Super funds have had a convincing finish to what was a bumpy 2019 financial year, with an improvement in sentiment and a rallying share market in June helping funds over the line with solid returns.

A promising 2.0% gain in the September 2018 quarter seemed to vanish before members’ eyes as funds suffered a 4.7% loss in the December quarter. Funds fought back strongly in the final six months, helped by a solid performance in June, bringing the FY19 result to 6.9%.

According to SuperRatings’ data, the median balanced option returned 2.3% in June, driven predominately by a rebound in Australian and international share markets. By comparison, the top 10 funds achieved an average return of 8.5% for the year. The return for the median growth option, with two thirds of the portfolio allocated to local and international shares, was 7.4% over the year, while the median capital stable option returned 5.3%.

While funds have ridden the wave of market fluctuations since the Global Financial Crisis, the FY19 financial year has nevertheless proved a fitting bookend to super performance over the past decade, during which the superannuation system has amassed an additional $1.3 trillion for members.

Median balanced option financial year returns since introduction
of compulsory SG

* Interim return

Source: SuperRatings

Australia’s leading super funds in 2018-19

UniSuper was the highest returning balanced option over the 12 months to 30 June 2019, delivering a 9.9% gain to members. This was followed by QSuper and Media Super, which returned 9.7% and 8.8% respectively. Both UniSuper and QSuper are among the top returning funds over 10 years, narrowly trailing AustralianSuper, which remains on top of the long-term leader board with a return of 9.8% p.a.

Top 10 returning super funds over 1 year

Source: SuperRatings

Top 10 returning super funds over 10 years

Source: SuperRatings

“UniSuper was a standout performer for the 2019 financial year, and they have also delivered consistently strong outcomes for their members over the past 10 years,” said SuperRatings Executive Director Kirby Rappell. “While year-to-year performance can fluctuate, the ability of the fund to provide solid returns over the long term, while protecting their members’ savings against the ups and downs of the market has been key to their success.”

While superannuation continues to deliver for members, SuperRatings warned that the system could become a victim of its own success, as higher account balances mean members will feel more of the bumps as markets move.

“The 4.7% drop we saw in the December quarter was felt more acutely for someone with a $100,000 balance than one with only $10,000,” said Mr Rappell. “Members should enjoy the strength of returns we’ve seen over the past decade, but as more and more workers enter and exit the system, it’s important that we keep talking about how funds manage market pullbacks and other risks for their members. The uncertainty that many consumers and investors feel at the moment reminds us that super is a long-term game, and members must have an understanding of both risk and return, and the effect they have on their retirement savings.”

High returns are not a free lunch – consumers should understand risk

Most consumers can’t define risk, but they know it when they experience it. For superannuation members, risk can mean the likelihood of running out of money in retirement, or not having enough cash to pay for holidays, car repairs, or an inheritance for their kids.

For a young worker with a relatively low super balance, being exposed to riskier assets is less of a problem – in fact, it can help them accumulate wealth over their working life. However, for members approaching retirement (aged 50 and over), an unexpected pullback in the market can mean the difference between living comfortably and having to cut back in order to get by.

While measuring risk can be tricky, it’s essential to understanding the value that members are getting from their fund. The conversation around risk will become increasingly important as a greater number of people begin transitioning to retirement and drawing down on their super.

Risk can be measured as the degree to which returns fluctuate over time. Members want high returns, but they also want consistent returns. Unfortunately, higher returns often mean taking on more risk, which means returns will be less consistent. The table below shows the top 10 funds ranked according to their risk-adjusted return, which measures how much members are being rewarded for taking on risk.

Top 10 funds ranked by risk and return (over 7 years)

Fund Risk/return ranking1 Return % p.a.
QSuper – Balanced 1 9.5%
CareSuper – Balanced 2 10.4%
Hostplus – Balanced* 3 11.1%
Cbus – Growth (Cbus MySuper)* 4 10.7%
BUSSQ Premium Choice – Balanced Growth 5 9.8%
Sunsuper for Life – Balanced 6 10.5%
Catholic Super – Balanced (MySuper) 7 9.7%
CSC PSSap – MySuper Balanced 8 9.4%
HESTA – Core Pool 9 9.9%
Media Super – Balanced 10 9.9%

1 Risk/return ranking determined by Sharpe ratio

* Interim return

Source: SuperRatings

QSuper’s return of 9.5% p.a. over the past seven years is slightly below the average of 10.1% across the top 10 ranking funds, but it has the best return to risk ratio of its peers, meaning it delivered the best return given the level of risk involved. Funds such as CareSuper and Hostplus were able to deliver higher returns, but for a slightly higher level of risk.

High returns are not a free lunch – consumers should understand risk

Following the introduction of MySuper, which provides a low-cost, ‘set-and-forget’ alternative for members, we have seen lifecycle strategies become increasingly popular. Members starting their working life in a lifecycle product are given a higher allocation to riskier growth assets like shares, which is gradually shifted over to safer assets as they age.

This allows members to benefit from higher risk and return earlier on in their working life, and having more certainty as they get closer to retirement. Approximately one third of MySuper products have some sort of age-based strategy, and tend to be offered by retail master trusts.

The chart below shows how a lifecycle product’s asset allocation changes as members age. For those starting out in the workforce, the allocation to growth assets like equities is high (around 90% for the median fund) and is reduced over time to around 50% by the time the member reaches the age of 60.

Lifecycle vs Single Default GAA

Source: SuperRatings

When assessing the performance of lifecycle products, SuperRatings found there are some retail funds that have improved their position. smartMonday MySuper – Aon MySuper High Growth (11.8% p.a.), ANZ Smart Choice Super – MySuper (10.2% p.a.) and Mercer SmartPath – MySuper (9.9% p.a.) have delivered strong returns over the three years to 30 June 2019 for younger members (in the 1995-1999 cohort), in excess of the not-for-profit median across both single default and lifecycle MySuper products.

It’s been an eventful month for markets. The Coalition’s Federal election win, the RBA’s rate cuts and a continuation of the US-China trade tensions have all impacted markets during the month of June. Domestic markets reacted positively to the Coalition win with some of the pessimism surrounding the housing market subsiding. The RBA’s rate cut was not unexpected with most analysts having already priced in the cut and potentially another.

Interestingly, the market narrative has turned to the possibility of the RBA undertaking a quantitative easing (QE) program domestically in a similar fashion to what we have seen in Europe and the US, whereby the RBA would buy government and corporate bonds using cash on its balance sheet. This would result in effectively flooding the market with liquidity while keeping rates low. Should rates continue their downward trajectory and QE become a reality, it may force investors into equities providing a tailwind for markets, as we have seen in Europe and the US in recent years. This is particularly relevant for retirees who may be forced into increasing their exposure to Australian equities as a source of income. The trade tensions between the US and China continue to adversely impact markets contributing to bouts of volatility. The longer the ‘trade wars’ the higher the probability that we will see longer-term impact on global growth.

These factors make it a challenging period for investors where factors other than market fundamentals are having a material impact in the trajectory of markets. In such an environment, we believe selective valuation opportunities will present themselves for long-term investors, however ensuring that your portfolio is diversified will be very important in navigating an increasingly volatile market environment.

Back in the 1980s, the administration of the newly-created Australian Football League (AFL) believed that eleven Victorian clubs were unsustainable in a national competition. Victorian clubs, many of which were in a poor financial state, were offered incentive packages of up to $6 million to merge. One of the proposed mergers was to have been between Fitzroy and Footscray in 1989, but Footscray members rallied to raise enough money to retain their Club as a separate identity, and Fitzroy eventually relocated to Queensland in 1996 to transform the Brisbane Bears into the Brisbane Lions.

What does this have to do with Superannuation?

On 4 April 2019, APRA (the Australian Prudential Regulation Authority) issued a media release, quoting Deputy Chair Helen Rowell: ‘In some instances, acting in the best interests of members will require underperforming funds to merge or exit the industry. If trustees and trustee directors are not willing or able to meet their best interests duties to members, they should be prepared to face serious consequences.’.

The catalyst for this media release was the passing of new legislation granting APRA stronger powers to take action against the trustees of underperforming superannuation funds.  The Treasury Laws Amendment legislation requires trustees to conduct an annual Outcomes Assessment against a series of prescribed benchmarks, covering all of their fund’s MySuper and Choice superannuation product options, and enhances APRA’s power to refuse, or to cancel, a MySuper authorisation.

Previously, APRA had been pushing for more super fund mergers, based on the earlier ‘scale test’, which many in the industry argued focused unfairly on ‘sub-scale’ funds, some of which were delivering perfectly satisfactory returns and services to their members.   In her Opening Statement to the House of Representatives Standing Committee on Economics on 10 October 2017, Helen Rowell stated that ‘The metrics considered under the existing scale test are insufficient to indicate whether a trustee is promoting the financial interests of, and providing quality, value-for-money outcomes for, fund members’.

Just as the AFL has made numerous, almost annual changes to the rules governing the world’s oldest major football code, Prudential Standard SPS 515 has gone through multiple revisions in this tumultuous environment, with the latest draft version bearing little resemblance to the original.

In the first version released in December 2017, strategic and business planning and member outcomes were contained in separate prudential standards. The strategic planning requirements sat rather unwieldy as part of the prudential standard on risk management.  The member outcomes requirements appeared to be somewhat more business operations focused, requiring funds to design a member Outcomes Assessment by segmenting its business so that ‘all parts of its business operations… are captured; and the assessment considers the outcomes provided to beneficiaries in each segment’. The way to assess each outcome was also unnecessarily rigid, requiring assessment with reference to both ‘objective benchmarks and targets, both internal and external’ and ‘outcomes provided to beneficiaries of other [funds]’.

It was pleasing to see that the December 2018 version of SPS 515 fixed both of the above issues.  Strategic planning and member outcomes requirements were amalgamated into the same prudential standard. Outcomes Assessments became member cohort-focused and there was no longer an explicit requirement to compare every single outcome metric to other funds. This version of SPS 515 was much more logically structured, and also struck a better balance between being prescriptive and permitting flexibility for funds to determine their own member outcomes assessment framework to suit their particular circumstances.

However, the passage of legislation to require an annual Outcomes Assessment under the SIS Act in early April 2019 necessitated further revisions to SPS 515.  The legislated requirements are more prescriptive, requiring comparison of a fund’s MySuper products to other MySuper products offered by other funds. For Choice products, funds are required to determine comparable Choice products for comparison purposes.

On 30 April, APRA issued the revised SPS 515 for industry consultation. The revised SPS 515 introduced a new ‘business performance review’ requirement that covers both monitoring of business plans and the Outcomes Assessment. The Outcomes Assessment encompasses two parts, the outcomes assessment as required under SIS and outcomes achieved for different cohorts of beneficiaries.

It is not immediately clear what specific outcomes are envisaged to be covered in the latter, nor is it clear whether APRA requires assessment by cohorts to apply to the Outcomes Assessment under SIS. Additionally, APRA requires funds to specify relative weights to different areas in making an overall assessment. As APRA issued only the revised Prudential Standard for consultation without the relevant Prudential Guidance, it is not 100% clear how APRA envisages the new requirements to work.

There is also uncertainty about the timing of the first annual Outcomes Assessment. As the relevant legislation became effective in April 2019, arguably the first annual assessment needs to be completed within a year, so by April 2020.

Meanwhile, the prospective commencement date of 1 January 2020 for SPS 515 draws ever nearer.  The latest legislative and prudential requirements have changed significantly from the earlier versions. Trustees need to review their assessment framework to cater for these changes, including how to determine the comparable Choice products and what summary results of the outcomes assessment to make publicly available as required by the legislation.

Whatever final form the Outcomes Assessment takes, both regulators and trustees need to be flexible enough to recognise that not everything that makes an organisation successful can be captured in calculable metrics.

After Footscray’s members saved their Club from extinction in 1989, they became the Western Bulldogs and stumbled from moderate success to financial crisis over the following 25 years.  However, in 2016 they memorably won the ultimate AFL prize, the premiership flag, paid off a multi-million-dollar debt and consolidated their position as a permanent community focus for Melbourne’s Western suburbs.  Definitely a favourable outcome for their members!

Prepared by Minjie Shen – Manager, Consulting and Bill Buttler – Senior Manager, Consulting

In what has since been touted as ‘Miracle May’, investors welcomed the shock federal election outcome, which saw the Morrison government returned to power for another three years. The Monday following the election weekend saw the S&P/ASX 200 Index surge in a post-poll relief rally, adding approximately $33 billion to its market capitalisation in what was the single largest gain this year. Much to the embarrassment of the political pundits who had boldly claimed a Labor victory was inevitable, the Coalition managed to secure a majority government in the face of pessimistic opinion polls and betting markets.

Investors have experienced a mild reprieve from some of the recent negativity, while the more pessimistic scenarios have been tempered by upcoming tax cuts—equivalent to around 0.5% of GDP—along with the prospect of further rate cuts from the RBA, APRA’s move to lower the serviceability buffer for home loans, and the removal of downside risk associated with Labor’s tax policy. At the same time, strong commodity prices are boosting export receipts and the government’s fiscal position. However, global risks remain, highlighted by the RBA’s concern about the US-China trade war, and some not-so-subtle indications that the Australian economy is in need of some real structural reform to take the pressure off monetary policy.

Period returns to end May 2019 (% p.a.)


Source: FE, Lonsec

Leading up to the election, equity markets had fully priced in a Labor victory, which had placed significant downward pressure on valuations, in part due to the proposed overhaul of the current taxation laws. As such, when the ‘Messiah from the Shire’ was safely returned to the lodge, investors reacted with exuberance, which saw the S&P/ASX 200 TR Index generate a 1.7% return for the month of May. While in isolation this may seem uninspiring, contrast this with the MSCI World ex Australia NR Index (AUD Hedged), which fell -6.0% over growing concerns of a synchronised global slowdown in concert with the on-again, off-again escalating US-China trade war. Resultingly, Australia was the only advanced economy able to buck the trend during the month of May and enjoy gains in its equity market.

Broadly speaking, investors had shifted their asset allocation away from domestic equities in anticipation of the abolition of excess franking credit refunds. The reason for this was two-fold. Returns on fully-franked securities were anticipated to decline, which in conjunction with a static equity-risk premium necessitated a lower entry price to entice prospective investors. Furthermore, the existing system favours an overweight allocation to domestic equities due to the favorable taxation treatment for those in a zero-tax environment.

Logically, once this incentive is removed, capital outflows overseas will likely ensue. In tandem with this was the proposed halving of the capital-gains tax concession which would have significantly dinted the value proposition associated with investing in property and shares. As such, simply maintaining the status quo was enough to see an extensive re-rate across the market throughout May.

The Financials sector was one of the largest beneficiaries of the election outcome, with the ‘big four’ surging 6–10% on the Monday following the election. Once the animal spirits had subsided, this translated into a 2.6% gain for the S&P/ASX 200 Financials TR Index for the month. Labor’s proposed negative gearing limitations, CGT amendments, increased bank levies and more onerous restrictions on mortgage brokers had all coalesced into an unfriendly environment for future bank earnings. This is in stark contrast to the reform-shy Coalition, which was rewarded for sticking with the status quo. Given then Treasurer Morrison was opposed to a Royal Commission into Financial Services, it is perhaps unsurprising that this sector received a healthy post-election bump.

Likewise, A-REITs enjoyed a surge with the S&P/ASX 200 A-REIT TR Index achieving a 2.5% return for the month of May. This was again attributable to more sanguine housing market sentiment with the threat of proposed changes to negative gearing and CGT discounts now ameliorated. Specifically, Stockland, which is one of Australia’s largest diversified property developers, has since rallied 14% due to its large residential property exposure. The subsequent dovish pivot by the RBA, which cut interest rates to historic lows at its June meeting, has since provided additional tailwinds for the sector too.


Source: FE, Lonsec

Similarly, the Coalition government and health insurers are singing from the same hymn sheet, which saw the S&P/ASX 200 Health Care TR Index deliver 3.3% for the month of May. As above, the prospect of a Labor government mandating capped health insurance premiums and increased regulatory scrutiny had seen the likes of Medibank and NIB de-rate significantly prior to the election. However, following the surprise election announcement, Medibank and NIB subsequently shot the lights out and returned 11.5% and 15.8% at the close on Monday 17 May, respectively. More broadly, the perceived ability for the Coalition to demonstrate fiscal responsibility in the face of gathering economic storm clouds ushered in a 2.0% return for the S&P/ASX 300 Consumer Discretionary TR Index.

While it may have been ‘Miracle May’ for the Coalition and equity investors, unfortunately you can’t have winners without losers. Shareholders invested in Sportsbet’s parent company, Flutter Entertainment, were left aghast at the election result, given Sportsbet had presciently paid out on a Labor win. Equally, Clive Palmer has been left questioning his return on investment, following a $55 million advertising blitz that failed to deliver his party a single seat in parliament.

While miracles are always welcome by investors, unfortunately they are often unreliable when it comes to long-term, sustainable growth. While markets have received a nice boost, the weakness in Australia’s underlying position is difficult to ignore. The latest National Accounts data highlighted the extent of the slowdown, with quarterly growth just 0.4% and annual growth a meagre 1.8%. Households contributed just 0.1% to growth in the March quarter as heightened uncertainty, subdued confidence, and weakness in housing combined with still weak wages growth to constrain household spending. A miracle may have saved us in May, but we have to get through the rest of 2019 and beyond.

The possibility of the RBA undertaking a quantitative easing program could have major ramifications for retirees, who may be forced to increase their exposure to equities if interest rates continue to spiral downwards.
It’s been an eventful month for markets – the Coalition won the federal election in a surprise upset, the RBA cut rates to record lows, and US-China trade tensions re-emerged with a vengeance. Domestic markets reacted positively to the Coalition win, with some of the pessimism surrounding the housing market subsiding. The RBA’s rate cut was not unexpected, with most analysts having already priced in the cut and potentially another.

Interestingly, the market narrative has turned to the possibility of the RBA undertaking a quantitative easing (QE) program domestically, similar to what we have seen in Europe and the US. This would involve the RBA buying government and corporate bonds using cash on its balance sheet, effectively flooding the market with liquidity while keeping rates low. Should rates continue their downward trajectory and QE become a reality, it may force investors into equities, providing a tailwind for markets as we have seen in the US and Europe in recent years. This is particularly relevant for retirees, who may be increasingly forced to lift their exposure to Australian equities as a source of income.

While it’s difficult to know exactly what the relationship is between large-scale asset purchases and the stock market, evidence in the US and Europe suggests there is a positive correlation. The launch of QE in the US resulted in significant share market gains, in part because the market anticipated an improvement in macroeconomic conditions. Proponents of QE tend to be critical of the US Fed for undermining the effectives of the program through its forward guidance (which made the program less open-ended by emphasising the eventual exit from QE), as well as not going hard enough for long enough. Critics of QE claim that large-scale asset purchases inflate asset values, which can lead to a stock market bubble and greater inequality. Yet others believe that monetary policy is entirely fruitless, and fiscal policy is the only effective mechanism.

The precise effect of QE is difficult to determine. While some claim it has been responsible for lowering interest rates, the evidence suggests it might in fact have led to an increase in yields during those periods where it was in effect (see chart below). Bond purchases raise the price of these assets, resulting in a fall in yields, which negatively impacts the return of safe assets like Treasuries, high-quality corporate debt, and cash. This is bad news for retirees who rely on these safe assets to preserve capital or generate a secure income stream. However, if QE manages to raise expectations for long-term growth, this would lead to a rise in longer-term yields, reflecting the prospect for higher growth and inflation.

QE episodes in the US have coincided with a rise in the 10-year yield


Source: FRED, Lonsec

How seriously the RBA is considering QE is unknown, but given the challenges facing conventional monetary policy with interest rates nearing zero, it must be something the bank is thinking about. If the RBA does go down the QE path, it will be difficult to satisfy the critics on both sides of the QE divide. According to economist Stephen Kirchner, the US experience with QE suggests the RBA would need to buy securities equivalent to around 1.5% of GDP to achieve the same effect as 25 basis point reduction in the official cash rate. This would represent a QE program of significant scale for Australia.

If retirees are worried about QE, the RBA is likely just as reluctant to pull the trigger. The not-so-subtle comments from Phillip Lowe and others about the need for structural reform should be heeded by Canberra to avoid placing too great a burden on monetary policy. This is critical given the challenges facing the global economy, including the current trade tensions between the US and China, which continue to adversely impact markets and are contributing to bouts of volatility. The longer the trade wars drag on, the higher the probability that we will see a longer-term impact on global growth.

This is a challenging period for investors, where factors other than fundamentals are having a material impact on the trajectory of markets. In such an environment, we believe selective valuation opportunities will present themselves for long-term investors, however ensuring that your portfolio is diversified will be very important in navigating an increasingly volatile market environment. It’s also a timely reminder that complex macro issues can play a large role in determining the right asset allocation in retirement portfolios, which requires an experienced investment committee with a range of skills and knowledge. This is especially important when it comes to the construction of retirement portfolios, where complex macro issues can have dynamic effects on outcomes.

A world-beating performance from Australian shares has been overshadowed by the re-emergence of geopolitical uncertainty and a wave of risk aversion in global markets, leading to softer performance for super funds in the final stretch of the financial year.

According to estimates from leading superannuation research house SuperRatings, the typical balanced option return was -0.7% in May as funds were dragged down by falls in international shares triggered by the re-emergence of the US-China trade conflict and uncertainty surrounding central bank policy.

The bright side has been the resilience of Australian shares and property, both of which saw a brief boost from the Coalition’s surprise election win, but this was not enough to save super funds from a month of negative performance.

Markets have since recovered following May’s weakness, but members should not expect a bumper end to the financial year. The year-to-date return is sitting at 5.1% for the median balanced option, which is below the 8.5% per annum return achieved over the past ten years.

Estimated median Balanced option returns to 31 May 2019

Period Accumulation returns Pension
returns
Month of May 2019 -0.7% -0.7%
Financial year return to 31 May 2019 5.1% 5.8%
Rolling 1-year return to 31 May 2019 4.8% 7.3%
Rolling 3-year return to 31 May 2019 6.8% 8.1%
Rolling 5-year return to 31 May 2019 6.6% 7.6%
Rolling 7-year return to 31 May 2019 8.7% 10.5%
Rolling 10-year return to 31 May 2019 8.5% 9.7%
Rolling 15-year return to 31 May 2019 7.5% 8.1%
Rolling 20-year return to 31 May 2019 6.8%

Interim results only. Median Balanced Option refers to ‘Balanced’ options with exposure to growth style assets of between 60% and 76%. Approximately 60% to 70% of Australians in our major funds are invested in their fund’s default investment option, which in most cases is the balanced investment option. Returns are net of investment fees, tax and implicit asset-based administration fees.

Members in the median growth option, which includes higher weightings to growth assets like Australian and overseas shares, suffered a larger fall of 1.2% in May, while the median International Shares option fell 4.0% and the median Australian Shares option held firm, returning 1.4%.

“It’s been a disappointing end to the financial year for super, but long-term performance remains robust,” said SuperRatings Executive Director Kirby Rappell. “The median balanced option return over the past 10 years is around 8.5%, indicating that super has delivered solid returns even in a low interest rate environment.”

Downside risks to the Australian economy, including weak inflation, falling home prices, and tighter credit conditions are taking their toll on consumer confidence, while the geopolitical risks in the form of US-China trade negotiations have also contributed to market volatility.

SuperRatings Index return estimates to 31 May 2019


Source: SuperRatings

However, the Australian market has held up reasonably well over the financial year to date, with the S&P/ASX 200 Index returning 7.6% so far to the end of May, outperforming global share performance of 6.3% measured by the MSCI World Ex-Australia Index. Listed property has been the leading asset class so far this financial year, with the S&P/ASX 200 A-REIT Index returning 14.5%. Both property and shares saw a modest boost in May with the negative gearing debate now effectively put to bed following the federal election.

“Labor’s negative gearing proposals were thought to favour developers by limiting tax concessions to new stock, but so far the improvement in sentiment has outweighed any negative impact, which may give some super funds a temporary boost to their property portfolios,” said Mr Rappell.

Long-term super performance steady

The negative performance for super funds in May has been reflected in a slight fall in the Balanced and Growth option indices for the month but long-term performance remains strong. According to SuperRatings’ data, $100,000 invested in the median Balanced option in May 2009 is estimated to have reached an accumulated $217,391 today.

The median Growth option is estimated to be worth $230,873 over the same period, while $100,000 invested in domestic and international shares ten-years ago is now worth $244,382 and $258,181 respectively. In contrast, $100,000 invested in the median Cash option ten years ago would only be worth $129,748.

Growth in $100,000 invested over 10 years to 31 May 2019


Source: SuperRatings

Release ends

Markets continued their upward trajectory during April which has largely continued unabated since the so called ‘Powell Put’ earlier in the year, with the US Fed chair signalling a pause to further rate hikes. However, market volatility has picked up as the US-China ‘trade war’ has been reignited and the US seeks to precent Chinese telecom manufacturer Huawei from accessing US suppliers.

At the recent Lonsec Symposium, geopolitics was a key topic of discussion and specifically what it means for investors. While we would argue that basing investment decisions on geopolitical issues is problematic, understanding the broader implications of such issues is important, particularly if they have the potential to impact global growth. At a minimum it creates market volatility and, as evident in recent years, we believe that we are experiencing more frequent bouts of volatility attributed to geopolitical issues.

From an investment perspective, while we believe that most markets look to be priced at the fair to expensive range, pockets of relative value are appearing. An example of this is our current active tilt to emerging markets versus developed markets. We also continue to believe that alternative investments have a role to play within a portfolio as a source of diversification. While some parts of the broad alternatives sector have been challenged in terms of performance, if we head into a different market environment, accessing alternative sources of risk and return will become increasingly important. We have been also seeking to further diversify our Multi-Asset portfolio exposure to value style equities via active managed funds. While value has materially underperformed growth in recent years, the addition of a specialist value manager further diversifies the portfolios and, given that we believe that we are getting closer to the cycle, we will see more value opportunities appear.

Behavioural finance tells us that herd behaviour is hard wired into our brains. As investors we don’t want to miss out on opportunities, especially when we see others taking advantage of them. Herd behaviour and a fear of missing out is what drives asset bubbles, which means as investors we need to be on guard to ensure our emotions take a back seat when we make buy and sell decisions.

Investors are familiar with the FAANG stocks (for the uninitiated FAANG stands for Facebook, Apple, Amazon, Netflix and Google). Some of them are among the highest valued stocks in the world (Apple became the first company in the world to reach a market cap of $1 trillion but has since fallen below this level due to falling iPhone sales). In Australia we have our own acronymised technology cohort called the WAAAX stocks, which include WiseTech, Altium, Appen, Afterpay and Xero.

While hardly on par with the US tech giants in terms of size, these businesses have managed to capture people’s attention and imagination in a similar way. But like the FAANGs, the WAAAXs are certainly not a homogenous group. While each has seen eyewatering growth in recent years, they are essentially very different businesses with different growth drivers and risks.

WAAAXing fortunes

It’s sometimes easy to forget how parochial the Australian share market can be. The WAAAX phenomenon is undoubtedly a good thing, especially given that the ASX remains dominated by banks and miners. Australia’s tech sector may still be small, but its growth is helping to provide some much-needed diversification. While only 2.4% of the ASX 200’s total market cap, there are now 15 names in the tech sector with a combined market cap of over $75 billion.

WAAAX share price returns (12 months to end March 2019)

Source: FE, Lonsec

When you look at the stellar growth of these shares, it’s easy to see why they’re considered the Australian FAANGs. But how useful is it to group shares together in this way? Certainly in the US, the FAANGs don’t always behave as a group. While the return of risk appetite contributed to their strong performance in the March quarter, most were unable to make up for earlier losses due to the ongoing impact of idiosyncratic issues plaguing each stock.

Facebook continues to be scrutinised for their lax privacy policies, Amazon is facing a challenging earnings outlook, Apple’s revenue and product launches have fallen short of expectations, Netflix faces increasing pressure from new competitors, and Alphabet (Google) received another fine from the European Union for violating antitrust laws.

In Australia, the diversity of the WAAAX stocks poses a similar challenge for investors. To give a sense of how different these businesses are, let’s have a quick look at two of them: Appen and Afterpay. These are among the most popular shares over the past two years, but they have fundamentally different core businesses. For Appen, revenue is driven by the growth in AI and machine learning solutions, with Appen providing quality datasets that help make these products smarter. In contrast, Afterpay’s extraordinary growth has been due to the company’s ability to take advantage of a potential step change in consumer behaviour, with a younger generation of consumers favouring digital payments and more flexible spending.

Source: Lonsec

While these stocks are different, there is no denying the extraordinary growth of the WAAAX group, which is indicative of some of the disruptive trends taking place in the digital world. This is reflected in the sales and EBITDA growth of Afterpay and Appen, which becomes starker when compared to other popular sector peers Seek and Carsales. Clearly there are good reasons to be optimistic, but the question is how best to take advantage of these opportunities in your broader portfolio.

Source: FE, Lonsec

Using WAAAX shares in your portfolio – key things to note

When incorporating the WAAAX shares in your portfolio, the most important thing to remember is that they are not homogenous, which means you shouldn’t group them together. While these shares may grow together in a risk on environment, each face their own set of risks and opportunities which could see results diverge significantly.

The second thing to note is that these are capital hungry businesses with a mandate to grow, which means you should not expect a steady stream of hefty dividends. Because they are long duration assets, they will also be more sensitive to movements in interest rates.

Thirdly, while each of these stocks appears to enjoy significant upside, there are always risks around valuation and potential bubble-like behaviour. Valuing things like network effects can be difficult, while forecasting consumer trends and the role of AI require a host of assumptions to hold true. When it comes to technology, there is usually a significant degree of uncertainty involved, not to mention the regulatory risks faced by successful disruptors.

Our view of the WAAAX stocks is that you want to take advantage of the growth opportunities they represent, but don’t fall into the trap of bucketing them together. Understand the drivers of each business and let the winners run, but be sure to carefully monitor the market and regulatory risks of each business.

IMPORTANT NOTICE: This document is published by Lonsec Research Pty Ltd ABN 11 151 658 561, AFSL 421 445 (Lonsec).

Please read the following before making any investment decision about any financial product mentioned in this document.

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When industry funds first came on the scene in the 1990s, the member contribution rate was three percent of wages and there was one investment strategy that applied for all members. The last thing trustees were thinking about was the need to cater to the increasingly complex advice needs of their members before and after retirement. Fast forward to today and the situation is very different. As fund membership grows and average account balances rise, the need to support advice is becoming critical.

To get a sense of how significant the advice challenge is across the whole super industry, consider how membership has changed over the past decade. As the chart below shows, there has been a steady decline in the proportion of benefits accruing to members under 65, while the proportion accruing to older members, including those over retirement age, has been rising.

Proportion of member benefits by age group – all fund types

Source: SuperRatings

For industry funds this means there is a need to adapt to the increasingly sophisticated needs of their members in retirement. Industry funds are now keeping more post-retirement members in their fund, rather than seeing them shift to a retail fund or SMSF. The larger the member account, the more likely the member is to consider leaving their money in the fund during the retirement phase. While the average account balance across all industry funds is not incredibly high, there is significant variation across individual funds.

Average accounts – industry funds 2018

Source: SuperRatings

In the 70-74 age bracket, the average account balance is well under $200,000, but there are funds out there with significantly higher average balances, with the largest ranging as high as $600,000. This gives rise to a range of different product and advice needs depending on the member’s situation. For members with relatively low account balances, the age pension can be used to manage investment risk. For members with larger account balances, their advice requirements will be closer to those in an SMSF.

The reality is that member advice needs are moving well beyond the capacity of the inhouse advice provided by the funds themselves. To meet the advice challenge, funds are increasingly turning to third party advice, but there is still some reluctance to support members in accessing advice outside the fund.

In the past there has been an element of tension between super funds and financial advisers. From the super fund’s perspective, the adviser is a possible threat to member retention and can disrupt the fund’s engagement process. For the adviser, the super fund can sometimes seem like a closed shop, unwilling to give up control of the advice experience or shed any real light on its investment process, structures and strategy.

Third party advice networks facilitate greater reach through their advice channels, while concerns over quality control can be managed through the delivery of accurate and timely information to advisers and dedicated monitoring. While funds must be prepared to give up some control, advisers will need to work harder to ensure their advice is in their clients’ best interest. The limitations of many advice businesses have been laid bare by the Royal Commission and there will likely be significant turnover in coming years, with more advisers distancing themselves from aligned groups. This provides an opportunity to support and build traction within the new advice landscape.

Many funds are already recognising this opportunity, but generally industry funds still have a way to go in embracing third party advice. According to SuperRatings’ data, only 59% of Not for Profit (NFP) funds have formal relationships with advisers, which have traditionally been the domain of retail funds through vertically integrated business functions. Even fewer NFPs have a dedicated servicing team for third party advisers – only 46% compared to 68% of Retail Master Trusts (RMTs) – which is essential for enabling advisers to provide a competitive service.

Industry fund support for third party advisers is lagging

Third party adviser servicing Not for profit Retail master trust All funds
Formal relationships 59% 84% 69%
Third party adviser panel 15% 15% 15%
Dedicated servicing team 46% 68% 55%
Adviser portal 12% 57% 29%
Ability to transact 15% 73% 38%
Access to client reports 38% 92% 60%
Facilition of fee payments 67% 92% 77%
Provision of data feeds 8% 81% 37%

Source: SuperRatings

Funds and advisers need each other, but how can they go about creating mutually beneficial and trusting relationships? The answer is by sharing information and being transparent about members’ needs. For advisers, this means having access to high quality investment product research that enables them to efficiently assess a wide range of NFP, retail and corporate funds, and ensures they have an in-depth understanding of how each fund stacks up.

Equally, super funds need to support this process by giving advisers the information they need to make decisions in their client’s best interest. Transparency is no longer a radical strategy for super funds – it not only reduces friction for the adviser and their client by making it easier to do business, it means that the adviser is in a position to assess the product and consider it for their client. Communicating third party assessments, such as Lonsec’s well recognised investment option ratings, also helps advisers to easily identify and justify high quality superannuation offerings.

We expect to see significant changes in funds’ external advice offerings in coming years, particularly as funds continue to report growing success in this area. SuperRatings is supporting this evolution by making its specialised superannuation research available to financial advisers via Lonsec’s market leading iRate platform, giving advisers the tools to make in-depth fund comparisons and ensure that they can fully justify their fund decision on a best interest basis.

With potential risks over default models and concerns about the sustainability of the old model, it is impossible for funds to ignore these opportunities. While funds and advisers might not always see eye to eye, they can’t afford to allow their differences to get in the way of the vast opportunity staring them in face.

When you ask clients how they think about risk in retirement, you are unlikely to get a textbook response. Instead, you’ll probably get a list of their deepest fears: running out of money, leaving their children with nothing, living too long, retiring during the next GFC, or not having enough cash on hand to pay for necessities.

When we define investment risks, we don’t define them in these terms, but these are the eventualities we’re attempting to guard against when we construct retirement portfolios. There are any number of objectives your client might be aiming to achieve, and each will come with their own set of risks.

Is it the chance of your investments going down? Is it asset class volatility? Is it not achieving the returns you need to meet your required income? In the end, risk is getting your investment strategy wrong by not understanding the relationship between your client’s competing objectives and associated risks.

For this reason, we believe there is a need to focus on retirement investing as a separate strategy. Even moving from the accumulation to the drawdown phase means you are managing a different set of trade-offs. The role of the financial adviser is not to eliminate the existence of these trade-offs but to manage them prudently in line with their client’s preferences and risk tolerance.

Source: Lonsec

Each of these competing objectives requires different investment strategies to achieve. For example, a rental property will provide the most consistent income but at the expense of liquidity. If we’re worried about market volatility we might be tempted to move to a more defensive asset allocation, but by foregoing growth we increase the chance of running out of money. In short, clients will always be exposed to various types of risk.

The problem with determining a client’s most important objectives is that often they are all equally important. Consider the following examples:

Paying the bills

Certainty of income is usually the key concern for retirees, but don’t discount the others. When you ask advice clients what their most important objectives are, the most common answers are things like relaxation, travel, family, and leisure. These all have a price associated with them. Liquidity is also a major consideration for retirees. Not having enough cash on hand for things like motor vehicle repairs and other essential spending can result in significant stress and prevent retirees from enjoying the things they were looking forward to after their working life.

Leaving a legacy

Most people wish to enjoy a comfortable life in retirement but also make sure their children and loved ones are left with some extra wealth. A 2017 ASFA study found that households are retiring with an average super balance of $337,000 (the gender breakdown is $270,000 for men and $157,000 for women). Leaving a meaningful inheritance or bequest would mean there is barely enough left over to support their own needs.

Maintaining purchasing power

As any basic economic textbook will tell you, different asset classes will perform better or worse in different inflationary environments. Inflation of 2% per year will erode more than half of your purchasing power over 35 years, which is the equivalent of a single GFC event. Managing inflation is just as important as managing sequencing risk or the risk of a large drawdown, even in periods where inflation is relatively low.

This adds an additional consideration to the construction of retirement portfolios. Real assets are a proven way of managing inflation risk, while fixed income is potentially the worst asset class for this purpose, with the exception of products like inflation-linked bonds.

Different assets perform differently depending on the inflationary environment

Source: Lonsec

Guarding against a crisis

If successfully timing the market seems more like luck than skill, then timing your retirement is no different. While market bumps are nothing to be feared when you’re building your wealth, a sudden major event like the GFC can spell disaster for those entering the decumulation phase. Sequencing risk refers to the order in which investors experience returns, and it can matter a great deal for retirement. Withdrawals during a falling market have the potential to accelerate the depletion of your asset base.

To see how this works, take a look at the returns from Lonsec’s balanced portfolio over the last 20 years. If you reverse the order of returns, there isn’t really much difference for those in the accumulation phase – both sequences deliver the exact same results over the long term. But for those drawing down on their investments, the reversed sequence results in the retiree running out of money much sooner.

The sequence of returns can mean the difference between having enough cash and running out

Source: Lonsec

Addressing sequencing risk requires advisers to look at a wider range of solutions, including variable beta or absolute return strategies, and even some more illiquid options to reduce volatility and manage drawdowns. Once again, there is a trade-off involved in making these decisions.

The reason we struggle to precisely define risk is that there simply isn’t a single source of risk that can be effectively managed or reduced to zero. Managing risk means understanding the often complex relationships between different retirement objectives. Effectively managing these relationships is the purpose of your investment strategy.

When we talk about risk at Lonsec in a portfolio context, what we are really talking about is the risk that the overall investment strategy is wrong or is not properly tailored to the client’s needs and preferences. This informs the approach we take to the management of our model portfolios as well as the selection of individual products to achieve a particular objective. We think this is the proper way to think about risk without being constrained by a single textbook definition, and it is the way in which advice clients intuitively understand risk as well.

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.