any other security listed on the ASX. Volatility risk may also arise when units in the LIT are thinly or heavily traded, which could make the unit prices very volatile regardless of changes in the underlying value of the investments held by the LIT.

It takes time to become fully invested

Unlike traditional private assets, where commitments are drawdown over time, investors in private market LITs pay their capital upfront in exchange for units. Private asset managers don’t invest 100% of that capital immediately, but instead wait for investment opportunities to arise. Consequently, it may take between 12 months to four years to reach the target portfolio allocations. During this ‘ramp-up’ period, private asset managers will invest in other liquid assets ranging from cash through to credit or even equities. This ensures investors are generating a reasonable return or income from an early stage while the portfolio is getting set.

However, it does of course introduce other risks and exposures. It’s important to understand what assets you will be exposed to during the ramp-up phase, as this will impact your returns (and risk). You may not be getting the exposures you expected for some time.

Lonsec believes retail investors can benefit from investing in private markets, but they need to be mindful of the trade-offs when investing via listed vehicles. Retail investors’ needs are inherently different from those of institutional investors—they typically have shorter time frames, a greater need for liquidity, and smaller amounts of capital to invest. While private asset managers have sought to meet a number of these needs in recent years, there’s no panacea for investing in what are inherently illiquid, long-term assets. Retail investors need to ensure that investing in private markets via LITs aligns to their long-term objectives and risk appetite.

For those inclined to question the value of financial advice, there are two important trends taking place right now that need to be reckoned with. Firstly, the federal government is committed to the scheduled rise in the superannuation guarantee, which will see the rate rise to 10% by 2021 and, if the government sticks to the schedule, to 12% by 2025. Workers are gearing up to have more of their retirement wealth exposed to financial markets in coming years, raising the stakes for the wealth management industry and making financial advice less a luxury and more a practical necessity.

Secondly, there have been some troubling signals coming from financial markets over the past six months. While the bull market trend in equities has held up since the start of 2019, the ‘recession dashboard’ is starting to light up, with leading indicators suggesting things might not be as rosy as the stock market suggests. Market turning points pose a real challenge for fund managers and have a way of pushing their process and discipline to their absolute limit. In times like these, product recommendations and manager selection really count, and advisers can quickly find their own processes exposed when things go wrong.

However, even as the value of advice is growing, the perception of advice has suffered through the trauma of the Royal Commission and the uncovering of illegal and unscrupulous practices. Regulatory changes and the shifting nature of advice will inevitably lead to some attrition in the industry, but for the rest there is an acute awareness that things won’t improve on their own. Clients need to be presented with a highly compelling value proposition that demonstrates how the advice process helps them. It also needs to address both the perception issues and the very real regulatory issues around conflicted advice and best interest duty. This is where having the right investment research becomes critical.

Quality investment research is essential to your value proposition

It’s tempting to see investment research as a cost of doing business. The reality is that research is not merely there to supply data, tick a compliance box, or support an established view on a particular product. Quality research is an essential part of the value proposition, because it enables advisers to deliver the things that clients expect from their financial advice: namely, to be able to take full advantage of the depth of Australia’s investment product market and be given recommendations that are most likely to satisfy their investment goals.

Achieving this requires advisers to conduct a full comparison of individual financial products covering a wide range of factors. For any recommendation to be meaningful, it must go beyond past performance to focus on the key qualitative factors that drive future performance and determine whether the product is in line with the client’s needs and preferences. To do this well, advisers must be able to draw on a full team of research specialists with experience across different asset classes, structures, and sectors. Having quality research means partnering with a team that can cover the breadth of products available in the market, and for each product perform the deep dive needed to truly understand how it works and how it can best be incorporated into the client’s portfolio. Having the right investment research means having the resources and capabilities to deliver on your value proposition.

This is why the regulatory challenge facing advisers should not be seen as something distinct from the value proposition. Meeting the highest regulatory and professional standards is something that clients expect, and it’s essential that advisers can demonstrate how they meet these standards. Advisers face a perfect storm of regulatory change, and the winners will be the ones able to adapt to the higher expectations set for them by the regulators and the community. Demonstrating a commitment to acting in the client’s best interest and an ability to avoid or effectively manage conflicts is key.

Tighter regulatory standards reflect the community’s desire for better investment outcomes

The Safe Harbour provisions of the Best Interest Duty state that, when recommending a financial product, an adviser must have conducted “a reasonable investigation into the financial products that might achieve those of the objectives and meet those of the needs of the client that would reasonably be considered as relevant to advice on that subject matter.” In practice, this means that the adviser has not simply looked at a product in isolation and determined if it’s likely to make their client better off but has actively compared it to other similar products and recommended the most suitable one.

In the case of super, there are specific requirements that relate to the due diligence advisers must undertake. Firstly, they must consider the client’s existing products and any products the client requests to be considered. Secondly, the adviser must show the benefits of a new fund, including qualitative factors such as the member servicing environment, the types of insurance the fund offers, the educational material it makes available, and the menu of investment options.

And the standards are getting tighter. The FASEA standards state that advisers “must not advise, refer or act in any other manner where you have a conflict of interest or duty.” This goes beyond the Corporations Act, which merely requires advisers to disclose a conflict and gain the client’s consent before acting for them. The FASEA standard is also broad in the sense that it isn’t limited to conflicts in relation to remuneration. The FPA’s view is that the primary ethical duty in this standard is: if you have a conflict of interest or duty, you must disclose the conflict to the client and you must not act. While these standards are tight, they reflect the community’s expectations that recommendations are free of conflict.

Partnering with a research provider gives you the resources and capabilities to conduct in-depth product comparisons and allows you to show the client how your expertise adds value. Having the right research means you’re better able to support product recommendations with in-depth analysis and detailed product comparisons. It puts you in a better position to meet the regulatory standards and it lets you have deeper conversations with your clients that directly address their needs.

Selecting the right manager involves looking at more than just past performance. It’s about delivering future outperformance based on an in-depth assessment of individual investment teams. This means understanding how people, strategies, and capabilities come together to position fund managers for success. When it comes to selecting for future success, qualitative research is not merely a filter or a heuristic, it’s the backbone of your entire research process.

While you might be able to get away with poor manager selection when the bull market is raging, the real test comes when the market reaches a turning point. Given the troubling signals from financial markets over the past six months, this is something many investors are starting to take very seriously. Market turning points pose a real challenge for fund managers and have a way of pushing their process and discipline to their absolute limit. In times like these, product recommendations and manager selection really count, and advisers can quickly find their own processes exposed when things go wrong.

Identifying future outperformance is an artform, not a science. Lonsec’s entire research process is built around understanding the range of qualitative factors that determine manager success and giving advisers the tools to select investment products based on individual client needs. Our analysis is based on an onsite assessment of investment teams, combined with a rigorous peer review process that safeguards the quality and integrity of our investment product ratings. Looking back over the past 10 years, our qualitative process has proven its worth. Lonsec’s Recommended and Highly Recommended managers have outperformed their respective benchmarks, even during a period where the long-running beta rally has pushed passive investment strategies ever higher, casting shade on many active managers who have struggled to offer value in this environment.

Conveying the importance of insurance to members is one of the biggest challenges that super funds face. Insurance is often seen as a cost rather than a benefit, especially for younger members, meaning funds need to be in a position to clearly communicate the advantages for individuals and for the system as a whole.

The government’s Protecting Your Super (PYS) package came into effect from 1 July this year and aims to reduce the erosion of account balances through unnecessary fees and costs. Part of the legislation involves the cancellation of insurance for members whose account has been inactive for 16 months or more. Based on early analysis conducted by SuperRatings, it’s clear that the PYS changes will have a significant impact across the industry. For the median fund, around 17% of insured members are expected to lose cover. For the quartile of funds most affected by the changes, this figure rises to over 23% (see table below).

What percentage of insured members have lost cover?
Quartile least impacted 13.7%
Median 17.2%
Quartile most impacted 23.4%

Based on an early analysis of member behaviour, it’s clear that members are more engaged with their insurance than was widely anticipated by the industry. According to SuperRatings, the median expected opt-in rate is around 20%. For a quarter of the industry, almost a third of members are expected to opt in, which is significantly higher than funds’ initial expectations. This suggests that inactive members are perhaps not as disengaged as commonly thought (see table below).

Expected Opt-in Rates
Quartile least impacted 32.9%
Median 20.0%
Quartile most impacted 13.4%

These results highlight the importance of fund communication in helping to convey the benefits of insurance and other member services. A member-centric approach to reinstating cover for members that opt in late is beneficial, with funds typically offering a 60 to 90-day reinstatement period. The provision of advice and insurance calculators will assist members in deciding whether to opt in and whether their level of cover is appropriate.

A variety of strategies have been used by funds over the last year to engage with this cohort of members. While traditional forms of member communications such as direct mail have been used in the past, funds have experienced success with email, outbound calling, SMS and digital marketing campaigns. There has also been significant coverage of these changes in the media, which has led to increased awareness and activity of members wishing to ensure they have the appropriate level of insurance coverage. But what’s clear is that, when presented with a clearly communicated choice, members are likely to engage and take action.

This is the start of the process, and undoubtedly it will be an evolving area that will pose different challenges for funds. A limited number of funds have passed on insurance premium increases, with a number indicating that their insurer has decided to wait and see what the overall impact of PYS and other changes such as the Putting Members’ Interests First legislation will be, and these funds may implement changes in the future. SuperRatings will continue to monitor the impact, but it’s anticipated that there will be upward pressure on insurance premiums as funds and insurers digest the changes.

Funds are operating in a different environment where there are conflicts between regulatory settings and potential claims that will emanate where insurance has been ceased for members. How funds are going to strike an appropriate balance when they’re in a somewhat invidious position will be one of the key themes that SuperRatings tracks in coming months.

This article is based on information from the upcoming Benchmark Report released annually by SuperRatings. The Benchmark Report is based on the most in-depth survey of Australia’s superannuation market, covering investment performance, fees, governance, member servicing, and insurance.

One of the topics asset allocators are grappling with at the moment is whether asset class valuations are expensive or not.  Whether you are an active asset allocator, or an active bottom-up stock picker, valuation will most likely be at the core or at least form part of your analysis when making a decision to enter or exit an investment. Valuation historically has been a good long-term metric in assessing the potential future return of an asset. However, with interest rates at depressed levels, asset prices that are expensive based on historical levels, don’t appear to be that expensive given the low interest rate environment. Equity markets in general and growth companies, in particular those that are expected to grow their free cashflow in the future, have benefited from the low interest rate environment as they tend to be more sensitive to interest rates akin to a long duration bond. It could be argued that if interest rates remain at low levels (and possibly lower) risk assets will continue to benefit. Despite this we believe that at some point markets will focus on fundamentals and that the market will need to demonstrate earnings growth to sustain valuations. Furthermore, studies suggest that the relationship between interest rates and valuations is not linear, meaning that markets benefit from low interest rates to a point.

From an asset allocation perspective, valuation remains an important tool to help make active asset allocation decisions. We believe that in the current environment you also need to consider medium-term signals such as where we are in the cycle, liquidity and sentiment, as these factors can influence the extent to which asset prices can remain elevated or depressed for periods of time.

Many behavioural studies have shown there are several traits and biases that can impede us from making reasonable decisions about everything from what to eat to how to invest. Understanding these biases and considering whether they may be negatively impacting decisions can be beneficial when implementing long-term investment plans. These studies show, in general, people have asymmetric risk profiles and fear losses more than the expectation of gains by at least a 2:1 margin[1]. Interestingly, and perhaps not surprisingly, this ratio increases substantially as people approach retirement.

American psychologist and economist, Daniel Kahneman, who won a Nobel Prize for his work challenging the prevailing assumption of human rationality in modern economic theory has stated, ‘If you have an individual whose objective is to maximise wealth at a certain future point in time, then loss aversion is very bad because loss aversion will cause that individual to miss out on many opportunities.’

This loss avoidance trait stands in contrast to a basic investment principal, that investors need to accept higher risk (and higher potential for near-term losses) in order to achieve higher returns over the long term, particularly during market sell-offs. When faced with losses, rational decision-making can become impaired by the emotional desire to avoid more losses.

There are a wide range of cognitive biases that can impact retirement plans, some are listed below:

Confirmation bias

Confirmation bias is the natural human tendency to seek information that confirms an existing point of view or hypothesis. This can lead to overconfidence if investors keep seeing data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, increasing the risk of being blindsided when something does go wrong.

Information bias

Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. Investors are exposed to an array of information daily, and it is difficult to filter through this and focus on the relevant information. In general, investors would make superior investment decisions if they ignored daily share price movements and focused on prices compared to the medium-term prospects for the investments. By ignoring daily share price commentary, investors would overcome a dangerous source of information bias in the investment decision making process.

Loss aversion bias

Loss aversion is the tendency for people to strongly prefer avoiding losses than obtaining gains. The loss aversion effect can lead to poor and irrational investment decisions, where investors refuse to sell loss-making investments in the hope of making their money back. Investors fixated on loss aversion can miss investment opportunities by failing to properly consider the opportunity cost of their investments.

Anchoring bias

Anchoring bias is the tendency to rely too heavily on, or anchor to, a past reference or one piece of information when making an investment decision. For example, if you were asked to forecast a stock’s price in three months’ time, many would start by looking at the price today and then make certain assumptions to arrive at a future price. That’s a form of anchoring bias – starting with a price today and building a sense of value based on that anchor.

How do we try and overcome the biases when building retirement portfolios?

The objective based nature of Lonsec’s Retirement portfolios means there is a greater focus on absolute rather than relative performance. Additionally, the portfolios have been constructed to manage risks, including:

  • Market and sequencing risk
  • Inflation risk
  • Longevity risk

Some investment strategies that can assist in controlling for these risks include:

Variable beta strategies can vary equity market exposure by allocating to cash in periods where equity market opportunities are perceived to be limited due to expensive valuations, or where market downside risk is considered high.

Long / Short – Active Extension (also known as 130/30 funds) utilise a broad range of strategies including short selling and adjusting the net equity position for performance enhancement, risk management and hedging purposes.

Multi-asset real return funds invest in a wide range of asset classes, with the managers having considerable flexibility in the type and percentage of asset classes allocated to. Typically, these funds will seek to limit downside risk, while also targeting a real return i.e. a CPI + objective.

Real assets such as property and infrastructure, commodities and inflation linked bonds can assist in managing against inflation risk.

When constructing the Retirement portfolios, Lonsec takes a building block approach by assigning a role for each fund – yield generation, capital growth and risk control.

The yield component of the portfolios generate yield, or a certain level of income from investments that have differing risk return characteristics. The capital growth component is designed to generate long term capital growth, with limited focus on income, and is more suited to early retirees. The risk control component is critical for retirement portfolios and is designed to reduce some of the market risks in the yield and capital growth components. It is important to note that the risk control part of the portfolios will not eliminate these risks but aims to mitigate them. Asset allocation and diversification are also important ingredients in managing the overall volatility of the portfolios.

The Retirement portfolios can assist in managing the risks that impact retirees, however it is important to note that none of these strategies provide a guaranteed outcome. The range of products that offer certainty of income or capital protection such as annuities has increased in recent years, in recognition of Australia’s aging demographics and demand for greater certainty in retirement. Separate guidance on the use of annuities is available from Lonsec.

 

[1] Gachter, Johnson, Herrmann (2010). Individual – level loss aversion in riskless and risky choices. Columbia Business School

The Australian equity reporting season was weaker than expected with a third of companies having their FY20 earnings downgraded. At the sector level, Healthcare and Resources had impressive results whilst the Financials sector reported poor earnings. Dan Moradi runs through the key themes that emerged over the reporting season.

August was a weak month for equity markets with continued concerns over trade tensions between the US and China. While equities sold off bonds, ‘bond proxy’ assets such as property generated positive returns. For the year to the end of August Australian bonds, as represented by the Bloomberg AusBond Composite 0+ Yr Index, returned an impressive 11.2%, outperforming Australian equities. Despite bond yields being at low levels and valuations generally indicating that bonds are overpriced, bonds have continued to provide diversification to equities in downmarket periods.

We continue to believe that bonds play an important diversification role within managed portfolios, despite valuations remaining high. From a portfolio perspective, the primary role of fixed income assets is to provide diversification, with the secondary role being to generate income. Lonsec’s portfolio construction process employs a fixed income allocation within the portfolios to provide a diversified exposure to duration, credit and absolute return bond strategies. We caution against ‘chasing yield’ in the defensive part of the portfolio as most high yielding bond assets tend to be correlated to equities, which work well when equity markets are performing well, but on the reverse will move directionally with equities in an equity market pull-back. In our most recent Asset Allocation Investment Committee, we did not change our allocation to bonds but we increased our exposure to ‘bond proxy’ assets such as global REITs providing some more defensiveness to the portfolios.

One of the lasting achievements of sports like golf and horse racing is the way the handicapping system can make it possible for athletes to engage in a close and enjoyable competition despite obvious differences in ability, experience or personal characteristics.  In Thoroughbred horse racing, the older steeds would otherwise win most races, hence the ‘weight-for-age’ system, whereby each horse carries a small additional saddle weight based on statistical analysis of the historical differences in ability by age.  The system has been working well for more than a century – so why can’t we do the same for measuring super investment returns?

In January this year, the Productivity Commission handed down its final report to the Federal government on its investigation into the superannuation system.  One of the terms of reference for the inquiry was the following:

‘The Productivity Commission should develop criteria to assess whether and the extent to which the superannuation system is efficient and competitive and delivers the best outcomes for members and retirees, including optimising risk-adjusted after fee returns.’

It is of course widely accepted in the superannuation industry that there is a trade-off between risk and return.  Moreover, there is a general consensus that performance comparisons should be done on the basis of products with a similar risk profile.

The most common risk metric tracks the amount of change in return over time (technically, it is the ‘standard deviation’ of the net investment return measured over a specified period, also known as ‘volatility’).  It should be noted that this is a measure of ‘market’ risk only – arguably a young investor saving for retirement should be more concerned about the risk of losing her capital (‘capital risk’) due to poor quality asset selection, but there are currently few metrics for this.  A ‘Standard Risk measure’ must be displayed on MySuper Dashboards  in accordance with the Corporations Act, and the SRM is essentially a Market Risk metric, expressed as the expected number of negative returns over a 20-year period, based on modelling of the fund’s investment strategy.

A long-standing proxy for Market risk has been the ‘Growth Ratio’ or the percentage of funds allocated to ‘Growth’ type assets, such as shares, property and, more recently, infrastructure.  There has also been much discussion about the methods used by funds to report the percentage of growth assets, particularly in relation to unlisted asset classes like property, infrastructure and hedge funds.

How good is the handicapping system used within our industry?  Despite some limitations, there seems to be a reasonable level of consistency across the different metrics, and returns are consistent with the expected risk / return trade-off.  The following graph is based on median rolling returns and volatility (risk) over the three-year period to 30 June 2019:

With the exception of ‘High growth’, the relationship between median risk and return is in line with expectations.  Even so, there is still a potentially wide dispersion of risk / return combinations within each classification. Is there a way to apply a handicapping system to enable a fair comparison across and within the risk profile categories?

The Productivity Commission was tasked with optimising ‘risk-adjusted’ returns.  The ‘Sharpe Ratio’ is one such metric – it attempts to adjust for the trade-off between risk and return (technically, it is a measure of excess portfolio return over the risk-free rate relative to its standard deviation).  It does this by giving a lower weight to excess return earned from taking additional risk.

We ran a test race with just five horses, based on the SuperRatings Option Type classifications, and here are the results:

Horse

Place

Risk-adjusted Return*

Actual return*

Market risk*

Balanced (60-76)

1

1.60

8.80

4.14

High Growth (91-100)

2

1.30

9.25

5.59

Conservative Balanced (41-59)

3

1.19

6.58

2.90

Growth (77-90)

4

1.13

9.68

5.30

Capital Stable (20-40)

5

1.05

4.81

2.16

Source: SuperRatings FCRS 30 June 2019
Risk-adjusted Return: Sharpe ratio
Actual Return: 3-year rolling net return % per annum
Market Risk: 3-year rolling Standard Deviation % per annum

On this basis, ‘Balanced’ was the horse to be on.  ‘High Growth’ can run faster, but the risk trade-off is too high (on this metric) to justify the extra speed.

What is ‘Conservative Balanced’ doing in third place?  It’s the second slowest horse in the race, but it gives its jockey a smooth enough ride to offset the performance difference.  This seemingly anomalous result reflects the current investment environment, with very low risk-free rates of return.  This option was able to achieve a higher excess over the risk-free rate per unit risk than any of the other options bar Balanced and High Growth.

Is Risk-adjusted Return (RAR) then a sensible metric for comparing different investment strategies?  One major weakness is that RAR takes no account of an individual member’s risk characteristics and assumes that the risk / return trade-off is the same for all members. Clearly this is not the case – younger members are less likely to be impacted by short-term fluctuations in market asset values, whereas members approaching retirement can be affected by sharp declines in market value immediately prior to retirement (‘sequencing risk’).  In the context of the table above, a member approaching retirement might value the stability offered by ‘Conservative Balanced’ enough to accept the lower return, whereas a younger member would (should!) be unhappy about the underperformance, given that market risk is not really an issue.

This suggests that a ‘weight-for-age’ handicapping system would make more sense for MySuper performance comparisons.  In fact, many fund trustees have already put this into practice via a ‘Lifecycle’ strategy, whereby each member’s risk exposure varies with age, becoming more conservative as retirement is approached. However, it is difficult to see much standardisation occurring in this area, given that there is not even consensus within the industry regarding the value of the Lifecycle approach, let alone the appropriate risk exposure for each age.

Despite these limitations, there is one group of members where there is broad general agreement across the industry.  Our analysis was based on MySuper default options – by definition, the investment strategy that will apply to superannuation fund members who do not make an active investment choice – generally those members who are less ‘engaged’, and typically the younger members for whom retirement is in the distant future, and accumulated super is relatively small.  As already indicated, market risk should be less of a concern for this group (although managing expectations after a share market crash can still be a challenge for fund communication strategies).

This graph shows 3-year rolling returns versus risk (standard deviation over 3 years) for all SuperRatings Balanced (60-76) options.  The highlighted options are the Top 10 by Risk-adjusted return (Sharpe Ratio).  These are the options that performed the best for a given level of risk over the 3-year period to 30 June 2019.

Risk-Adjusted Returns therefore have some value in highlighting the best performers for a chosen level of risk, but even within the constraint of just Balanced options, there is a wide range of risk experience.

The SIS Act and Regulations require that trustees must formulate an investment strategy taking into account at least ‘the membership profile (for example, members’ age and expectations, occupational profile …)’.  The investment strategy decision is likely to be a bigger determinant of performance outcomes than the fund’s ability to manage assets.  Thus we have the current situation where the trustee of one fund can decide that the appropriate default level of risk for a 50-year-old is a Balanced option, while the trustee of another fund can quite legitimately decide that a Capital Stable option has the appropriate level of risk.  There is potential here for uninformed commentators to label a fund as a ‘dud’ or underperformer simply on the basis of ‘first past the post’ outcomes, when the underlying reality is that the trustee is managing efficiently to its stated investment strategy.

Einstein is reputed to have said ‘Everything should be made as simple as possible, but no simpler’.  In the world of superannuation investment performance measurement, there may be no black and white answers, and we will have to wait and see before we place any bets on future performance measurement systems.

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