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 Corporation

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 www.investmenttechnology.com.au

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 falling…

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 work.


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.{sidebar id=19}

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. {sidebar align=left id=20}

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

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