Super's asset shock
Given the 47 per cent loss recorded by the ASX All Ordinaries Index between October 2007 and January 2009, and the implosion in global equities more generally, it is timely to consider how our $1.15 trillion worth of superannuation savings are actually being invested. In particular, how do Australian super funds and their asset-consultant advisors justify a 50 per cent portfolio weight to global equities in view of what we now know about the extreme risks that seem to be characteristics of the asset class? This question is especially germane in light of the looming recession and the Australian equities market’s exceedingly poor performance during the last severe downturn in 1990/91. For the avoidance of doubt, the objective of this analysis is not to address 'tactical' asset-allocation issues from one investment class, say, equities to another, such as property. My chief motivation is to examine the much more fundamental question of the long-term 'strategic' asset-allocations made by Australian super funds and whether there is a case for these to be revisited.
I experienced a rather unforgettable shock – literally and figuratively – when I was just five years old. Prior to that time I had always made what I thought was a reasonable assumption: a fence is a fence.
But on a traumatic day in the 1970s I discovered three things: first, and perhaps most importantly, don’t make suppositions about the behaviour of things based on (limited) empirical observation; second, all fences are not run-of-the-mill fences – in particular, some fences are electrified; and third, electricity is transmitted through fluids. Suffice it to say that I would not voluntarily relieve myself on an electric fence any time thereafter.
Australia’s $1.15 (was $1.3) trillion superannuation fund industry is experiencing a similarly painful shock, albeit one thankfully unaccompanied by the inconveniences I endured back in the 1970s.
According to the leading industry researcher, Rainmaker Group, Australian super funds – which have had every opportunity to diversify their investments across a multiplicity of possible asset-classes – have delivered their members strikingly poor performance over the last one, two and three years.
Yet the 40 per cent plus losses registered by the median super fund’s most important investment holding over the last year or so – listed equities (which consumes about 50 per cent of all super fund capital) – would have been inconceivable in the minds of most pundits prior to the advent of the global financial crisis.
What is even more surprising is how much equities market risk Australian super funds assume. And this exposure is greater than you may think since many so-called 'alternative' asset-classes, such as hedge funds and private equity, are – contrary to their purportedly 'uncorrelated' labels – highly correlated with equity returns. Indeed, it is hard to understand how private equity and many (predominantly long) hedge fund strategies are categorised as distinct investment classes given that the assets that underlie them are largely the same.
The table below depicts the median Australian super fund’s performance over the last three years. In nominal terms, the 'default' industry, corporate, or government super fund produced a negative return of 0.1 per cent over this period. In inflation-adjusted terms, members that selected the default option have worn a circa 12 per cent loss since late 2005. By way of contrast, a 'naïve' strategy of simply putting your money in an online savings account during the last three years would have yielded a 20 per cent total pre-tax return.
The news is worse for those who opted for the 'growth' or 'balanced' alternatives, which have recorded total negative nominal returns of 2.4 per cent and 1.2 per cent, respectively, over the three years to November 2008.
Finally, it is instructive to note that the performance of Australian super funds’ 'property' investments – which are usually limited to the commercial, industrial, retail and 'opportunistic' sub-sectors – have been particularly questionable. In the year to November 2008 the median super fund’s real estate investments experienced a 30.5 per cent nominal loss while over the three years to November they had fallen in value by 4.6 per cent. And this came with volatility of up to 30 per cent per annum in the Listed Property Trust sector (since unlisted property index returns are largely based on 'appraisals' it is nigh on impossible to accurately measure their risk).
These results beg the question as to how super funds are strategically (nb: not tactically) allocating their capital. This is a profoundly important issue for most Australian employees since their financial welfare hinges crucially on the efficacy of such decisions.
To help address this question, the second table below depicts the median Australian super fund’s portfolio weightings as at September 2008 (again using Rainmaker data).
The first thing that jumps out is that the typical Australian super fund has tremendous exposures to Australian and international equities with around half (yes 50 per cent) of all their money invested in these two (correlated) sectors. In comparison, much less risky fixed income and cash investments account for only 23 per cent of super fund capital.
When most lay folks think of 'property' they normally mean residential real estate combined with a bit of commercial, industrial and retail. In valuation terms this makes sense: the $3.3 trillion residential property asset-class dwarfs the $252 billion of commercial, industrial and retail (CIR) property that is available to super funds in the listed and unlisted markets (according to UBS). A nationally diversified portfolio of residential real estate also has dramatically lower volatility – of less than 5 per cent per annum – than its CIR counterparts based on publicly available house price indices that utilise around 30,000 residential sales per month. Yet despite the fact that 30-50 per cent of all super fund members do not own a home, most Australian super funds have no exposures whatsoever to what is in fact the largest investible asset-class (see the chart below).
The final 15 per cent of all our super fund money is committed to so-called 'alternative assets'. This bucket normally comprises private equity, hedge funds, and infrastructure. The idea is that these asset-classes are 'uncorrelated' with the other major investment categories (and the super funds’ 50 per cent equities allocations in particular). However, the global credit crisis has proven this not to be wholly the case.
During the 2008 calendar year the RBC Hedge 250 Index realised a net negative return of 21.01 per cent. Another widely-quoted hedge fund benchmark, the Hedge Fund Research Global Hedge Fund Index, fell by 23.25 per cent. Amazingly, Hedge Fund Research’s global “Absolute Return” Index also fell by 13.09 per cent in 2008 notwithstanding that the hedge funds included in this benchmark are meant "to provide stable performance regardless of market conditions, [and] which are characteristically less volatile and less correlated to market benchmarks.” Along similar lines, Hedge Fund Research’s 'long-short' Equity Hedge Index was off by 25.45 per cent. (I guess they had more longs than shorts!) Even the explicitly "Market Neutral" Index, which covers funds that are meant to "generate consistent returns in both up and down markets by selecting positions with a total net exposure of zero”, evidently carried some directional market risk and was down by 1.16 per cent in 2008.
The bottom line is that the global hedge fund universe does not appear to offer Australian super funds genuinely uncorrelated returns. Indeed, they appear to be strongly correlated with movements in major equity market indices. And this is to say nothing of the heinously expensive fees charged by these managers. In fact, all hedge fund investments appear to have achieved is to 'parlay-up' Australian super funds’ already high 50 per cent exposures to global equities. Arguably the greatest myth propagated by the hedge fund industry is that they are a 'separate asset-class' when in fact all the typical hedge fund is doing is investing in listed equities (and sometimes hybrid debt markets).
Unfortunately, many of the same points can be applied to private equity, which Australian super funds have piled into over the last 10 years. Not only are private equity returns (to the extent you can actually measure them) correlated with equities markets insofar as their main exit mechanism is via listings of their portfolio companies on the share market, or through trade-sales to listed companies who are funding these acquisitions by issuing equity, but, just like their hedge fund peers, most private equity funds are also heavily leveraged and therefore reliant on credit markets.
To cast this point into sharp relief, a recent study by Ernst & Young in Britain found that around half of all of the excess returns generated by private equity managers can be attributed to the use of leverage. Another one-third of their excess returns originated from a "rising stock market.” Less than 20 per cent of the private equity funds’ outperformance came about because of “strategic and operational improvements”, which is supposed to be how they add-value.
So just how much risk is the $575 billion worth of super fund money that is invested in the Australian and global equities markets wearing? A lot more than we once thought (continued tomorrow).
Christopher Joye writes Business Spectator's property blog and is managing director of research group Rismark International which produces the RP Data-Rismark Hedonic House Price Indices in conjunction with Australia’s largest property information company, RP Data.