Funds disappointed with ‘defensive’ alternative assets
Fees a major issue for private equity managers
By James Dunn
Australian superannuation funds’ move into alternative assets may have hit a speed-bump, with allocations falling in 2010 for the first year in eight, but the imperative that drives the move - the desire for returns uncorrelated to those of the major asset classes - remains strong.
According to Alex Dunnin, head of research at Rainmaker Information, at June 30, 2010, Australian super funds had 15.7% of the superannuation pool invested in alternatives, down from 16.4% in 2009 (see chart.) Of that A$193 billion (US$194 billion) invested, 53% was invested in infrastructure, 23% in hedge funds, and 12% each in private equity and ‘other’ categories.
The Australian government’s sovereign wealth fund, the Future Fund, is the biggest local investor in the alternative space, with $11.4 billion invested, being 12% of all the money run by the Future Fund Management Agency (FFMA), or 17% of the Future Fund itself. The Future Fund was set up to meet Australia’s unfunded public-sector superannuation liabilities, and began its investment program on July 1, 2007. Mr. Dunnin says the Future Fund’s alternatives portfolio comprises $8 billion in hedge funds, $2 billion in infrastructure and $1.4 billion in private equity.
By the time it is fully invested, the Future Fund’s statement of investment policies envisions 30% of its holdings in tangible assets - defined as property, infrastructure and utilities, in listed or unlisted form - and 20% in alternative assets, which the fund considers to include to a range of risk premiums (for example, commodities and futures and insurance-based strategies) and skill-based absolute-return investments.
"The really interesting thing about the Future Fund and alternatives is that it is the number one Australian investor into the sector, plus they’ve said they want even more," says Mr. Dunnin.
The move into alternative asset classes was pioneered in Australia by the not-for-profit sector, the industry super funds, which began to invest in the alternative investment space in the late 1990s, looking for portfolio diversification and non-correlated returns, inspired by example such as the US university endowment funds.
"The industry funds certainly went harder at alternatives earlier," says Jeff Bresnahan, managing director of superannuation research firm SuperRatings. "Certainly over the last decade they’ve been on a progressive entry into alternatives. Pre-GFC, the industry funds’ average allocation got close to 20%, and they’re still sitting on average at between 15-20% in alternatives.
"Of course, there are huge variances in that strategy: there were three or four industry funds that got up to 40-45% in alternatives - the likes of MTAA Super, Westscheme, Statewide and Prime Super - but there were others that were nowhere near as keen. You’ll find some not-for-profit funds that have less than 5%, or none at all, while others are still overweight."
In contrast, retail super funds, where they went into alternatives at all, stayed at allocations of 5% at most. Mr. Bresnahan says the greater weighting to alternative assets - in addition to lower fees - is the main reason why the industry funds have outperformed their retail counterparts. SuperRatings data shows the median balanced investment option (the category in which more than 80% of Australians hold their super) in the industry fund universe returned 5.25% a year in the ten years to August 31, 2010, compared to 3.18% a year in the retail master trust category. In contrast, the median fund returned 4.62% a year (reflecting the impact of the GFC: pre-crisis, the September 2007 figure was running at 12.84% a year.)
Mr. Bresnahan says the industry funds’ greater allocation to alternatives helped them initially in the GFC market slump, but this turned into a millstone in 2009. "Early in the GFC, the retail funds got absolutely hammered; they were much harder hit than the industry funds. The main reason for this was that the great majority of their assets were in listed markets: not just equities, the retail funds favoured listed property trusts (A-REITs), while the not-for-profits preferred direct property. So the retail funds got smashed in 2008 because they were almost wholly in listed markets, and endured 50% plus falls.
"The industry funds didn’t suffer this immediate pain: they didn’t start to struggle until 2009, when their unlisted assets began to be revalued downward. At the same time the retail funds rebounded earlier - and quicker - because of the listed nature of their assets. It’s only now, when we’ve had some sort of sustained floor put under the rebound, that the not-for-profits funds have probably got back into a position outperform over the coming 12 months, if markets continue to crawl sideways."
Alexander Austin, chief executive officer at specialist alternatives asset consultant Access Capital Advisers, says there has been "quite a bit of disappointment" among super funds in their alternative investments. "I think we’ve all learnt some lessons from the GFC, prime among them being one, when sentiment is bad enough, everything correlates to one; two, when that happens, liquidity is not assured; and three, what is the real effect of leverage: we know now that leverage can drastically change an asset, and turn a safe cashflow into a dangerous investment."
All of those things are now being re-assessed by investors, he says. "For example, a lot of hedge funds promised to be uncorrelated and proved to be very correlated. I think funds have actually been more disappointed with their ‘defensive’ alternative assets - with hedge funds the standout - and on average probably been happier with their ‘growth-focused’ alternative assets, for example infrastructure.
"While infrastructure assets have fallen in value and had negative returns when you look at peak values in 2007 compared to today, but most of those ‘core’ infrastructure assets have probably fallen by around half what equities have fallen by over the same period. I don’t think that’s a bad result."
Mr. Austin says his firm advises across about $6 billion of alternative investments, of which about $3 billion is direct infrastructure investments. "Across that portfolio, the operating earnings (EBITDA) line over the GFC has been incredibly strong. The defensive qualities of infrastructure - its earnings don’t fall when we have a recession - I think have been absolutely delivered on. But where the bad investment performance outcomes have come have been on assets that have been over-levered, they had too much debt and then not being able to refinance that debt at acceptable terms: that’s where the particularly poor investment outcomes have come. The funds aren’t questioning the merits of investing in infrastructure, but they’re certainly questioning how that is best achieved," says Mr. Austin.
It is a similar story in the absolute-return space, says Simon Ibbetson, managing director of asset consultant CPG Research & Advisory. "I think a lot of the smaller funds used funds-of-hedge-funds as their source of uncorrelated returns, and were not very happy to find out that those funds had significant beta in them, and they rode the market down. I don’t think that’s quite fair, because those allocations probably came from their equity allocations - which would have been hit a lot harder - but the end result is that super funds don’t want to be paying fund-of-funds a 2-plus-20 fee structure if they’re only getting beta.
"The other part of the story is that at the big end of the market - the Future Fund and the very big funds - while they’re clearly disappointed with their returns in 2008, they haven’t really given up the belief that hedge funds can add alpha in an uncorrelated way. So they’ve been allocating more, in fact, but they’ve rotated out of the fund-of-funds and gone into a range of single-strategy funds, and that clearly is a trend at that level," says Mr. Ibbetson.
Mr. Austin says the fee issue is also a major one for private equity managers. "Private equity is a perfectly valid alternative investment, but the real challenge for private equity is that it is very expensive in terms of the fee structure, and you need to be a very good manager and be able to prove that you’ll be a good manager to justify those fees. We’ve definitely got in Australia - and I think globally - too many managers, many of which aren’t good enough at what they do to justify the fees they charge. That’s the real pressure on private equity: at a 2-and-20 fee structure, you can’t afford to be average," he says.
Mr. Bresnahan expects allocations to alternative investments by super funds to increase over time, but says the retail side of the industry is "not as convinced" as the not-for-profit sector. "The retail funds are probably up to about 7-8% exposure on average, but I don’t think they’re going to get up to the industry-fund-style 15-20% allocation anytime soon. I think they like the attraction of uncorrelated returns, but that’s offset in their minds by the potential liquidity risk, because you’ve got APRA (Australian Prudential Regulation Authority) putting new liquidity filters on them: they have to have the liquidity to meet member switching requests. So funds will have to be much more aware of their liquidity positions: each fund will have to find an equilibrium between liquidity needs and the attractions of uncorrelated returns."
Mr. Ibbetson is worried that APRA’s insistence on high liquidity levels is a "classic unintended consequence" that potentially will make funds not act in the way they should. "The problem we have at the moment is that APRA is imposing this liquidity filter on everything: it is getting very difficult about long-duration assets that don’t have a readily available mark-to-market price. It wants to get more liquidity into portfolios, which is discouraging some of the smaller super funds from investing in infrastructure and direct property and private equity.
"That’s all well and good, but super funds also need long-term liability matching cashflows, which something like direct infrastructure provides. It’s actually a natural fit for a super fund, but APRA now wants funds to have regular independent revaluations of unlisted assets, which starts to get expensive.
"If you’re a large super fund with $500 million of positive contributions coming in every year, the liquidity risk is minimal, but if you’re a smaller super fund, I’m not sure you should be discouraged from investing in infrastructure and property and private equity, when they can play an important role as a source of uncorrelated returns. I don’t understand why this liquidity filter is becoming so onerous," says Mr. Ibbetson.
The pressure on costs in the super industry is generally working against alternative assets, says Brett Elvish, founder and director of specialist multi-manager asset consultant Financial Viewpoint. "Whether My Super (the low-cost, no-frills default super account option proposed by the 2010 Cooper Review into the Australian superannuation system) comes about or not, the Cooper Review was emphatic about the need to lower the costs of super investment.
"The true costs of alternatives is much higher than the traditional listed asset space, so whether that puts some sort of lid on demand in the alternatives area is bit of a question mark - as well as broader constraints around liquidity," says Mr. Elvish.
Mr. Austin believes alternatives can play a role in simpler super products. "You’ve had industry funds running relatively simple menus of investment choices, with relatively vanilla marketing and distribution efforts, and being particularly focused on delivering good investment performance - and part of that has been significant allocations to alternatives.
"The retail funds, of course, have tended to offer 150 investment choices. If Cooper is going to force those retail funds to be offering far simpler products, over time the investment performance of those products is really going to matter, and that’s where alternatives are really going to play a big part. If we were to look at two or three years of choppy equities returns from here, you’ll need to have something other than listed equities in your portfolio to provide a better risk-return," he says.