The chief investment officer of Victorian Funds Management Corporation, LEO DE BEVER, leaves us in August for the Alberta Investment Management Corporation, a C$75 billion manager recently spun out from the Alberta Treasury.
He is already on record as saying his new employer’s scale, governance and autonomy from government makes for the type of fund Australia needs more of, and here he fleshes out that argument. Within 20 years, one in four Australians will be living on retirement savings. Their financial comfort will depend in part on how efficiently those savings were invested. Given the importance of the issue, it is appropriate that a few years ago, then Treasurer of Victoria John Brumby set a goal for Melbourne to become a centre of excellence for the super fund industry.
A laudable objective but what does it take to achieve it?
International evidence suggests that the answer is no different from what it is in other industries: a good governance model with minimal distraction from agency issues, a clear vision of how to meet the central objective of pension security, and a relentless passion for efficiency in identifying and implementing promising new ideas.
The quality of a super fund is typically judged by its gross investment return. That aspect of the problem is least controllable in the short run, but fairly tractable in the long run. Investing in safe assets like CPI-linked bonds builds purchasing power safely but slowly. Betting everything on equities generates an average of 4 per cent a year more in the long run, with enormous volatility in the short run, but reasonable certainty that stocks will beat bonds over 20 years or so. The typical balanced portfolio is two-thirds weighted to equity-like assets, so the expectation is for at least 4 per cent x 2/3 = 2.5 per cent per year more than bonds 50 per cent of the time, and no less than bonds in the long run.
Implementation costs of such a strategy are typically around 0.2 per cent. If excellence is defined as doing better than this passive alternative, we have some way to go in achieving it: less than a third of retirement funds deliver better than passive returns.
One key reason is lack of scale. In money management, adding a zero to funds under management does not increase cost tenfold. Running a super fund with less than $1 billion in assets can cost in excess of 1 per cent. At $40 Billion, 0.5 per cent is easily achievable, and at $100 billion, costs can fall to 0.20 per cent. Every 0.25 per cent sustained reduction in cost or increase in return over a member’s working life adds 10 per cent to annual retirement income.
Unit costs fall in part because size brings with it the financial capacity to employ a larger and better qualified internal investment team, which leads to a better mix of external and internal management. External management has its place when there is a need for specialised expertise, but it is generally expensive. A
good internal team rewarded for results at commercially competitive rates can be very cost efficient. A strong internal team also facilitates a better balance than between board oversight and delegation of strategy formulation and implementation to management. Funds with strong long-term records have boards that are truly independent, and Board membership selection criteria based solely on skills needed to meet the fund’s objective.
Larger funds have potential for higher return beyond their cost advantage through better access to strategies that exploit having lots of cash and the patience that comes with a long-term investment horizon. Size matters most in areas like infrastructure (because it is easier to control larger transactions) and private equity investing (because having a strong internal team makes for a more attractive investment partner).
Australia pioneered private investment in infrastructure, but imitation has diminished that initial advantage, and the tyranny of distance means that global opportunities are more expensive to access. International cooperation between super funds can remedy this to some extent, if the investment decision process can be smoothly coordinated. On the operations side, smaller funds have difficulty paying for the largely fixed cost of portfolio management systems, risk systems, and client account management software.
Good systems provide a much better fix on where the money is, what the real exposures are and what can be done to better coordinate component strategies. Better cash management alone can add 0.25 per cent a year to total return. Systems also help in quick identification of implementation errors.
The industry funds recognise that scale is an issue, and that fund consolidation to date has been insufficient. One very human obstacle is board pride in the history of their fund and in their involvement in investment decisions. It may be difficult to accept that the best you can do for members is to merge with other funds, and by implication relinquish your board seat.
If experience elsewhere is a guide, Australia has an urgent need for a few $100 billion funds, or barring that, for a number of funds outsourcing the investment process to a jointly owned organisation that can apply the skills of a strong internal team to making timely decisions for that $100 billion.