While most super fund members may miss it, one piece of information in the annual reports of their funds for the year just gone will say a lot about how the funds are likely to fare over the next 12 months and beyond. That is the funds’ cash balances.
Headline returns always grab, well, the headlines. And negative returns grab bigger headlines than positive ones. But how the funds are adapting to the market volatility which produced the negative returns can be seen in the build-up of cash. Notwithstanding their determination to maintain a long-term perspective, cash allocations for funds have tripled or more in the past few months. Strong cashflows are not being equitised the way they normally are. Getting invested quickly is not the problem it was up until the credit crunch last year.
How long this situation is allowed to last will vary from fund to fund. Hopefully, the investment staff and investment committees have made the conscious decision to wait until the dust settles on bond and share markets before they return, rather than allowing cash to build because they don’t know what else to do.
Hopefully, also, they have examined the risks in this new strategy. When the so-called risk-free rate is 7.5 per cent or better and markets are not yet showing signs of bottoming, a big tactical increase to cash may well be the best course of action.
But do markets ever show signs of bottoming or peaking before the fact? One of the conclusions of the major research project from Watson Wyatt Worldwide (see News, page 7) is that the frequency of financial crises in the world is likely to increase. Respondents to a survey of managers and funds as part of the research felt that the likelihood of financial crises would continue at or above recent experience, “consistent with three to four financial crises in the next 10 years”.
If that is so, funds may be tempted to maintain a high cash allocation, which history shows is unlikely to be in the best interests of most members. The reason that DIY super funds have consistently lower returns than other funds is because of their high cash balances. Last financial year, of course, will be an exception.
An advertisement in a current campaign by AMP Capital Investors points out that by investing $100,000 in the broad sharemarket over the past 10 years an investor would have tripled his money. But if he or she missed just the 30 best individual days on the market, the portfolio would have increased to only $137,000. So, there is a real risk of underperformance for funds allowing cash to remain high for too long. What would be much better is if they develop new strategies to provide similar liquidity offered by cash, for the crisis times, but with growth-style returns. Old-style enhanced cash products need to be revamped to handle new liquidity stresses. Super funds are liquidity givers and are therefore able to take advantage of shortages. But they are also financial institutions in their own right, subject to possible large-scale withdrawals in times of crisis.
The Watson Wyatt report identified six forces for change which were currently at work and would likely continue for the next five years. It then identified six longer-term forces for change. The shorter-term trends were: pressure for talent; improvements in governance; product proliferation; extra-financial factors; more defined contribution models; and organisational change, such as scale and globalisation. The longer-term trends were: better multi-period investment design; better defined contribution value proposition; a new food chain, including the rise of the CIO; new investment content; continued crisis contagion; and new players and new organisational order.
The one consistent theme throughout the report is increasing complexity. For funds, nowhere is this more evident than with investments. A more sophisticated approach to cash balances and other liquidity reserves is just one example.
Another consistent theme, thankfully, is that absolute return solutions are here to stay. Australian super funds have advanced further than many of their overseas counterparts down this path.
The report says: “In our world investors do not want a global equity portfolio that is designed to outperform the world index by 1 per cent per annum subject to specified risk parameters. They need to accumulate wealth that can be converted into an appropriate form, for example, cash sum or annual pension, usually at a specified time in the future. Investors are currently undertaking a process of discovery to identify the most efficient way to achieve this. It is our contention that relative return investing will not constitute the most efficient way.”
The report says that a particularly thorny challenge for funds as complexity and product proliferation grow and their governance struggles to keep pace is ensuring that investment manager mandate design is appropriate to the new investment content required. Absolute return mandates require careful use of benchmarks. An interesting example of this was illustrated at the Global Dialogue conference (see Cover Story, page 16) by Graeme Bevans of the Canadian Pension Plan. The fund assesses its private equity managers by building custom benchmarks which change with each investment decision. The performance of an unlisted investment is compared with that of the relevant market sector index.
To better reflect the desires of their members, especially the growing number approaching retirement, mandates will also start to be defined by the solution they offer rather than investment style – say, CPI plus 4 per cent rather than asset class and, Watson Wyatt says, specific time horizons to delineate between investment styles that favour short-term or longer-term approaches.
All this requires better fund governance, which really means greater internal resources, with delegation to staff by a board which concentrates on long-term strategy and oversight of member interests.