The question no-one wants to ask is – Why are APRA collecting, interpreting and then publishing information in the public domain? The answer is simple – They shouldn’t be!

Instead of regulating, APRA are now trying to play the shame game through their just released heatmaps. But there is a real risk that some of those shamed will be the wrong funds. As the founder of SuperRatings, Jeff Bresnahan says, “The problem is that no one in the industry wants to tell the regulator that they have got it wrong.”

Effectively, APRA is putting into circulation data which analyses just parts of a super fund, not the whole. By ignoring things like Governance, Advice, Insurance and Member servicing structures, consumers are not being provided with the whole picture.

As Bresnahan says, “While conflicts of interest were identified as a major issue in superannuation during the Royal Commission, it seems ironic that APRA has deliberately avoided reporting any measurement of a Fund’s Governance structure”.

In an industry which carries inherently conflicted Directors, it would appear that Governance is ignored in favour of more easily assessable information. Whether such omissions create any legal liabilities for APRA in the future remains debatable.

As a result, APRA continues its foray into unchartered territory. This is not the first time APRA have got it wrong. They have been producing performance tables for over a decade. Unfortunately, the performance tables were flawed from a usefulness perspective, in that they don’t reflect the performance of a super fund’s investment options. However, they continue to produce them and in doing so confuse and possibly mislead Australians.

And so it continues with the heatmaps. Having reviewed the heatmap methodology, SuperRatings is of the opinion that their release into the public domain may create more questions than they answer and that consumers could well be influenced into products that are inappropriate for them.

Aside from the bigger question of why APRA is publishing such data, there remain a number of problems with the methodology adopted. Critically, APRA appears to ignore implicit asset fees when measuring net investment performance.  As Bresnahan says, “This methodology can easily overstate the net benefit a member receives. Similarly, a low-cost investment option with high administration fees creates the very real possibility of consumers investing monies in cheap investment options that have no chance of outperforming the relevant index over any time period, whilst getting slugged high administration fees.”

Investment analysis since the onset of the Superannuation Guarantee in 1992 has shown that all implicit fees and performance must be analysed together on an actual net of fees basis. Many leading funds, in terms of balanced option performance, have had higher allocations than the average fund to traditionally more expensive asset classes such as infrastructure, private equity and unlisted property. These asset classes have continually outperformed cheaper alternatives.

It’s only when all actual fees and returns are combined that the range of results is clearly evident in dollar terms, as the following graph indicates. The graph shows the disparity of net earnings on a $50,000 starting balance (and $50,000 salary) with SGC contributions mapped over both the last 3 and 10 years. Notably, many of the funds that added the most value, over both the short and long term, invested into the more expensive asset classes. Driving people into low-cost options will come at the expense of future earnings, something that taxpayers will ultimately have to bear.

Net benefit trend analysis (over 3 and 10 years)

Source: SuperRatings

And the anomalies continue. The heatmaps are judging funds on short term performance over just 3 and 5 years. Whilst it will be claimed this is necessary due to the limited performance history of MySuper products, it should be noted that most funds have been around for over 25 years and that their default option provides an accurate MySuper proxy.

As Bresnahan said, “Given super is a key plank of Australia’s economic future, it seems counter-intuitive for the Government’s regulator to not measure funds over a more realistic period. Certainly, it is commonly accepted that 7, 10 and 15 year performance analysis is best practice given the long term (60 years plus) nature of superannuation membership.”

Again, a consumer moving funds due to seeing a 3-year performance gap, mid-way through an economic cycle, will no doubt be moving for the wrong reasons.

The way forward

Bresnahan says, “Australians are not stupid, but they remain frustratingly unengaged with their superannuation.” This problem remains the real challenge for much of the industry. APRA’s endeavours are admirable, but questionable at the same time. He goes on to say, “A regulator should set the structure under which funds need to operate. The morphing of this regulatory process into public comparisons leaves it open to being seen as stepping across the line. One wonders what they are actually trying to achieve by moving into this public domain.”

If APRA must continue down this path, then SuperRatings suggests that they need to concentrate on the whole picture, rather than isolated parts therein. This should, aside from earlier mentioned issues, also include:

  1. Regulations to enable consistent fee disclosures, including the inequitable use of tax deductions and transparency to members;
  2. The disclosure of risk within portfolios, both via the assumptions within their growth/defensive disclosures and accepted risk measures;
  3. Compulsory disclosure of major asset holdings;
  4. Moving members into go-forward products and removing legacy structures;
  5. Continued rationalisation of member accounts; and
  6. Increased focus on the decumulation phase and the optimisation of the alignment with retiree objectives.

Identifying poorly run funds is not difficult and APRA would be well aware of them. A series of simple measures such as the non-public fee analysis shown below, when combined with other key assessments, quickly shows those funds who have spent the past few decades masking conflicts of interest at the expense of members.

When it costs a fund over $1,200 to run every account (versus a median of $300) or a fund’s operating expenses as a percentage of assets are over two and a half times the median, then those funds bear further scrutiny. Similar work can be done across Investments, Governance, Administration and Insurance, to name a few. By putting together the whole picture, the poor funds are very quickly exposed.

Operating expenses versus size and members

Source: SuperRatings

But it’s not all gloom and doom for the process. Importantly, after 14 years of industry debate, APRA has finally made a call on what constitutes a growth asset and what constitutes a defensive asset. The growth/defensive debate remains loud within the industry but with APRA’s call of Australian Unlisted Property and Australian Unlisted Infrastructure being 25% defensive, at least there is a starting point. SuperRatings suspect this will not however be the final position.

Certainly, APRA’s front foot involvement with data will give cause for reflection for all super funds, as the funds review their results and assess whether it has any implications for their future.

SuperRatings continues to watch the evolution of the market and continues to monitor funds on their effectiveness in responding to key challenges. We look forward to seeing whether the heatmaps evolve over time and remain broadly supportive of APRA’s underlying intentions. However, we underline that this remains only part of the picture and that the risk of making providers look alike is real. In an environment where innovation is needed, regulatory settings to support innovation are vital to ensure a vibrant industry that thrives into the future resulting in better outcomes for members.

Release ends

We welcome media enquiries regarding our research or information held in our database. We are also able to provide commentary and customised tables or charts for your use.
For more information contact:

Jeff Bresnahan
Founder & Chairman
Tel: 1300 826 395
Jeff.Bresnahan@superratings.com.au

Kirby Rappell
Executive Director
Tel: 1300 826 395
Kirby.Rappell@superratings.com.au

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.

Super funds are off to a positive start in the December quarter, regaining momentum following a rocky September and paving the way for double-digit returns for the 2019 calendar year.

While markets have come under pressure in recent months, super funds have once again proved they are up to the task of navigating the significant uncertainty in markets, geopolitics, and the global economy.

Super fund returns held up well in October, despite weakness from Australian shares and signs of softer economic growth globally. The major financials sector has come under pressure due to constrained lending, lower net interest margins, and continued fallout from the Royal Commission. IT shares also suffered a dip as investors questioned the lofty valuations of Australia’s local tech darlings.

According to SuperRatings’ estimates, the median balanced option returned a modest 0.3% in October, but the year-to-date return for 2019 is sitting at a very healthy 12.5%. The median growth option has fared even better, returning 14.4%, while the median capital stable option has delivered a respectable 7.1% to the end of October.

Over the past five years, the median balanced option has returned an estimated 7.6% p.a., compared to 8.3% p.a. from growth and 4.7% p.a. from capital stable (see table below).

Estimated accumulation returns (% p.a. to end of October 2019)

  YTD 1 yr 3 yrs 5 yrs 7 yrs 10 yrs
SR50 Growth (77-90) Index 14.4% 11.9% 10.1% 8.3% 10.1% 8.5%
SR50 Balanced (60-76) Index 12.5% 10.5% 8.9% 7.6% 9.1% 7.9%
SR50 Capital Stable (20-40) Index 7.1% 6.8% 5.0% 4.7% 5.3% 5.6%

Source: SuperRatings

Estimated pension returns (% p.a. to end of October 2019)

  YTD 1 yr 3 yrs 5 yrs 7 yrs 10 yrs
SRP50 Growth (77-90) Index 16.4% 13.3% 11.2% 9.4% 11.4% 9.5%
SRP50 Balanced (60-76) Index 13.8% 11.7% 9.8% 8.3% 9.9% 8.7%
SRP50 Capital Stable (20-40) Index 8.3% 7.7% 5.9% 5.5% 6.0% 6.4%

Source: SuperRatings

“This year has provided further solid evidence of the ability of super funds to deliver for their members through a challenging market environment,” said SuperRatings Executive Director Kirby Rappell.

“Whether it’s the US-China trade conflict, the weaker economic outlook, falling interest rates, or the rolling Brexit saga, there’s been a lot for funds to take in. This has been a real test of their discipline and ability to manage risks on the downside. Growing wealth in this environment while protecting members’ capital is a tall order, but they have managed it well.”

Shifting asset allocation key to managing risk

One of the most important trends in the superannuation industry is the broadening of members’ investments across different asset classes. Over the past five years, super funds have shifted away from Australian shares and fixed income and moved a higher proportion of funds into international shares and alternatives (see chart below).

Change in asset allocation (2009 to 2019)

Super fund asset allocations have shifted towards alternatives

Source: SuperRatings

The shift to alternatives is significant and has been the subject of debate within the industry. Alternatives include private market assets and hedge funds, which despite the negative connotations can provide an important source of diversification and downside protection when markets take a turn for the worse.

These assets tend to be less liquid, but they can play an important role for funds looking to generate income while managing risks for their members in a world characterised by low yields and growing uncertainty. However, funds should be clear about their alternatives strategy and the risks they could potentially add to members’ portfolios.

“This shift in asset allocation is in part being driven by the low interest rate environment, which has prompted super funds to reach for yield by allocating to alternatives and other less liquid assets,” said Mr Rappell.

“This isn’t necessarily a bad thing, and it may in fact result in a more robust asset allocation, but it’s something members should be aware of. Alternatives can help protect capital under certain market conditions, but they can also be used to boost returns by taking on some additional risk. We generally think the shift to a broader asset allocation is positive, but funds should not be complacent in ensuring risk is appropriately managed.”

Lonsec has again been voted Research House of the Year according to an annual survey of financial advisers and fund managers conducted by and reported in Money Management magazine.

Lonsec this year was considered highly regarded among advisers for the quality of its staff, its model portfolio capabilities, value for money, the quality of its consulting services, the depth of its investment product research, and the sophistication of its asset allocation research.

“We’re absolutely delighted to be named Research House of the Year for 2019, and to be voted number one by advisers for the fourth year in a row,” said Lonsec Research Executive Director Libby Newman.

“This is testament to our people, whose commitment to the continual improvement of our research capabilities and the value of our offering has kept us on top.”

The results come as Lonsec launches new enhancements to its iRate platform, which allow users to incorporate ASX shares in their portfolio analysis and comparisons, with individual superannuation investment options to be added in December. This will enable advisers to get the best possible picture of their client’s portfolio, from shares and other listed products to traditional managed funds and superannuation.

“Our ability to provide in-depth investment product research is the most important factor our advisers look for, and we’re happy that they continue to regard us highly in this area,” said Ms Newman.

“We’re also working on delivering the most powerful tools in the market, so you have the best possible view of how your advice delivers value across your client’s portfolio. This is a very exciting time for Lonsec, and we’re grateful to our adviser community for putting their faith in us once again.”

Check out the full results of the Money Management survey.

 

 

 

 

Congratulations to all of the award winners and finalists for this year’s SuperRatings and Lonsec Fund of the Year Awards Dinner. A full list of the awards is available below.

Lonsec Disruptor Award

Drawn from the Lonsec rated universe, products or issuers who have challenged the status quo.

Winner
Vanguard

Finalists
Allianz Retire+
VanEck Vectors MSCI International Sustainable Equity ETF
Vanguard

Lonsec Investment Option Award

Drawn from the Lonsec rated superannuation investment options and based on a qualitative assessment of the investment team and portfolio design to meet member needs.

Winner
Sunsuper for Life (Balanced Fund)

Finalists
AustralianSuper Balanced (MySuper) Investment Option
Cbus Industry Growth
Sunsuper for Life (Balanced Fund)

 

Lonsec Sustainable Investment Award

Seeks to recognise and highlight the work of asset managers and key players incorporating ESG.

Winner
Ausbil Active Sustainable Equity Fund

Finalists
Alphinity Sustainable Share Fund
Ausbil Active Sustainable Equity Fund
BetaShares Australian Sustainability Leaders ETF

Super funds have managed to push through a challenging quarter for markets, posting gains in September and recovering from August’s falls. Despite the recent volatility and geopolitical risks that have shaken global markets in recent months, Australia’s super funds have proved up to the task of navigating the current uncertainty.

The median balanced option returned 1.2% in September, according to leading superannuation research house SuperRatings. The median growth option fared slightly better, returning 1.5% in September, while the capital stable option returned 0.4%.

It has been a successful year for super funds, which has seen the median balanced option return hit 11.5% over the calendar year to date. Over the past five years, the median balanced option has returned 7.8% p.a., compared to 8.6% p.a. from growth and 4.9% p.a. from capital stable.

Accumulation returns (% p.a. to end of September 2019)

  1 mth 1 yr 3 yrs 5 yrs 7 yrs 10 yrs
SR50 Growth (77-90) Index 1.4% 7.0% 9.1% 9.5% 10.3% 8.3%
SR50 Balanced (60-76) Index 1.2% 6.9% 8.5% 7.8% 9.1% 7.7%
SR50 Capital Stable (20-40) Index 0.4% 5.8% 4.9% 4.9% 5.4% 5.6%

Source: SuperRatings

Pension returns also saw promising growth in September, with the balanced option returning 1.2% over the month, compared to 1.5% from the median growth option and 0.5% from the median capital stable option.

Pension returns (% p.a. to end of September 2019)

  1 mth 1 yr 3 yrs 5 yrs 7 yrs 10 yrs
SRP50 Growth (77-90) Index 1.5% 7.9% 10.6% 9.7% 11.5% 9.3%
SRP50 Balanced (60-76) Index 1.2% 7.8% 9.3% 8.5% 10.0% 8.6%
SRP50 Capital Stable (20-40) Index 0.5% 6.7% 5.6% 5.5% 6.1% 6.3%

Source: SuperRatings

However, while pension returns have held up well, the low rate environment is making it challenging for super funds to deliver income to those in the retirement phase. The RBA’s interest rate cut last week brings the cash rate to a new record low of 0.75% and has pulled longer-term rates down with it. Falling rates have resulted in capital gains in bond markets since the start of 2019, but the downside is the challenge the low rate environment presents to retirees in need of income.

“With interest rates so low, the hunt for yield is intensifying and is likely to become more of a challenge for super funds going forward,” said SuperRatings Executive Director Kirby Rappell.

“Pension returns are holding up well, but the split between capital gains and income is critical for retirees, because they rely on income streams to fund activities in retirement. Over the past few years we’ve seen super funds steadily reduce their allocation to bonds in favour of other income-generating assets like alternatives and property in order to generate their required yield. We expect this theme to continue to play out as rates remain low and possibly move lower over the next year or two.”

The income challenge

The key theme throughout 2019 has been the steady fall in yields as uncertainty surrounding the economic outlook has seen investors move into bonds and other safe assets. In Australia, the yield on 10-year government bonds ended September at 1.0%, down from 2.3% at the start of 2019. As the chart below shows, yields have been on the decline since the Global Financial Crisis, with the 10-year yield falling from a high of 6.5% just prior to the market meltdown. Meanwhile, the cash rate is now 225 basis points below the “emergency lows” of 2009.

Falling yields have supported capital growth but at the expense of income

10-year bond yields are at an all-time low

Source: Bloomberg, SuperRatings

Over the past 15 years to September 2019, an estimated growth rate of 6.9% was observed for the SR50 (60-76%) Balanced Index, which is well ahead of the return objective of inflation plus 3.0%. Over this period, a starting balance of $100,000 in the median balanced option would have accumulated to over $271,000, which exceeds the return objective by around $43,000.

Growth in $100,000 invested over 15 years to 30 September 2019

Super funds have exceeded their return objective

Source: SuperRatings

“Long-term super returns are healthy, even when you include the GFC period,” said Mr Rappell. “However, there’s no doubt that super funds are finding it harder to identify opportunities in the current environment. With valuations stretched, funds are paying more for growth, while lower interest rates mean they need to look beyond traditional assets to generate income.”

One of the most common investment pitfalls is to back the current winner. All too often investors pile into the best performing share, asset class or fund manager over the past year in the hope that its success will be repeated. This type of naïve momentum strategy can pay off in the short term, but investors quickly find that prior successes are not so easily replicated.

Very rarely does this kind of momentum strategy hold up in the world of managed funds, even over relatively short periods of time. For example, looking at three-year rolling returns for global growth managers, it’s clear that performance can get shuffled around a lot. Those who have outperformed over the previous three years can easily find themselves near the bottom of the pack over the next three years. Equally, those languishing near the bottom can suddenly find themselves out in front of the pack.

Following the winner can make you a loser: Global growth manager return rankings (2016 versus 2019)

Source: iRate

Obviously, if your manager research is focused on performance, you need to take a long-term view. The challenge, however, is that your analysis will inevitably be limited to those managers who have built up a sufficient track record. There’s also the classic survivorship bias problem: researchers tend to focus on the performance of those funds that have managed to remain in existence over their period of analysis. For active managers, medium- and long-term market dynamics can also have a significant impact on performance. For example, there will be periods when the market favours growth managers and periods when it favours value managers. Just because growth has outperformed value over the past decade doesn’t mean it will continue to outperform in the next. A change in market fundamentals can upend even the most thoroughly researched investment theses.

This all creates a significant conundrum for quantitative research. While qualitative research methods are sometimes criticised for being subject to arbitrary rules, in fact it’s the opposite that proves the case. Determining which quantitative metrics are relevant for which managers over which timeframe is difficult to do with a high degree of precision or confidence. Determining which are the main predictors of future performance is nigh impossible.

So how do successful researchers overcome this challenge? Clearly, quantitative measures are essential in assessing which funds are capable of delivering on their investment objectives. But they are far from the only measures that should inform your investment decisions. Qualitative factors should ideally make up the bulk of your research, but they tend to play a back-seat role because gathering the qualitative intelligence required to pick successful managers is a resource-heavy, time-consuming task. This can result in its own form of selective bias, where researchers focus on those factors that are relatively easier to measure and compare.

The limitations of quant-only research

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.

Performance of Australian equity managers rated Recommended or higher by Lonsec

Performance of global equity managers rated Recommended or higher by Lonsec

Source: iRate. Average performance is calculated based on historical monthly performance of managers currently rated.

Despite the fact that some active managers struggle to beat the market, we know that there are some that can consistently outperform. But identifying them has little to do with their past performance and much to do with having the right people, resources and processes in place to deliver on their mandate. Looking back through history, there have been funds that have been highly successful, producing people who went on to found their own funds and enjoy similar success. For new funds and products entering the market, there’s often no track record to speak of, meaning qualitative factors are the only means to measure the likelihood of success. If you screen these products out simply because you don’t have enough performance data, you risk missing out on new innovations and strategies that could prove highly valuable.

People and resources

Arguably the most important factor to consider when assessing a fund is the people responsible for making the investment decisions. Your research should take into account the size of the team, its quality, its stability, and its key person risk. Is the team large enough to carry out its mission? Does its analysts have the right level of experience and a track record of success working together? Is the fund overly reliant on a single person whose departure could adversely affect the fund’s performance?

Your research should also examine the culture and structure of the fund. Does the investment team demonstrate a real passion for investing? Do they treat it as a business or a profession? Do they have a stake in the fund’s long-term performance?

Investment philosophy

One of the most telling tests of a fund manager’s capability is to ask them to explain their investment philosophy as simply and concisely as they can. A fund’s investment philosophy should not be a string empty words displayed on the manager’s website and then largely forgotten. An effective philosophy is regularly consulted to ensure that all investment decisions ae consistent with the fund’s purpose. Your research should examine the fund’s philosophy to see if it is consistent and lived out through its investment decisions.

Is the manager sticking closely to its mandate or is it stretching it too far? Is it remaining true to label and delivering on investors’ expectations, or could it end up surprising investors when the market turns? Does the manager exercise patience and buy/sell discipline, or are they liable to panic? While this is fundamentally a qualitative research exercise, this is one example where quantitative research can play a crucial supporting role. For example, Lonsec considers key valuation metrics, performance across differing market conditions, and output from style research tools using holdings-based style analysis software.

Research process

Once the soundness of the investment philosophy has been established, the next step is to ensure that the fund has a robust process in place to identify securities and incorporate them in their portfolio. This involves everything from the idea generation process to the intellectual property and software used to value assets. If the size of the manager’s investable universe is very large, what process do they have for narrowing down their list of potential opportunities? What attributes are they looking for when searching for the right stocks, bonds or properties?

What macro or market themes are they looking to take advantage of? How do they carry out their fundamental analysis and what valuation methods do they use? Do their people and systems have the appropriate breadth and depth to carry out their research process? Lonsec typically requests that managers explain multiple investment theses as a means of demonstrating the investment process at work and gauging consistency with the fund manager’s stated investment style and objectives.

Partnering with a research house to achieve in-depth qualitative research at scale

Developing an effective qualitative research model requires a lot of work, but the real challenge is in supporting the process with the right people and resources. Most investors don’t have the data or the capabilities to be carrying out in-depth qualitative research at scale, which is why they partner with a research house like Lonsec. For investors committed to generating long-term outperformance, a world class research effort is required to be able to identify and evaluate those managers that can generate consistent outperformance from the thousands of managers out there.

In addition to the SuperRatings honours, Lonsec will also present a number of awards recognising excellence across the broader wealth management industry:

Lonsec Disruptor Award

Drawn from the Lonsec rated universe, products or issuers who have challenged the status quo.

Finalists
Allianz Retire+
VanEck Vectors MSCI International Sustainable Equity ETF
Vanguard

Lonsec Investment Option Award

Drawn from the Lonsec rated superannuation investment options and based on a qualitative assessment of the investment team and portfolio design to meet member needs.

Finalists
AustralianSuper Balanced (MySuper) Investment Option
Cbus Industry Growth
Sunsuper for Life (Balanced Fund)

 

Lonsec Sustainable Investment Award

Seeks to recognise and highlight the work of asset managers and key players incorporating ESG.

Finalists
Alphinity Sustainable Share Fund
Ausbil Active Sustainable Equity Fund
BetaShares Australian Sustainability Leaders ETF

Active management has fallen out of favour among investors, reflecting changing investor preferences and the scars of the Global Financial Crisis, which have led investors to shun stock pickers and more elaborate strategies in favour of lower-cost, vanilla products. Investors today are focused far less on alpha generation, with its goal of outperforming benchmarks, and are now far more content in generating the majority of their returns from index funds or similar passive strategies.

The growth in passive management has been astonishing. In the last five calendar years, investors moved US$1.5 trillion into funds managed by Vanguard, one of the world’s largest managers of passive strategies. Blackrock, the second largest passive manager, took in US$685 billion over the same period. Vanguard now manages close to US$4.0 trillion globally in passive strategies and on average owns around 7% of every listed US company, according to Bloomberg data. As passive managers continue to suck up funds, active managers are struggling to get a positive message through.

Passive managers don’t apply any security selection, meaning the money simply flows into passive or index strategies that replicate benchmarks like the S&P/ASX 300 Index in Australia or the S&P 500 Index in the United States, with Exchange Traded Funds making it easier than ever before for investors to gain relatively cheap passive exposure.

At its core, passive investing is a momentum strategy. It buys more of those stocks that go up in price and sells more of those that fall in price. Passive strategies tend to work best when financial markets experience strong upward moves in share prices. Passive management is used mostly in the portfolio management of equities (Australian, Global and Emerging Markets) and fixed income (Australian and Global) and have given rise to the major ETF providers that currently dominate the market (see chart below).

FUM share of Australia’s major ETF providers (August 2019)

Source: ASX, Lonsec

The beta rally has put active managers in the shade

The post-GFC period has been characterised by strong equity market returns, but given the length of the bull market to date, investors are questioning how long this situation can last.

Given the inevitable cyclicality of financial markets, the one thing that’s certain is that strong markets will not last forever. In a low return environment, market beta may end up providing disappointing returns, making alpha a valuable contributor to portfolios.

The aim of active management is to be an additional incremental return source, above market returns. Alpha doesn’t scale well with beta, meaning it becomes a smaller percentage of returns when beta is very high. This is the environment we find ourselves in, so we would expect beta to do well and for seekers of alpha to struggle. But even taking a broader view, the case for active management does not appear great.

The hard truth is that most active fund managers underperform benchmarks constructed by index committees. One of the world’s most widely used benchmarks for assessing US equity fund performance is the S&P 500 index. The committee looks at only a handful of criteria when looking to add new stocks to the index, including: liquidity, financial viability (four consecutive quarters of positive earnings), market capitalisation (must be greater than US$6.1 billion), and sector representation (the committee tries to keep the weight of each sector in balance with sector weightings of the S&P Total Market Index of eligible companies). Changes to the index are made when needed.

The S&P committee does no macroeconomic forecasting, invests over a long-term horizon with low portfolio turnover, and is unconstrained by sector or industry limitations, position weightings, investment style, or performance pressures. Yet this straightforward strategy has generally outperformed active fund managers.

Some active managers can consistently outperform

If alpha were easy to find, it wouldn’t exist. There are three general sources to generate excess return for investment portfolios: strategic asset allocation, tactical tilts within asset classes (including opportunistic investing), and superior fund manager selection. While opportunistic investments tend to be episodic alpha generators in portfolios, the biggest long-term drivers of alpha are asset allocation and manager selection.

Even as managers have struggled to generate alpha, a significant number of managers are still generating returns in excess of market indices. The key is having the right resources and the right approach to find them. Average active fund managers tend to underperform industry benchmarks, but the best fund managers outperform over longer time frames.

There’s a deep body of research that looks at how investors can gain an edge by identifying active fund managers that are able to tap sustainable sources of alpha. Research indicates that to meaningfully outperform, it is often helpful to find active fund managers with a portfolio that looks significantly different to the benchmark they are attempting to beat (i.e. they have a high degree of ‘activeness’).

In the financial literature, there are numerous studies showing that the average active fund manager underperforms the benchmark index after fees. However, research presented in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management introduced an idea called Active Share. This is a new method of measuring the extent of active management employed by fund managers and is a useful tool for finding those that can consistently outperform. By analysing 2,650 US equity funds from 1980 to 2003, Cremers and Petajisto found that the top-ranking active funds—those with an active share of 80% or higher—beat their benchmark indices by 2.0–2.7% p.a. before fees and by 1.5–1.6% p.a. after fees.

Active share aims to measure the proportion of a manager’s holdings that are different to the benchmark. It is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager’s portfolio versus the weight of each holding in the benchmark index and dividing by two. For a long-only equity fund, the active share is between 0% and 100%. The active share for fully passive strategies that replicate an index is 0%, and more than 90% for strategies that are very different to the benchmark index.

As you might expect, the portfolios of active, high-conviction fund managers will diverge significantly from the benchmark, and will frequently incur volatility relative to benchmark returns. However, this differentiation provides investors with the opportunity to add value over the long term.

What to look for when assessing active managers

Skilled managers with high active share have shown a higher tendency to outperform the market. Investors that tilt towards active managers with high active share have a greater chance of outperforming. They tend to be smaller fund management organizations, often where the founder is an investor first and invests his or her wealth alongside external clients, bringing their investing acumen to a portfolio of funds.

Active managers with high active share tend to maintain this high level consistently over time. This proves useful when conducting analysis to help identify managers that are likely to outperform in the future as well. While some of these managers may not have beaten the index in recent periods, when there are dislocations in markets, these managers will be well positioned to generate long-term returns above the fees they charge.

Active share by itself does not indicate whether a fund will outperform an unmanaged benchmark. There are other important aspects to consider when conducting manager due diligence. Here are a few things you should consider:

  • Find out as much as you can about the fund’s culture and process. Outperformers see investing as a profession and not a business. Examine the fund’s investment philosophy to see if it is consistent and lived out through the fund’s investment decisions. Does the manager exercise patience and discipline?
  • Successful active fund managers have low portfolio turnover with long holding periods of at least four years versus roughly one year for average performing funds. This is a useful metric to look at when assessing a fund’s buy/sell discipline. Another strong indicator is for active managers to add to stock holdings when market pricing improves, rather than giving in to agency behaviour of selling into a falling market.
  • Alpha generators are high conviction stock pickers. This means their portfolios are concentrated in their best ideas, leading to a higher level of ‘activeness’ and differentiation from the benchmark.

While there are active managers that are persistently generating alpha, finding them is not a simple task. For investors that are committed to generating long-term outperformance, it’s critical to have the right resources in place to identify these managers. A world class research effort is required to be able to identify and evaluate those managers that can generate consistent outperformance from the thousands of managers out there.

Historically, high valuations in a range of asset classes including equities, sovereign bonds, credit and unlisted assets mean future beta returns are expected to be lower. This will make it a challenging environment for investors to meet their investment objectives. For those with the knowledge and capacity, finding alpha can help bridge the gap.

When accumulating savings for retirement, the investment objective is clear – to grow and maximise savings. Risk in the accumulation phase is also well-defined and focused on the loss of capital, as measured by the volatility of investment returns or related downside risk measures. Risk tolerance is then typically used to determine appropriate investment profiles, with the aim of achieving greater wealth to fund retirements.

However, the risk-return landscape becomes significantly more complex once retirement comes into the picture. The primary objective in the decumulation phase ceases to be pure growth and more about using accumulated wealth to sustain a target level of income throughout retirement. Therefore, volatility of investment returns is no longer a suitable risk measure as it does not describe the risk of failing to meet this objective.

Retirement income risk measure

Traditional measures of variance (standard deviation) focus on both upside and downside variation. However, behavioural economists commonly point out that individuals are more averse to downside variation than upside variation. A more relevant risk measure in the context of decumulation is the probability of running out of money, or a measure of income variation. This captures important dynamics such as the sequence of returns, which can be particularly damaging in decumulation.

The risk can be depicted as:

 

The importance of risk measurement in retirement products is highlighted in a Treasury consultation paper which proposes a range of standard metrics to help consumers make decisions about the most appropriate retirement income product for their own circumstances.

The discussion paper proposes that a measure of income variation be provided in respect of all retirement income products and this measure is presented on a seven-point scale.

The finance industry uses terms like longevity risk, market risk, sequencing risk and inflation risk, which are all relevant to the outcome experienced by investors in a retirement income product. However, these terms are not well understood by a lay person, so an income variation measure could help fill in some gaps.

Retirement objectives

Lonsec’s Retirement Lifestyle Portfolios are objectives-based portfolios focused on delivering a sustainable level of income in retirement, as well as generating capital growth. Specifically, the portfolios are designed to assist advisers in constructing portfolios to meet retiree essential and discretionary income needs, while generating some capital growth to meet lifestyle goals.

Differences to Lonsec’s core accumulation model portfolios are:

  • Income objective of 4% p.a. for all portfolios
  • Greater bias to AUD denominated assets – historically higher dividends, franking credits
  • Greater focus on absolute rather than relative performance
  • Constructed to manage capital drawdown risk
  • Fixed income allocations have less duration and greater credit exposure
  • Key building blocks are Yield, Capital Growth & Risk Control

In reality, risk in retirement is multi-dimensional. An individual retiree may have multiple goals, such as leaving a bequest, with a different level of importance attached to each. An individual’s risk aversion in retirement will therefore be defined by a holistic view of their retirement goals, and the risks to those goals across all scenarios that could play out during retirement. Typically, more than one risk measure is necessary, with multiple scenarios required to truly appreciate the risks inherent with each solution.

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.