Written by Partner Geoff Sanders
The Productivity Commission Draft Report into the Efficiency and Competitiveness of Australia's superannuation system, weighing in at a substantial 549 pages, contains a treasure trove of information on, and analysis of, a wide range of aspects of the industry.
Quite rightly, given its fundamental importance in the ultimate success of superannuation for individual members, the investment activities of funds are one aspect of the industry that gets its fair share of real estate in the Draft Report. That analysis got us to thinking about the impact that the Draft Report's recommendations might have on what the investments of the (potentially far more concentrated) super funds of, say, 2028 might look like.
While the differences in investment outcomes across different segments of the industry grabbed many of the headlines, also of interest to us was some of the deeper analysis the Commission has done around the drivers behind good (and poor) investment outcomes.
Some of the key observations in the Report (although, in the interests of full disclosure, some of these are, strictly speaking, our interpretation of the data contained in it) included the following:
- Funds generally outperform benchmarks: On a relatively cheery note, the Report noted that about two thirds of member accounts in APRA-regulated funds are in funds that have outperformed their expected benchmark (which was adjusted for an assumed level of taxes, fees and costs), suggesting that funds, on the whole, are adding value for their members over and above what a purely passive investment strategy would add (with, interestingly, high-growth options performing better against benchmarks than conservative options). Of those, as has been widely reported in the media, not-for-profit funds were found to have outperformed their retail fund counterparts, with retail funds being singled out as the bulk of the so-called 'tail' of underperforming funds.
- Larger funds tend to perform better: While not always the case, the evidence suggests that larger funds have generally outperformed smaller ones and that (perhaps not coincidentally) default products have generally outperformed choice products. The Report doesn't draw any firm conclusions as to why this is the case (leaving aside the obvious one of the general purchasing power that larger pools of assets bring) but we suggest one possibility is that larger funds have tended to insource more investment management functions in recent years, and also have the capacity to invest more into private market assets (although the Report does note there is 'no clear relationship in the APRA data between fund size and the share of unlisted assets in a fund's portfolio').
- Hard to assess impact of private market asset allocations: One thing that is more difficult to tell from the Report is what impact a high (or low) allocation to private market asset allocations is having on fund performance. This is partly because the methodology employed by the Commission was deliberately controlled for 'differences in asset allocation across parts of the superannuation system' – ie the test of under-or-over performance it used was devised to be asset-allocation agnostic. That said, a number of submissions to the Commission state what seems to be the generally accepted wisdom – that industry and public sector funds have traditionally allocated more to private market assets (and, by implication, that such higher allocation to private market assets explains at least some of the outperformance by those industry and public sector funds as compared with retail funds).
- Level of fees and costs (particularly investment fees) is a significant driver of performance: What is clear, however, is that the level of fees and costs (and particularly the level of investment fees) is a major (perhaps even the major) driver of relative investment performance – in the Commission's words, there is a 'strong negative relationship between net returns and total fees … – that is, funds with higher total fees on average deliver lower returns (net of all fees) for their member'. In addition, the Commission suggests that international benchmarks indicate investment costs in Australia are still higher than in comparable pension systems around the world (it states that international data indicates investment fees should be around 0.4 per cent of assets, whereas Australian funds are at approximately 0.68 per cent of assets), suggesting that activities such as insourcing have further to go in reducing total fee rates.
To summarise then (and noting that these are our massively over-simplified conclusions, not the Commission's!), perhaps the Commission's work shows that some of the keys to investment outperformance are: to have a large fund; be a fund that invests heavily into private market assets; and be a fund that keeps investment costs as low as possible, by insourcing and taking other steps to reduce total fees and costs.
All of that then brings us to a bit of crystal-ball gazing as to what the investment activities of funds might look like if the Draft Report's recommendations are implemented (which is, granted, a big 'if' at this stage, and almost certainly some time away, even if they are).
- A smaller number of bigger funds … : One thing seems universally accepted – any move to implement the Commission's recommendations (whether wholly or in some other form) will almost certainly drive industry consolidation (even more consolidation than is happening organically now). Interestingly, we're already hearing, in the early days and weeks post release of the Report, that the mere fact it has been released in its current draft form might lead to an increased pace of successor fund transfers. If that is so, there will likely be a markedly smaller number of much larger funds in the foreseeable future. In addition, that process might be turbo-charged for the 'winning' top 10 funds over two or three cycles – ie even leaving aside consolidation, those funds might grow faster than the rest of the market, due to increased inflows from default members, as well as the knock-on effects from the attraction and retention of other members.
- … which might mean more private market asset investments … : Those larger funds may then devote greater capital to private market assets – partly because the evidence (perhaps) suggests those assets lead to outperformance, but maybe also because of the public perception coming out of the Report (among other things) that the industry funds are 'winning the investment battle' in part because of their allocation to such assets. Perhaps retail and other funds will also feel the need to increase their allocation to private market assets, in an attempt to compete with industry funds in the 'top 10 shootout'.
- … and bigger in-house investment teams (and a related shift away from related party managers) … : Similarly, we suggest that the move towards a greater insourcing of investment management capability will accelerate, in an attempt to capitalise on their size and to reduce investment costs. We query whether there will also be a corresponding shift away from related party manager appointments in all parts of the industry (driven by not only the Commission's work and recommendations, but broader market forces and the Royal Commission, which may well lead to the disaggregation of vertically integrated financial services institutions).
- … BUT will the Commission's proposals, perversely, put some of that at risk?: However, we do wonder whether the cut-throat nature of the Commission's 'top 10 best in show' recommendation might, perversely, undo some of the above (we think largely positive) trends. In particular, we wonder whether one of the consequences of the recommendations will be that all funds (but particularly those that are realistically competing for a place in the top 10) won't have the same certainty of future inflows that they do now – ie those funds may rightly be nervous every three years about their ability to make the 'top 10' list and thereby accurately model member contribution inflows. If so, we worry that will mean all funds (both the 'winners' and 'losers' of the top 10 shootout alike) will be less willing to take the necessary long-term decisions required to eg invest the time and resources to insource a new asset class, or to invest in an infrastructure or real estate asset that might have a 20- or 30-year investment horizon attached to it.