Super funds are on track to finish 2019 with the strongest returns in years, defying fears of a market fade in the final quarter. While market conditions have been challenging, investors have not yet succumbed to the negative economic headlines, which has been good news for super funds.

If momentum holds up through the rest of the year, members in the median balanced option will be looking at an annual return of around 15.0% for 2019 – a result not seen since 2013.

According to leading research house SuperRatings, funds have done a good job of managing uncertainty, which has only been exacerbated by global risks and challenging economic conditions at home. But while consumers are feeling the pinch, their super is holding up well.

A rebounding share market saw the ASX 200 Index return 3.3% in November, putting Australian shares on track to deliver a return of around 26.0% for 2019, which would be the highest investors have seen since 2009. This is despite weakness from the major Financials sector, which slipped 2.0% over the month as the major banks were marked down due to the lower interest rate outlook, while Westpac (-13.1%) was the latest to be hit with negative headlines.

Looking at November’s results, the median balanced option returned an estimated 2.0% over the month, with Australian shares contributing 0.6% and international shares 1.0%, bringing the year-to-date return to 14.8%. The median growth option delivered an estimated 2.3% over the month, bringing the year-to-date return to 17.2%.

Over the past five years, the median balanced option has returned an estimated 7.9% p.a., compared to 8.7% p.a. for growth and 4.9% p.a. for capital stable (see table below).

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

YTD 1 yr 3 yrs 5 yrs 7 yrs 10 yrs
SR50 Growth (77-90) Index 17.2% 15.2% 10.5% 8.7% 10.4% 8.6%
SR50 Balanced (60-76) Index 14.8% 13.4% 9.3% 7.9% 9.3% 8.0%
SR50 Capital Stable (20-40) Index 8.3% 8.5% 5.5% 4.9% 5.4% 5.6%

Source: SuperRatings

Pensions products have similarly performed well over the course of 2019, with the median balanced pension option returning an estimated 16.3% year-to-date to the end of November, compared to 19.6% for growth and 9.6% for capital stable.

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

YTD 1 yr 3 yrs 5 yrs 7 yrs 10 yrs
SRP50 Growth (77-90) Index 19.6% 17.1% 11.5% 9.9% 11.7% 9.6%
SRP50 Balanced (60-76) Index 16.3% 14.9% 10.0% 8.5% 10.2% 8.8%
SRP50 Capital Stable (20-40) Index 9.6% 9.4% 6.3% 5.7% 6.2% 6.4%

Source: SuperRatings

“We may not have seen the ramp up in shares before Christmas that some were hoping for, but it’s still safe to say that 2019 has been a highly successful year for super funds and their members,” said SuperRatings Executive Director Kirby Rappell.

“It’s been a nervous year for investors, so it’s great to see that super can deliver some much-needed stability and solid returns during this period. There might not be a lot of positive economic news at the moment, but at least super is one story we can all draw some hope from.”

“Since the Royal Commission’s final report at the start of the year, super funds have fought hard to restore members’ trust in the system. We’ve seen good funds responding proactively to the changing regulatory landscape, which has been pleasing. We expect to see an increase in fund mergers in 2020, but it’s important that regulatory responses don’t move us towards a one-size-fits-all approach, which could be detrimental to member outcomes.”

Members must look beyond raw returns

Everyone agrees that funds that aren’t delivering for members have no place in the super system. However, focusing purely on returns as a measure of a fund’s success ignores a range of factors, not least of which is the level of risk involved in generating that return.

As the chart below shows, there is a significant dispersion of risk and return outcomes among different funds. Looking at how balanced options compare over the past five years, there are some producing higher returns than the median option, but many are producing these higher returns by taking on a higher level of risk (measured as the standard deviation of returns).

Risk and return comparison – Balanced (5 years to 30 November 2019)

Risk and return quadrant - Balanced

Source: SuperRatings

When assessing investment performance over time, the top-left quadrant (higher return for lower risk) is what members should generally aim for. Similarly, the bottom-right quadrant (lower return for higher risk) represents the laggard funds. Over any given time period, there will always be funds that outperform and those that underperform.

Looking at past performance can be useful when picking the right fund, but it shouldn’t be the sole criteria. For one thing, past performance is no guarantee of future performance, but there are many factors members should take into account when assessing a super fund, including insurance, governance, member services, and of course fees.

Markets continued their upward trajectory in November. When you look at the returns across key asset classes over the last 12 months most asset classes have generated double digit returns. Growth assets such as equities and listed real assets generated over 20% for the year ending 30 November, while bonds generated high single digit to double digit returns. This has been a great outcome for investors and certainly well above Lonsec’s long-term expected returns for asset classes.

Part of what has fuelled these high returns, post markets getting the wobbles after the US yield curve inverted in August, can be attributed to markets pricing in the avoidance of a recession and the expectations of a potential recovery in growth. We have witnessed such ‘mini-cycles’ in the past, in 2013 and 2016, however what is different this time is that EPS growth is more muted and other factors which contributed to previous mini-cycles, such as the US or Chinese fiscal stimulus, are less likely to have an impact.

So what does this mean for markets? We think markets may experience a short-term upswing as the ‘mini-cycle’ plays out. We have therefore slightly adjusted our dynamic asset allocation tilts deploying some of the excess cash in our portfolios towards Australian equities. Our overall asset allocation continues to have a defensive skew with the objective of diversifying the portfolios by asset type and investment strategy. This positioning reflects our broader view that asset prices are stretched and that while some economic indicators have stabilised, we believe we are closer to the end of the cycle.

Earlier this month, at his first public speech for 2019, RBA Governor Phil Lowe conceded the rate outlook is now “evenly balanced”, dropping the rate tightening bias present in RBA communications throughout 2018. In its latest forecasts contained in the Statement of Monetary Policy, the RBA has also revised lower its GDP and inflation forecasts.

So what has caused this change in outlook?

Weaker global outlook
Overall, global growth was strong in 2018 with falling unemployment and above-trend economic growth in the advanced economies. In Q4 2018, a few factors weighed on the growth outlook and the financial markets, including trade tensions between the US and its trading partners, slower growth in Europe and Asia, and political risks including Brexit and rising global populism. A greater-than-expected slowdown in China especially weighs on the outlook for Australia.

Stubbornly low inflation
With an improving domestic economy and tightening labour market, the RBA had been expecting inflation to move higher to its target band of 2–3%. That has not eventuated, and underlying inflation has been around 1.75% for some time. While there has been some pickup in wages growth, it remains subdued. In addition, rent inflation and the cost of new dwelling construction have remained soft given a weaker housing market.

Falling dwelling prices and a constrained household sector
Despite an improving labour market and falling unemployment rate, Australian households remain under considerable pressure, and household consumption growth has been weaker than expected. Factors weighing on household spending include subdued wages growth, rising cost of living (utility prices and mortgage interest rates), the high rate of part-time employment and underemployment, high household indebtedness, falling consumer sentiment in recent months, and also the declining wealth effects from falling house prices and weaker equities markets.

Tighter credit conditions
While domestic financial conditions remain accommodative overall, credit conditions for housing and small business have been tighter. Banks are facing higher funding costs as well as tightening lending standards as a result of the Royal Commission.

What’s ahead?

This change in rhetoric has seen financial markets pricing in a 60% chance of a rate cut by 2019, but in our opinion the RBA is likely to remain in wait-and-see mode. While it was forced to revise down its growth forecast, GDP is still expected to grow by 2.5% in 2018-19 and 2.75% in 2019-20, which is around the long-term trend level, while the unemployment rate is expected to stabilise around 5.0%. In addition to inflation, the RBA is likely to watch:

The business sector
As mining investment and exports return to more normal levels, non-mining business sector is expected to drive growth forward. However, business conditions and confidence have been trending lower, as measured in the NAB Business Survey. There are a few headwinds facing Australian businesses, including policy uncertainties associated with the federal election, slowing growth in China, tighter lending standards, falling building approvals and peaking mining exports. Retail conditions especially have been weak for quite some time—another reflection of a constrained household sector. The upcoming federal election is likely to contain business friendly policies to stimulate the economy and investment, while large infrastructure spending is also expected to drive investment growth in the medium term.

Household sector
The household sector remains constrained. As income growth has been weak, households have been saving less of their income to maintain consumption. Wages growth is therefore needed to maintain sustained consumption growth. The RBA will watch developments in the labour market closely. Leading indicators including the NAB survey employment index and SEEK job ads have pointed to a peak in employment growth. A marked slowdown in the labour market could see the RBA start cutting rates.

Dwelling investment
As the apartment building boom passes its peak, the fall in dwelling investment will be a drag on the economy and will likely see job losses in the construction sector and related industries. The RBA forecasts dwelling construction to decline by a cumulative 10% over the next two years. Given falling house prices, new approvals for houses and units are likely to be slow to come online. While infrastructure projects can absorb some construction employment, the overall drag on the economy would be significant over the near term.

Exports
The lower AUD will likely support export growth. While 2019 export growth will be driven by the completion of several large-scale LNG projects, once they reach full capacity their contribution to overall economic growth will be reduced. Rural exports this year are also expected to be lower due in large part to the severe drought.

The financial services industry was collectively holding its breath on Monday as Commissioner Hayne delivered the final report into misconduct and the 76 recommendations for how the system can be redeemed. Already chastened by the interim report, and already responding to the increased public awareness, there was a palpable sense of standing outside the headmaster’s office waiting for the punishment to be meted out.

But it was a case of ‘sell the rumour, buy the fact’ as the market had clearly factored in more severe measures, particularly with respect to the vertical integration model. The share prices of the major banks and financial services institutions rose in the wake of the report’s release, but the sector as a whole took a beating through 2018, weighing down the index and contributing in part to the relative underperformance of Australian equities. Investors were reminded of the importance of a sustainable financial services industry given its predominant weighting in the ASX.

ASX index performance versus financials


Source: FE

While the Royal Commission has played an important role in highlighting specific instances of gross misconduct and brought to the public’s attention some of the key regulatory challenges facing the industry, the seeds of change had been laid much earlier. The shift in behaviour and the heightened focus on risk and the management of conflicts has already resulted in three of the major banks largely exiting the funds management business, which has kept the research team, and the fund managers we interact with, busy for almost two years. The Royal Commission may act as an important catalyst for further cultural change, but already self-interest and common sense have prevailed in setting the major institutions on the right course.

On a sector specific basis, Lonsec will be having further discussions in its upcoming income sector reviews with funds impacted – directly or indirectly – by the ban on trailing commissions and the heightened focus on responsible lending.

 

Australia’s small cap shares have rarely failed to capture investors’ imaginations, not least for their ability to generate eye-watering returns when company narratives become reality. Since the start of 2016, sustained growth from small industrials combined with a rallying mining sector have produced remarkable performance for investors willing to move outside Australia’s biggest names.

Now, confronted with a rolling bear market, small cap managers are experiencing a period of pain and possibly some introspection. The past three years have taught us that dreams can be kept alive, even if they don’t always come true. Looking back, it’s fair to say that small cap outperformance was not a broad-based phenomenon. But even in an environment of elevated volatility and with market risks tilted to the downside, this does not necessarily mean that opportunities have dried up.

Taking a look at Lonsec’s peer group of small cap managers, past returns have shown significant dispersion due to a range of different sector and stock exposures. As we now know, the small cap rally was led by a narrow group of shares over the preceding six months to January 2018, and this trend continued through the second half of 2018, albeit with increased volatility.

The range of small cap fund manager returns has been wide
(returns to October 2018)

Returns based on Lonsec’s small cap fund manager peer group

Source: Lonsec

For the 2018 financial year the Small Ordinaries Index returned +24% (wouldn’t that be nice!) but this is not representative of the performance of the broad range of small cap stocks. Closer analysis reveals that 20 stocks delivered 60% of these gains, while the median stock in the index returned a more down-to-earth +9% for the year.

These top 20 hot stocks that drove the small cap index over the last 12 months are essentially companies with exposure to three themes which have dominated small cap strategies. That is, stocks exposed to the Chinese ‘Daigou’ distribution channel, resource stocks exposed to the emerging battery technology theme, and emerging technology companies.

Small cap darlings have been driving performance (FY19 P/E ratio)

Source: Lonsec, Bloomberg

Looking at the largest 20 shares in the small cap index, eleven had a P/E ratio of over 20x and the average P/E of this group was 30x. Among these were a number of market darlings which have delivered strong returns for investors but due to their popularity saw their valuations pushed ever higher. Prior to the start of Lonsec’s annual review of small cap managers, the FY19 P/E ratio of the ASX Small Ordinaries Index was in excess of 19x versus the historical average of around 13x, indicating a large part of the index gains have come from multiple expansion more so than earnings growth.

Small cap sectors have seen significant divergence
(period returns to end November 2018)

Source: Lonsec, FE

Most recently, those fund managers that have held up better than the peer group average (in the face of significant declines in share markets) have done so due to a significantly higher cash weighting in their portfolios. Managers generally anticipate volatility in equity markets will remain elevated in the medium term. As the price of risk is reassessed, valuations remain lofty and earnings growth remains elusive.

But all is not lost. Managers continue to see a broad range of attractive investments across the smaller company sector, with funds able to provide exposure to a number of niche opportunities and fast growing emerging trends, including the impact of growth in IT spending and the transition to cloud based computing, as well as quality domestic franchises expanding into larger global markets.

Add to this the disruption we have seen in financials as new business models compete with established players, along with the recovery in certain commodity markets from cyclically depressed levels, and there still plenty of themes to capture investors’ attention. The rally in small caps may be over for now, but opportunities remain for those managers who can identify the emerging trends.

To find out more about Lonsec’s Australian equities research, sign up for a free research trial or get in touch with our client services team.

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.

Warnings: Lonsec reserves the right to withdraw this document at any time and assumes no obligation to update this document after the date of publication. Past performance is not a reliable indicator of future performance. Any express or implied recommendation, rating, or advice presented in this document is a “class service” (as defined in the Financial Advisers Act 2008 (NZ)) or limited to “general advice” (as defined in the Corporations Act (C’th)) and based solely on consideration of data or the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person.

Warnings and Disclosure in relation to particular products: If our general advice relates to the acquisition or possible acquisition or disposal or possible disposal of particular classes of assets or financial product(s), before making any decision the reader should obtain and consider more information, including the Investment Statement or Product Disclosure Statement and, where relevant, refer to Lonsec’s full research report for each financial product, including the disclosure notice. The reader must also consider whether it is personally appropriate in light of his or her financial circumstances or should seek further advice on its appropriateness. It is not a “personalised service” (as defined in the Financial Advisers Act 2008 (NZ)) and does not constitute a recommendation to purchase, hold, redeem or sell any financial product(s), and the reader should seek independent financial advice before investing in any financial product. Lonsec may receive a fee from Fund Manager or Product Issuer (s) for reviewing and rating individual financial product(s), using comprehensive and objective criteria. Lonsec may also receive fees from the Fund Manager or Financial Product Issuer (s) for subscribing to investment research content and services provided by Lonsec.

Disclaimer: This document is for the exclusive use of the person to whom it is provided by Lonsec and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by Lonsec. Conclusions, ratings and advice are reasonably held at the time of completion but subject to change without notice. Lonsec assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the information.

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The SuperRatings and Lonsec Day of Confrontation 2018 may be over, but the conversation hasn’t finished. Once again, the event has sparked discussion on a range of critical issues, from the government’s view on the ‘Best in Show’ proposal to the future of financial advice and the vexed issue of licensing. Below is a selection of articles flowing from the day’s event as well as the 16th Fund of the Year Awards dinner.

Market turmoil could force super mergers

Australian Financial Review
A detailed review and survey prepared for the event by SuperRatings executive director, Kirby Rappell, suggest operating expenses for an average super fund are rising by around 5 per cent a year. Read

Top super funds announced by SuperRatings

Sydney Morning Herald
The $70 billion fund for those working in the higher education and research sector, UniSuper, was named fund of the year by researcher SuperRatings at a dinner at Melbourne’s Grant Hyatt on Tuesday night. Read.

Robert wants ‘mutt’ funds closed

The Australian
In remarks at the annual “Day of Confrontation” conference organised by research company SuperRatings, Mr Robert said there were 220 funds in existence — which “would seem to be very, very excessive especially when a whole heap aren’t working.” Read

Super sector faces rising costs as funds fight for active members

Adviser Voice
Super funds are battling to improve active member ratios while operating costs per member are rising across the sector, with long-term implications for the sustainability of smaller funds. Read

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.