OPINION | Superannuation funds should be demanding more transparency and flexibility from their hedge fund managers.
A drive for transparency is one of the key forces re-shaping the superannuation industry.
The Australian Securities and Investments Commission’s regulatory guidance note 97 (RG 97), requiring local superannuation funds to make much more detailed disclosures about their underlying investments, takes effect from October 1, 2017. Internationally, the European Union’s Markets in Financial Instruments Directive (MiFID) rules are driving the unbundling of global broker relationships and mandating best-execution practices.
Meanwhile, improvements in environmental, social and governance (ESG) reporting and after-tax performance measurement are among the other drivers of change that will bring to light previously opaque areas of superannuation fund portfolios.
The traditional ‘black box’
A recent research paper by Parametric, Bypassing the Black Box, explores the impact of this transparency trend on a superannuation fund’s allocation to hedge funds, which traditionally rely on an opaque ‘black box’ investment structure.
In the hedge fund industry, low levels of portfolio transparency typically guard a manager’s intellectual property and obscure a complex array of underlying alternative strategies, derivatives trading and counterparty arrangements. It is difficult for a superannuation fund or adviser to interrogate a hedge fund manager on the potential risks – such as liquidity, leverage and counterparty risk – inside its black box.
Parametric’s research suggests that this makes it difficult for super funds to assess the true value of hedge fund strategies and whether the fees these managers demand are worthwhile.
The report acknowledges, however, that superannuation funds need to find alternative assets to invest in that provide a source of returns not correlated with their fixed income and equity portfolios.
In recognition of this, Parametric suggests that super funds look for more transparent strategies for investing in alternatives that bypass the black-box style of traditional hedge fund investing. Potential approaches include taking a discrete mandate or targeting alternative risk premia in a transparent, rules-based way.
To demonstrate how this is possible, the report looks at a case study in which a Volatility Risk Premium harvesting strategy, based on an ASX 200 portfolio, incorporates an options overlay.
The research investigates the source and size of this alternative risk premium and then sets itself the task of capturing this return source by designing a self-contained portfolio for a hypothetical superannuation fund that uses only listed instruments and is liquid, unlevered, fully funded (collateralised) and implemented in a systematic, rules-based, repeatable way.
The research characterises this as a “portfolio of no surprises”, since superannuation funds can see exactly what the portfolio consists of, how it works and how it is expected to perform in different market environments. The Volatility Risk Premium is shown to be uncorrelated with equities (ASX 200) and fixed income (Bloomberg AusBond Composite), making the hypothetical strategy a good fit in a superannuation fund’s alternatives allocation.
In an interesting twist, the research points out that alternative strategies that are “freed from their black box” can be ported into other parts of a superannuation fund’s portfolio. For example, the defensive characteristics of Parametric’s Volatility Risk Premium approach suggest potential uses as a component in a comprehensive income product for retirement (CIPR), in a defined benefit fund or in lifecycle strategies.
This demonstrates an important relationship between portfolio structure and innovation. Transparent strategies available as custom mandates are tools that a superannuation fund can use to solve their investment problems in innovative ways. Black box investing, in contrast, blocks not only transparency but a fund’s ability to innovate as well.
Raewyn Williams is managing director of research at Parametric Australia, a subsidiary of the Seattle-based funds management and portfolio services firm Parametric Portfolio Associates.