There has been considerable public discussion from Australia’s largest superannuation funds on how they benefit from economies of scale that enables them to outperform their smaller industry peers. In this article PAUL KESSELL discusses how small superannuation funds also benefit from utilising their size to their advantage.
While Australia’s large superannuation funds tend to attract the media spotlight, there is less focus on the inherent structural advantages that ensure smaller superannuation funds remain just as attractive, especially when it comes to achieving strong and competitive investment performance. One benefit of large size is undisputed: the largest super funds have the capacity to cultivate a high profile in the media and at conferences. It would, therefore, appear intuitive that the well structured delivery of this branding strategy would be transferred across to their assertion that economies of scale lead to superior investment returns. However, I would argue that it is not just a one-way street, and that large funds face certain challenges as a result of their size, while many of the characteristics of smaller funds allow them to perform as well as, or better, than their larger counterparts.
The challenge of complexity Large superannuation funds often have high profile trustee boards, significant funds under management (FUM), positive cashflows and large internal investment teams employed to review their broad range of global investment opportunities. Even though an increasing level of FUM does offer economies of scale, there is little, if any industry agreement about the point at which the benefits of this scale are optimised. In other words, are funds aware of the FUM “sweet spot” beyond which scale advantages erode and unwelcome and unwarranted complexity emerges? As FUM grows, the economies of scale benefits to the investment strategy may initially arise from the ability to invest across a broader investment universe, achieving lower investment fees and developing a greater in-house investment skill-set to produce improved investment performance.
However, the initial benefits of scale cannot continue indefinitely. Ultimately, the economies of scale that have been achieved across the business will eventually be reduced or lost due to the ‘cost of complexity’ that manifests across the fund’s operations. This complexity can develop over time and may not be identified until it has become excessive and already embedded – affecting the fund’s strategic plans, structures, processes and systems. The complexity may not easily be reversed and, unless actively managed, is likely to have an adverse impact on investment performance. This would seem to be consistent with Parkinson’s Law, a management theory that states “work expands so as to fill the time available for its completion”. Such a scenario is generally avoided in small superannuation funds due to natural limitations on their level of resources.
This has become, and will continue to be, an increasing issue for those large superannuation funds competing aggressively for growth – especially if they do not have the business structure to support their planned expansion. Increasing the choice of investment options, the range of products and services, as well as corresponding promotional activity, requires an equivalent increase in skills and resources across the business to maintain the same quality of service. So why it is generally accepted – or at least not openly brought into question – that large superannuation funds are best placed to outperform small superannuation funds solely by virtue of their size, when this continues to be unsupported by industry investment performance data? How does complexity aris e? Investment strategy complexity arises over a period of time, but generally as the fund’s FUM and profile grows.
The competitive nature of the industry compels these funds to seek better investment performance and develop an investment strategy that is regarded by the industry as leading-edge and, perhaps, globally competitive. This is most often observed in the increasing complexity of the portfolio construction process, in areas such as the following.
• Size of the global investment universe has increased, particularly across the property, private capital and liquid alternatives asset classes and become a prominent component of larger funds’ strategic asset allocations. The corollary to this development is that the opportunities are generally unlisted and introduce illiquidity, valuation and governance issues.
• Boutique investment managers have replaced established investment managers through a strategy of investing in, or “incubating”, new Australian and overseas boutique managers. This was built on the view that they are better skilled, more nimble and structurally more efficient in implementing decisions than traditional managers; so more likely to generate alpha.
• Number of investment managers employed continues to increase as large funds are limited in making the desired percentage allocation to their preferred managers due to capacity issues and the need to diversify manager business risk. This may eventually result in employing too many managers and achieving very expensive index performance.
• Capacity constraints may arise in alternatives and less liquid sections of listed markets, which compels larger funds to seek more investment opportunities. In addition, the minimum allocation for an opportunity to meaningfully contribute to performance increases. These constraints will ultimately limit the investment universe the fund has actively sought to expand.
• Large in-house investment teams have been developed to identify global and alternative investment opportunities, manage fund assets internally and leverage this in-house capability across the investment strategy. It has led to the increasing use of strategies akin to those offered by investment managers. Having such large teams may compel the fund to invest in, or have exposure to, certain (illiquid) asset classes even if valuations are unattractive.
• Internal stakeholders have increased in number requiring greater operational and management control to ensure all investment activities are aligned with the fund’s strategic investment strategy. More stakeholders produce internal competition for access to the fund’s limited risk budget and capital allocation and may result in a sub-optimal investment strategy. These complexities require a more active management approach by the fund and additional internal resources and fixed-cost funding that are forcing increases in the administration fee imposed on members. They also come with higher fee structures that may offset some, or all, of the ‘economies of scale’ benefits that had previously been achieved. Limited transparency makes it is difficult to assess the value each of these activities adds to investment performance. Investment strategies, and their associated complexity, have developed at a faster rate than the investment governance policies of many large funds.
This has created a potential knowledge gap between the inherent sophistication of the investment strategies employed and how well they are understood by the trustee board. It imposes increasing demands on trustees and their ability to make informed investment decisions. Such factors inevitably add to a lengthening of the decision-making process – from idea generation to trustee board approval and implementation – resulting in an opportunity cost and creating the risk of sub-optimal investment performance relative to the resources, scale, capabilities and innovation the fund has applied to the investment strategy. The decision-making process is one that perhaps demands more attention by the industry.
I would argue it is fundamentally important to have a decision-making process that enables trustee boards to clearly focus on investment strategy rather than operational issues. Notwithstanding, prima facie, large funds are better placed than small funds to provide a broader range of services and implement an investment strategy that generates consistently strong investment performance. However, scale of itself is not sufficient; there needs to be a clear process as to how best to capture the benefits of this scale. Only recently have the large funds acknowledged they could be more proactive in pursuing lower fees from their service providers. A couple of other areas where large funds may achieve scale benefits are the broader range of investment opportunities they are presented primarily, due to the ability to make large investment commitments, and the access to a wider range of information sources that can feed into the investment management process.
However, unless this greater choice translates into better investment performance it simply increases complexity and inertia. By comparison, smaller funds have generally implemented investment strategies that are much less complex and this gives them a powerful advantage. I also assert that small funds have the capacity, resources, skill and governance structure to effectively compete with their larger counterparts. The trustee boards of the smaller funds continue to retain a close industry connection with their fund’s members. This promotes an alignment of interests with members and supports a robust and high-quality investment governance policy framework. Importantly, the parameters of this governance policy are broader than the complexity of the investment strategy.
This helps to create a constructive and well-informed environment for the trustee board leading to informed decisions being made as the primary focus is on assessment of the key factors affecting the investment strategy and attainment of the fund’s investment objective. So it is not surprising then that we find smaller funds having a higher allocation to traditional asset classes and a limited appetite, or governance budget, for investment in alternative opportunities. Implementation and management of an investment strategy with limited complexity does place less demand on fund capacity in terms of resource, skill and operational requirements and controls the overall cost structure of the fund. Small funds are in the enviable position of being able to continue to benefit from the advantages that economies of scale provide as their FUM grows as they plan and grow towards their FUM “sweet spot”.
This approach has been adopted by Professional Associations Super, a Melbourne-based industry super fund managing assets of around $1.3 billion. An investments delegation matrix clearly sets out the roles and responsibilities of each primary stakeholder in setting and implementing the fund’s investment strategy. We have a dedicated investment team of two staff and a single ‘whole of fund’ asset consultant, with whom we work collaboratively to develop and manage the investment strategy policy guidelines. A key decision was to outsource management of the fund’s assets and focus resources internally on the investment strategy, which we believe will be the primary driver of investment performance and achieving members’ expectations.
With frequent investment committee and board meetings we accomplish approval and timely implementation of decisions; limiting opportunity costs that result in strong, and competitive, investment performance. Summ ary Small superannuation funds have the skills, processes and governance structures in place to achieve strong investment returns and provide for members’ financial futures. They are also in the desirable position of being able to continue to reap the benefits from improved economies of scale as their FUM grows. While large super funds are well positioned through their size to achieve the benefits of scale and better provide a range of services to members small can be beautiful too – and this part of the industry has begun to show its best features and natural advantages.