After a tumultuous past 12 months, set off by
the crisis in the US sub-prime mortgage market, some financial institu­tions
are still looking shaky, the sharemar­ket remains in
the doldrums at 30 per cent below its peak, consumer and investor confidence is
low and inflation looms as another possible dark cloud on the horizon.

In a roundtable in Melbourne last month, Conexus Financial (publisher of Investment & Technology)
and BNY Mellon Asset Management discussed “The Age of Turbulence: Managing Risk
and the Implications for Asset Allocation” with some leading super fund
executives and asset consultants.

Participants at the roundtable were:

Charles Jacklin, president and chief
executive, Mellon Capital Management

James Gruver, managing direc­tor, BNY Mellon Asset Management Australia

Don Russell, global investment strategist, BNY Mellon Asset Manage­ment

Craig Hughes, head of portfolio management, Victorian Funds Manage­ment

Mark Delaney, chief investment officer and deputy chief executive, Austra­lianSuper

Tim Hughes, chief investment of­ficer, Catholic Super

Graeme Miller, head of investment consulting, Watson Wyatt Australia

Daniel Needham, general manager, investments, Intech

Kristian Fok,
deputy managing director, Frontier Investment Consulting

David Stuart, principal, Mercer Investment Consulting

Tim Farrelly, principal, Farrelly’s financial consultants

Greg Bright, publisher, Investment & Technology

Amanda White, associate publisher, Investment & Technology.

This is an edited version of the discussion.
A full transcript is available on

Amanda White: Everyone seems to have an
opinion on whether we have seen the worst of the credit crunch, whether the
world is in, or going into, recession and how long this is going to last either
for markets or world econo­mies. As first country into the situation, what’s
the latest thinking in the US?

Charles Jacklin: It’s not over, of that there is little doubt. However, the
non-financial sector went into this in the best shape it’s ever been … It’s a
very odd economy.

This year, in March, when Bear Sterns was
bailed out credit markets had pretty much frozen in the US. Things improved in
April, May and June and had become a lot better in terms of liquidity. But in
July and August they got worse. And in fact the end of August was as illiquid,
as tight as it was in March. So there’s still some
issues going on there. So that’s one extreme. The other extreme is people are
talking about the US entering a ‘lost decade’ as Japan did in the 1990s. But
the situation in the US is way different to the situation in Japan. First of
all the real estate bubble was only a bubble in housing as opposed to the
triple bubble in housing, commercial real estate and the stock market in Japan
– and every­thing burst there. Also the bubble in housing alone wasn’t as big
in the US as it was in Japan in real terms. And real estate is a smaller part
of the whole US economy.

The key ultimately will be when housing
prices stop falling. You have a lot of economists who say housing prices will
fall until the middle of next year. But these economists also talk about
rational expectations and some­how we should think that prices will just keep

More recent numbers – the last monthly
reported numbers – showed that new home sales and existing home sales were up
and house price declines were decelerating in terms of the Case-Schiller Index,
which is the best index.

The US has about five million homes for sale
today. It normally has about three million homes for sale. So there are
basically two million excess homes. But there are about a million new
households that are constituted every year between kids growing up and coming
of age and immigration. It’s not like Japan where population growth is flat and
you have a big excess supply. The excess supply in the US will get absorbed.
It’s just a question of how quickly…

In the credit markets I think one of the
things that’s going on is that there’s a lot of refinancing that’s taking place
right now. You have SIVs (special investment vehicles) that, when all the
problems broke out a year ago, extended debt. They were short term out for one
year. And that’s coming due. They ei­ther have to get refinancing or they have
to sell some of these liquid instruments that they have. There’s a lot of money
waiting – vulture funds – to step into the credit markets.

SIVs, of course, are struggling to get
through the financing and a lot of that is happening in August and September.
So I think we’ll know a lot more in a month or so about whether another shoe
has dropped, in which case I think it will trigger a lot of people entering the
credit markets.

And hopefully after we get through that that
the liquidity and credit mar­kets will pick up.

And I think that will be key.

Greg Bright: Can we hear from either or both
of the super funds pres­ent on liquidity? Australia’s super funds are obviously
in a very different position from other pension markets because we have 9 per
cent guaranteed inflows each year. And the anecdotal evidence is that the super
funds are allowing cash to build up.

Mark Delaney: The
market supply of liquidity is still very tight outside the natural holders of
liquidity. Increas­ingly we’re getting people coming to us with deals and
transactions which you wouldn’t have seen before, across infra­structure,
private equity, whatever. But super funds probably have slightly less inflow
than they would have anticipated prior to the crises as discretionary flows
have slowed down. They’ve contin­ued, or we’ve continued, to build up
liquidity. There’s a concern that in the unlisted markets some of the IRRs and
the pricing of the transactions have not reflected the change in pricing which
we have seen in the listed markets. The overarching issue is that listed
equities are probably one of the cheaper asset classes. And it’s likely they’re
go­ing to be the recipients of the (renewed investment) when it gets put to

Tim Hughes: Nothing
enhances value more than a 30 per cent fall in prices. That’s certainly what
we’ve seen in the listed equity market. I think there does seem to be this
belief that some­how super funds are absolutely flush with cash and they’re all
just sitting on their big buckets of money. But that’s not really the case at
all. Certainly not for us. We’ve been gradually
building up cash but then we’ve been redeploying it too. And we have been
redeploying it primarily in the listed equity market where, you have some
terrific oppor­tunities and the prices have adjusted, compared to, as Mark
said, infrastruc­ture and property. People are clearly operating in a
capital-constrained world, and there are lots of people out there who want
capital, but prices really haven’t adjusted.
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Amanada White: Are you talking domestic or global?

Tim Hughes: A
bit of both. Equi­ties are liquid assets, which is an impor­tant consideration
because if, for some reason, you change your mind, you can sell. Whereas once
you go into property or infrastructure, if you change your mind, you can’t
sell, you’re there. The other issue which is weighing on our minds at the moment, is that the regula­tor, APRA, has over the last year
and a half been talking about fund liquidity.

There is at least one fund which has had a
very substantial proportion of its members decide to switch into its cash
option. We simply have to be in a position where we can manage those sort of member decisions if and when they’re made.

Amanda White: Is that the same for you, Mark?
Are you looking at listed equities?

Mark Delaney: When
we did our asset location review, we thought that obviously cash rates or bank
bill rates above 8 per cent in a slowing economy were quite attractive. As Tim
said, the big declines in equity prices indicate that, all things being equal,
equities will be attractive at some point in time. And other investments will
rank further down the relative attractive spectrum.

Tim Hughes: One
example is that if someone comes along to you with a dis­tressed infrastructure
asset and they’re talking about sale of that asset with an IRR of 9-12 per
cent… That’s hardly at­tractive pricing relative to what you can buy listed
assets at. So we’ve yet to see a full adjustment in the unlisted space.

Mark Delaney: What’s
the reason why the unlisted market is not adjust­ing? Is it just the lack of
ability or willingness to transact?

Tim Hughes: I
think there’s a whole lot of things going on there.
There’s always a reluctance to accept a price below you’re expectation, unless
you’re actually a distressed seller. If you are a distressed seller, then
you’re selling at prices that probably don’t represent fundamental value. So I
think the whole industry is sitting and waiting to see what the prices really
are in theseunlisted assets.

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Greg Bright: Graeme,
do you have a view on different attitudes between funds? Your firm has been
fairly public on the issue of governance for funds and the rules of thumb that
funds of a cer­tain size should or shouldn’t be heading down a certain path.

Graeme Miller: I
think recent events have highlighted the age-old idiom that if you don’t
understand it you shouldn’t be investing in it. There are many, many holders ofsecuritised debt that woke up one morning and
suddenly discovered that what they thought they owned was very different to
what they actually had. 

I entirely concur that there’s nothing in the
current environment that would indicate that unlisted illiquid assets were
particularly compelling relative to their listed counterparts. Everything is
pointing in the opposite direction. And, of course, smaller funds face the
additional hurdle of having to access these unlisted funds through managers and
through fee structures which mean that the return hurdles that need to be
overcome are very challenging…

I suspect there are many assets in the liquid
space right now that are unloved and it feels, to us at least, that they’re a
much safer bet – look for the gems that have been cast off amongst the stones
within liquid markets, within credit markets and the like…

Within investment grade credit markets these
days, spreads have never been higher in many places. And talk about unloved,
there’s a lot of unloved stuff there right here, right now.

Charles Jacklin: If I could add to that a little bit: if you think about the
structured credit markets, 18 months ago they were very liquid. They were very
liquid dealer markets. Because of overexposure in other parts of the banks
where they dealers sit, they basically have left that market. So what was a
very liquid dealer market has become a very illiquid broker market. It’s very
different in the character of that market. And with that has come a big
illiquidity premium. Prices have fallen to a point where they reflect more than
just the credit risk – they reflect this liquidityrisk.
And, of course, if you need to be liquid, they’re not necessarily the right
thing to go into. It’s not a deep market any more. But it is attractive from a
long-term holder’s perspective.

Tim Farrelly: The weird thing is at the moment, there’s a liquidity pre­mium
in the listed markets but not the unlisted markets. That is bizarre.

Charles Jacklin: I think that’s prob­ably true, particularly from everything I’ve
heard here. One of the things I was surprised to see is how much the REITs
market has fallen relative to the property market.

Tim Farrelly: The REITs mar­kets were crazy ahead of time. The thing that
intrigues me is that the US REITs haven’t fallen nearly as far as the
Australian version and the US REITs appeared to be far more overpriced to start
with. It feels like there’s a lot more damage to be done there in the US,
whereas here, things have been marked down to crazy prices. There’s a bit of a
bounce now.

Tim Hughes: Coming
to the basic issue of overall investment risk, I think we’ve been reminded that
banks, the banking system, the financial system, is totally reliant upon
confidence. Once confidence goes whole markets disap­pear, liquidity
disappears. Financial institutions are in trouble because either their
depositors are walking away or they can’t refinance. The residential
mortgage-backed securities market should have been a stable market, but that’s
disappeared as well and it’s purely lack of confidence.

Greg Bright: What we are mainly talking about
is asset allocation. I wonder if there’s anything in what we’ve been through
and are still going through which represents a secular change. The move down
the endowment model, which Australian funds have pursued, I wonder whether that’s
going to stop at some point as a result of this.

Craig Hughes: If
you mean, going down the endowment model means investing in real assets, taking
some risk out of listed assets, then I probably think the opposite. I think for
us, what we’ve seen in the last year pushes us even further down that model.
VFMC commenced 18 months ago to beef up our real asset exposure, affectively
from zero. We’re not going to stop that. The structuring around some of these
vehicles, the leveraging of the vehicles, yeah, sure that’s going to be
interesting. These structures do need to change. Leverage needs to come out of
a lot of these vehicles. But the push away from listed equity risk to other

sorts of risk, I think is going to continue.


Greg Bright: Does it have a natural cap on


Craig Hughes: At
some point yes, because ultimately liquidity will come into play. So there is a
cap at some point. But it’s not a cap at 10 or 15 per cent.


Greg Bright: Would you hazard a guess at what
it would be for you?

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Craig Hughes: We’re
in a situation where we don’t have tremendous cash­flow.
We’re probably cash flow neutral in a medium-term sense… We could certainly
push towards 50 per cent in our unlisted securities.

Greg Bright: You don’t have to wor­ry about a
Chant West or SuperRatings rating, of course. Warren
Chant’s been vocal saying that with anything over somewhere between 20 and 30
per cent in alternatives and the fund won’t get a top recommendation from him.


Craig Hughes: No,
we don’t and obviously that’s something… We set a strategy and implement it.
We’re at advantage in that sense. But what we’ve seen recently, with the
volatility in these markets, won’t hold us back at all in a push for greater
focus on non-listed equity risk.


Greg Bright: Don, you’re the chair of a fund
that’s closed (State Super of NSW)…


Don Russell: We’re
closed but I think Craig’s made an important point that there is a scale
involvement in all of this – large funds can do some things, particularly in
the current market, that smaller funds can’t do. There are opportunities in the
direct space in an environment where large assets will get shaken out from
distressed sellers. So, if you are in a position where you can put up quite a
lot of money very quickly and if you have the internal expertise to do a good
job in terms of valuations, I think there are opportunities there which can
prove to be to the benefit of funds which don’t have that pressing liquidity
need immediately.


Amanda White: To what extent will the
changing demographics have anything to do with you looking where money’s going
to be moving from members?


Tim Hughes: I
don’t think the demographic is a particularly significant constraint for us
because the majority of members for our fund are staying with the fund
post-retirement. And they’ve got a very long time span after retire­ment in
which they need cash. So they still need growth investments.


Greg Bright: There are some people who
suggest that the illiquidity issue for some unlisted assets, such as infrastruc­ture,
is overstated.


Kristian Fok: The
thing about li­quidity is generally when you want it orneed
it that’s probably when you don’t have it. So you always plan on the basis that
you never want to be in a position where you’re forced to sell. And I think one
of the advantages that a lot of the Australian superannuation funds have had is
that cashflows have been a very big proportion of
investment. So even if you change your mind about the prospects of an asset
class you have the luxury of making current decisions with future cashflows to dilute that position. Over time that will
change as funds be­come mature and the average member balances become higher.

Some thought needs to be given to the types
of unlisted assets you have… There’s no one right asset allocation. Funds can
cope with some degree of switching, particularly if cashflows
are still 10 per cent of the fund and you can pay 15 per cent of the members
switch­ing. You can make a specific decision to redirect cashflows
over a year and try to win it back.

Charles Jacklin: I think there’s an aspect of illiquidity that is very relevant
for the defined contribution plans and that is that illiquid assets aren’t
necessarily priced accurately. If you have people leaving your fund, or even people
coming into the fund, and they’re coming in at prices that are question­able,
they can have a big impact. If you let a lot of people out of the fund and you
have a big chunk of illiquid assets and those assets are overpriced at the time
they go out, it’s going to hurt your return to the remaining people in the
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David Stuart: The
listed market gives you a discipline on management. If you do badly and your
trust trades at a big discount to asset base, you can’t raise money. If you
trade at a premium you can raise money. So, good man­agement gets rewarded.
That’s not happening in the unlisted space. And I think that’s the issue:
there’s no market discipline. So, I generally agree that there are big problems
with the unlisted model. People give away the manage­ment rights,
which are actually worth an awful lot of money … and is
unable to be


Tim Hughes: To
counter that, we have had the example right now of an ABN AMRO private equity
fund where the manager has been removed by the investors.


David Stuart: There
are some exceptions. You’ve had another one recently with a Babcock and Brown
fund where management rights had been built up and sold for a substantial sum
of money, which is money that the investors had probably not realised they’d donated to anyone.


Amanada White: Is choosing the right partner or funds manager in
unlisted markets more important than in listed?


Daniel Needham: It’s
always hard to assess returns in private equity, by defi­nition, because you
need to wait until they’re wound up the fund basing it on cashflow
And then you have to adjust your return for leverage. On average you get market
returns, right? But the upper quartile outperforms significantly. The lower
quartile does much worse than listed markets …


Greg Bright: Given that manager selection is
more important in private equity and alternatives generally, why is it that the
major asset consultants are not as strong in that area? If you look at the
staff of the big Australian funds, most are devoted to the alternatives area.
The funds of funds have had a great run in private equity despite their extra
layer of fees because they have a large number of research staff.


David Stuart: You
can choose a highly rated equity fund manager and you can continue to provide
advice to clients who will generally, for a signifi­cant period of time, be
able to access that fund manager. You will poten­tially have a significant
proportion of your clients with that manager. But if you’re looking at
individual private equity strategies, or for that matter individual hedge fund
strategies, the problem is that it requires a lot of work and analysis to
properly rate them and then you’re likely to get very few of your clients
through the door at the time that that manager’s open…

You could say that’s an excuse and that we
should do better. I guess all the consultants have been building up their
alternatives research but we still find the problem of sustainability is a big


Amanda White: Is there an option to change
the business model?


David Stuart: There
are certainly moves. I think some of the other con­sultants around the table
are makingmoves as well. The problem is that
traditionally we’ve been re­warded with retainers or some other kind of payment
which has been irrespective of funds under management. And that works well in a
scalable activity where, to be honest, providing the advice to a small fund may
not cost you very much more, or much less, than providing it to a big fund. In
these areas where capacity is extremely constrained and the amount of work
relative to the funds invested is significantly more you have to look at
something which is probably closer to a fund management style of fee. There
have been some moves towards that and that will probably continue.


Mark Delaney: What
they’re really aiming to do is to be an implemented consultant. And it’s by far
the most lucra­tive part of the consultancy business. You don’t see many
funds-of-funds people who aren’t affluent. It’s been a sur­prise to me that the
consultants have been slow to move into what looks like the most lucra­tive
area of the consulting task. I don’t know your business, but it’s surprising.
Other people have been operating in that space and making lots and lots of


Kristian Fok: If
you look at private equity, first of all it was a fairly small part of client
portfolios. And secondly, once it became bigger, it’s not just about assessment
of manag­ers, it’s about actually getting into those managers, particu­larly in
some areas like venture capital. We wouldn’t be doing the right thing if we
weren’t able to actually put together a decent portfolio. But there are
components that make more sense. If you look at any asset class where you can
select qual­ity assets and get reasonable amounts away, then that makes more
sense for asset consul­tants to look at. Individual deals make more sense in
big­ger licks. So from our perspec­tive we’ve identified infrastruc­ture and
real estate as the areas it makes sense for us to do that. If we try to do
everything it would compromise our ability to deliver the other things that we
do. We don’t necessarily rush into every single alterna­tive asset class. We
just pick the ones that we think we can actually add value.


James Gruver: Many
funds consider peer risk. In par­ticular, I’ve heard several super fund CIOs
and CEOs say that if only they had had more in unlisted assets they would have
had a better shot at the league tables. Any comments on that?


Tim Farrelly: The peer stuff is really interesting. Everybody treats peer risk
as if it’s okay and often it’s just a massive conflict of interest where you’ve
got one group of people that don’t actually own the money looking after their
interests and not looking after the interest of the end inves­tors. And no-one
says this…

Graeme Miller: It
seems to me that in the for -profit sector what peer risk does is it drives you
to mediocrity and it forces you to adopt ‘me too’ strategies because your most
valuable asset is the body of funds under management that you have; that’s what
generates your revenue stream.

I’m not sure that that’s true in the
not-for-profit sector. I think that what peer risk actu­ally does in the
not-for-profit sector, as a general rule, is itencourages
trustees to have the conver­sation about ‘how can we do something better for
our members?’ And peer risk comes up all the time in every trustee meeting and
every investment commit­tee meeting that I go to. But it’s very seldom in the
context of ‘we can’t afford to do X or Y because we’re going to be different from
our peers’. It’s much more in the context of ‘how can we add value …’.


Greg Bright: My contention is that super
funds’ in-house teams are at least challenging the traditional asset
consultants in terms of resources in their chosen areas. Does that skew the
recommendations from the in-house staff vis-à-vis the recommendations of the


Graeme Miller: Greg,
you men­tioned the governance research that we published late last year and one
of the key conclusions of that was that the best-governed funds have got very
strong internal teams. And that that doesn’t preclude in any way the use of
external consultants. In fact, I share Kristian’s
view, we find that the clients who are able to extract most value from us are
those that have got strong inter­nal teams and that can actually utilise the sort of scale and resources we bring to them. I
think the thing that’s missed in this is that internal resources are seen as a
substitute for external advisors. They are not… The way the business model has
evolved has precluded invest­ment consultants from developing very deep
expertise. And it’s simply because there’s a rule written somewhere that says
fund managers deserve this amount of money and internal people and con­sultants
deserve that amount. Until we break down that rule I think that funds’ internal
teams and, indeed, consultants will face a giant headwind in terms of being
able to add a lot of value.


Tim Hughes: One
of the things that really surprised me when I moved from the fund management
side of this industry to the super fund side is just
how chronically under-resourced super funds are when it comes to their invest­ment
staff. There is a massive mismatch between value add, or potential value add,
and where the investment spend is.


Mark Delaney: I
think that’s worth looking at. We have a lot of measure­ments on how you
perform relative to your competitors. There are lots of surveys. But there’s
insufficient time spent on how much you’re paying for what you’re getting in
managing the portfolio. None of these portfolios need to be actively managed.
You don’t need asset consultants. You don’t need a su­per fund internal team.
You don’t need anybody pretty much bar the custodian. You could just have the
same asset allocation as everybody else and index everything. So, what you’ve
really got to do is you have to make money after fees above that. And we don’t
focus enough on the link between the money we’re making and the money we’re
paying. It just gets washed around the big pot. If it was a commercial business
you’d never get away with that behaviour.

Amanda White: Do you assume the value add in
setting an asset allocation and the time spent with asset consul­tants is more
than the after-fee value of funds management?

Mark Delaney: I’ve
worked out all those numbers and in broad terms manager selection accounts for
less than half of the value add over the last seven years, less than half. And
yet manage­ment fees account for 90 per cent of our fee bill.

Greg Bright: Getting back to the state of the
markets, I don’t know if I can hazard a guess at consensus within the industry
but people are starting to say that maybe this time next year there’ll be a few
more smiles on every­one’s faces.

Craig Hughes: We’re
still very concerned about the deterioration of the macro environment. So what
we’re talking about there is just basic econom­ic growth and a propensity for
inflation through basic commodities. Propensity for inflation to be above
targets globally. So what we’ve seen in the UK, what we’ve seen in Europe, what
we’ve seen in the US, those sorts of economic down­turns we haven’t seen for
some time and so the potential impact on profits we suspect has yet to come
through fully. So the markets have corrected, they’ve corrected a lot but
there’s probably still scope for further deterioration in earnings.

David Stuart: We’re
unashamedly sitting on the fence at the moment, which is not very comfortable …
If this was a normal recession, you’d be looking to buy equities by now. You
need to buy equities, clearly, before you see the upturn. But at the moment
this looks like an L-shaped recovery. And that’s not one which we that
confident that we’re going to be a standard recovery in equity markets at this
stage… Like Craig, and probably like a lot of the oth­ers, we are suggesting
that where people have gone underweight that they use cashflow
to get their equity weightings back to a long-term position. But we’re not yet
moving them overweight.

Amanda White: What’s the prog­nosis for the
US financial system?

Charles Jacklin: There are banks that are in trouble and they’re going to have to
sort through that. I think the Fed is more worried about the hous­ing market
grinding to a halt… And I think the Fed is more worried about the contraction
of credit than anything else. And they’re worried about banks only because if
they’ve got capital problems, then they’re not substituting for this in the securitised debt market. So they’re worried about Fanny Mae
and Freddie Mac and you have (Treasury Secretary) Paulson who’s worried about
introducing covered bonds so the banks will have a substitute way to finance
mortgages. But they’re worried about the contraction of credit more than
anything else, I think.

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