A member base hurtling towards retirement, when the investment outlook many years ahead is for weak growth with ultra-low cash and bond yields, poses a major challenge for Local Government Super’s (LGS) Craig Turnbull.
The chief investment officer has already responded quickly by lowering the return target on the fund’s conservative option, to keep member expectations in check, and tilting more of the investment portfolio into alternative unlisted assets to try and bolster long-term performance.
Over the past couple of years LGS has been shifting capital out of listed stocks and bonds and re-deploying it into semi-liquid, defensive illiquid and absolute return strategies. The goal in diversifying into these alternative asset classes is to put the fund in a stronger position to continue delivering stable returns. This is critical as the core demographic of its membership shifts rapidly towards retirement age.
Turnbull is best known in the industry as a pioneer of, and passionate advocate for, sustainable investing – in the sense of accounting for environmental, social and governance (ESG) risks. Measuring the climate change impact of companies and projects the fund invests in has long been a focus.
In May, the Asset Owners Disclosure Project ranked LGS as the number one institution in Australia for environmentally sustainable investing. Even more impressive, LGS was ranked number two globally in the study of more than 500 institutions.
But Turnbull is preoccupied by more prosaic questions about financial sustainability.
His recent push into alternative unlisted asset classes is a trend that is set to continue at the nearly $10 billion public sector fund, which manages the compulsory retirement savings of around 90,000 current and former NSW local government employees.
The LGS investment committee, headed by James Montague, recently voted to approve Turnbull’s continued development of the portfolio into “illiquid” assets over the next three years.
Of the $9.6 billion LGS has under management, $4.1 billion is in accumulation funds, $1.9 billion in pension funds, and $1.7 billion in defined benefit funds, with the rest in other funds that are partly funded by employers.
Higher return for unrelated risks
As one-fifth of assets are already in the drawdown phase, Turnbull is trying to develop strategies that do not introduce any more equity, interest rate or credit risk, but rather can give a higher return for unrelated risks.
“The main worry is how to get the return we are looking for in a low return environment. We have lowered the investment objective for the defined benefit fund and it will be a challenge to reach the objectives for the other funds,” Turnbull told Investment Magazine.
Eight years ago, he hired an asset consultant to advise the fund on how to build up its holdings in private equity, private credit, infrastructure, and hedge funds.
A goal was then set to build holdings across these alternative asset classes up to the value of 25 per cent of the total portfolio.
“It’s taken five or six years to do that, but we [are] pretty well at our limits now,” Turnbull says.
At June 30, the asset allocation in its balanced option was 31.41 per cent in equites, 7.16 per cent in property, 10.59 per cent in private equity and semi-liquids, 0.87 per cent in commodities, 25.47 per cent in fixed interest, 4.64 per cent in bonds, 12.16 per cent in absolute return funds, 3.71 per cent in defensive illiquids, and 3.99 per cent in cash.
Earlier this year John Peterson was recruited to the newly created role of portfolio manager illiquids, bringing LGS’s in-house investment team to nine.
Turnbull has headed LGS’s investment team for more than eight years, having been appointed by chief executive Peter Lambert six months after took the reins.
Immediately prior to becoming chief investment officer, Turnbull spent three years as head of real estate securities for MacarthurCook. A number of MacarthurCook property trusts became distressed in the global financial crisis, before being de-listed or sold off, so Turnbull has first-hand experience of the liquidity risks associated with investing in unlisted assets.
Illiquids an ‘essential ingredient’
Still he is confident, that with the right mix of assets and tenures, illiquids will prove an essential ingredient in the years ahead if LGS is going to have a reasonable chance of meeting its stated return targets.
The return target for LGS’s defined benefit option, favoured by retired members, was recently lowered to 6.5 per cent from 7 per cent above inflation as measured by the consumer price index (CPI).
Over the past three, five and 10 years the conservative option has delivered an average annual return of 5.21 per cent, 5.95 per cent and 3.86 per cent respectively. But Turnbull is worried it could be impossible to repeat those sorts of results in the year ahead.
“On the view that inflation could revert back to 2 or 3 per cent and you need to earn a 2 per cent margin above that, it raises the question of how to get 6 or 7 per cent return?”
Return targets on the balanced and growth options have not yet been lowered, but remain under review.
A need for yield is why Turnbull started shifting money out of low-risk sovereign bonds into riskier corporate credit.
The Australian bond mandate is now aligned to a “composite benchmark” that includes an allocation to local corporate bonds. PIMCO, Brandywine Global Investment Management and Ardea Investment Management have been appointed to manage a “high conviction” composite international bond portfolio.
Diverting capital from sovereign bonds into corporate bonds heightens the risk of a blowout in credit spreads, as happened in the global financial crisis of 2008.
“It’s not too hard to imagine a scenario where the returns on bonds could be actually negative. The rates wouldn’t have to rise very far for that to happen,” says Turnbull.
Because of this, LGS has been down-weighting its bond allocation at the strategic level, though they remain vital for diversification.
“If things go bad they are the one thing that can go up for you,” he said.
They also have the ability to go underweight tactically, and recently with bond yields 2 per cent and lower, that capability to underweight has been utilised.
“The same thing with cash,” Turnbull says. “If anything, you would logically be moving further away out of bonds and cash into something else that gives a better return.”
Best fixed income opportunities
One area where LGS is hunting for value is semi-liquid fixed income funds. These are funds with an investment duration typically of five to six years.
These funds provide exposure to the best fixed income opportunities in the market, and can include distressed credit and private credit.
LGS already has a $291 million portfolio of defensive illiquid assets. Two-thirds of this is invested in long term infrastructure holdings. A stake in a pharmaceuticals royalties trust is another defensive illiquid holding that has performed well.
Turnbull says defensive illiquids have been the “star performers” of the portfolio in recent years.
“There is some sensitivity with infrastructure in the way that it’s valued, but valuation discount rates used in our portfolio are still up around 10 per cent.”
Another asset class that offers strong returns but can require a lot of patience, similar to infrastructure, is private equity.
“In private equity there is often a J curve effect, you go down before you start coming up, so you have to be very patient,” Turnbull says.
The super fund has private equity mandates with 14 managers including Cerberus, Terra Australis, Bain Capital, Paul Capital Partners, EQT, Hawkesbridge Capital and Quadrant.
Eight years after the fund began allocating more to private equity, the strategy is really starting to pay off.
In pursuit of more stable returns Turnbull has also restructured the absolute returns portfolio, which tanked in the global financial crisis, and built it out to roughly $1 billion.
In the December quarter of 2008 the absolute returns portfolio lost 20 per cent, which came as a shock due to a lack of transparency on how much equity risk was within it.
“That was too volatile for our liking and there was a big restructuring post-GFC,” Turnbull says.
“It started off with all credit spreads, but as spreads came in we’ve reduced credit and started introducing other strategies.”
These include hedge fund beta strategies, low-cost illiquid strategies, risk premia strategies, as well as picking strict general strategies and working off indexes.
Other unusual components of the absolute return portfolio include a “commodity trading advisor trend-following strategy”, and a hedge fund invested in energy markets.
Over the seven years to June 2016, the LGS’s balanced option has returned 7.5 per cent. The industry average over this period was 8.2 per cent, according to SuperRatings.
This article first appeared in the November print edition of Investment Magazine. To subscribe and have the magazine delivered CLICK HERE. To sign-up for our free regular email newsletters CLICK HERE.