Originally published by Cuffelinks
Large super funds in Australia recently reported their eighth consecutive financial year of positive investment returns, with the median growth option delivering 10.7% over 2016-17 (source: Chant West). All investment options have met their long-term objectives since leaving behind the tough years of the GFC. While this is good news, our new research shows it is for investment success to breed complacency.
Larger funds have a great store of resources and experience, so it seems they are well-placed to search for, test and embed new investment ideas. But the irony is that large funds face innate headwinds in thinking innovatively and may in fact be leaving it to their smaller counterparts to develop the investment ideas of the future.
Status quo traps
These headwinds to investment innovation are identified in our research on ‘status quo thinking traps’. Larger funds have built knowledge and processes around the historical markets for their products. This includes investing a superannuation contribution stream on behalf of disengaged members to generate a lump sum payout to these members once they retire. Larger funds represent hold $1.3 trillion of superannuation capital which is no small investment pool!
So what’s the status quo?
1. Same investment processes
Current investment thinking starts with a strategic asset allocation framework, adds active or passive philosophies across the asset classes and a currency hedging belief, then selects managers across the asset classes to run slices of the investment portfolio, often with the help of an asset consultant. Funds may cite their post-GFC investment success as the reason to continue investing this way. There is an organisational impetus to continue investing this way which can make it difficult to adopt new investment ideas and genuinely innovate.
2. Familiarity of current structures
The larger the fund’s stake in the $1.3 trillion capital pool, the more its resources, processes, organisational structure and cultural values are built up around this existing way of investing. There is familiarity around these investment paradigms and it is easy to make decisions inside the paradigms that maintain the overall structure; for example, moving from active to passive, placing pressure on management fees, changing a manager or adjusting the fund’s currency hedging ratio.
3. Incremental changes only
Changes like these are no doubt valuable and funds think intelligently and then manage their governance processes well to implement these investment changes. But in our experience, what a large fund might call a ‘big’ or ‘innovative’ change is,say, changing the asset allocation, moving from pooled funds to separately managed accounts, or recognising a new asset class like private credit, US municipal bonds or emerging markets small caps. The problem is that these changes are fairly incremental, not really that big or innovative.
If the investable markets or investment problems of the future prove to be different from the past, these funds are only inching forward on the journey from ‘here’ to ‘there’.
Changing investment horizon
Our concern is that the horizon for large fund investing does suggest significant differences from the past, including:
- Expected lower growth and yield in investment markets than historical averages
- Flows to factor-based investing and other ‘smart beta’ trends
- Ongoing nervousness about volatility, country shocks from political risk, climate change
- Investment objectives focused on yield (not growth or total return)
- Shift from mass accumulation to mass decumulation
- Fragmenting investment risk appetite and, indeed, definitions of risk
- New investment fees and costs transparency and accountability (RG 97)
- The rise of Responsible Investing (ESG, values-based) approaches
- The ageing population and governmental pressure to address longevity risk
- Capital flows generated by ‘robo-advice’ and DIY investors
- Insourcing of some investment management by funds
- Capacity constraints due to the amount of capital in Australia’s superannuation system.
Investment innovation is needed to face these challenges
Meeting these (and other) investment challenges requires thinking not just within the existing paradigms, but beyond the paradigms themselves. Genuine innovation in investing could look at matters like:
- Instead of an optimal investment risk/return blend, introduce investment efficiency and portfolio transparency as third and fourth dimensions.
. - Instead of dividing managers into active or passive, create a spectrum of manager strategies that span the continuum of possibilities between pure market-cap passive, enhanced passive, smart beta and ‘systematic alpha’ approaches, right through to active managers targeting pure ‘idiosyncratic risk’ from stock insights. There are additional levers to pull around active tax management (or not) within these possibilities.
. - Instead of choosing between investment outsourcing and insourcing, break up and re-optimise all sourcing arrangements based on their components. This includes thinking about re-positioning a fund as the ‘investment ideas generator’ and working with a specialist implementation partner.
. - Instead of slotting investment opportunities into asset class buckets, target common underlying risks or themes (for example, interest rates) that transcend asset classes.
. - Instead of investment trading done independently by each of the fund’s managers (sometimes in opposition to each other), centralise trading to eliminate redundant trading and create a whole-of-portfolio view for the fund rather than a collection of manager slices.
. - Instead of starting with a market-cap portfolio and introducing ‘tracking error risk’, start with a reference portfolio that reflects the real, asymmetric risk preferences of superannuation members (limited volatility and downside risk, full upside risk).
The potential payoffs from genuinely innovative ideas are lucrative because they will deliver over and over again. The long-term investment horizon of super funds and many other investors would powerfully leverage the value of any such rewards. The investment success of large super funds to date could help them think boldly and confidently about what is needed for the future … or it could trap them in the investment paradigms of the status quo.
Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment advisor.