In most finance courses academics will teach you the maths behind asset pricing and diversification. Often, the first real-world lesson is on the risk of the liquidity mismatch. Over the years that discrepancy between assets and liabilities has proven fatal for companies, industries, governments, banks, managed funds and many hedge funds.
Yet, many Australian super funds appear to have gone down this very path. Around 15 super funds offer single sector options, mostly property, which offer typically daily liquidity, but invest in unlisted assets. To what degree are these funds playing with fire?
I have written plenty on unlisted assets and the associated governance challenges, but the focus has mostly been on balanced funds. Here I shine a light on single sector funds but I have applied the same framework that assesses the first-order risk (the risk of liquidity failure) and three-second order risks (remaining portfolio quality, equitable unit pricing and costs of rebalancing).
Before we start, it is important to understand the mechanics of single sector options. Consider an investment option which invests 100 per cent in unlisted assets but provides daily liquidity. Standing alone (and noting that super funds cannot use leverage) it would instantly be unable to meet its obligations as soon as it had a single redemption.
The solution to this is a ‘banker’ arrangement: typically, the largest default option which will provide liquidity to the single sector option by buying some of its unlisted assets without overly affecting its own asset allocation.
So what may initially seem a huge risk of a liquidity failure is actually very small. It also means that the quality of the option is preserved because it is always invested to target. And there are few rebalancing costs because they are diluted by the much larger banker. It is worth noting that the concept of the banker would be unheard of outside of any mutual-style structure.
This doesn’t mean it is a case of “nothing to see officer”. Quite the opposite, as the recent crisis has revealed. These options have experienced huge member equity issues. A different feature of this crisis has been the sharp impact on property and infrastructure. So when these assets were revalued, either in-cycle or out-of-cycle, the mark-downs were large. The unit prices of some single sector options fell more than 10 per cent in a day.
This creates significant member equity issues. Clearly, the assets didn’t fall by that much in a single day, yet members who switched or redeemed the day before are relatively well ahead. There are solutions to this problem, the most obvious being more frequent valuations. The prudential regulator’s SPG 531 (valuation) outlines a range of practices. The challenge is, by how much can price discovery be manufactured? These assets often rely on transactions and judgement to determine sensible valuation assessments.
An alternative would be to offer much less frequent liquidity, which seems an unpopular solution. Surely there is a practical message in this: if an option doesn’t stand up on its own feet then why go down the banker path?
There are also issues of equity for members of the banker option, which is usually the MySuper default option. Every time a member of an unlisted asset single sector redeems in a difficult environment, the banker option is providing liquidity at probably an overstated price and is taking on more illiquid assets when it may prefer to remain liquid. The size of the impacts may be small, but the visuals aren’t good, especially when it feels like the governance of the super industry is under the spotlight more than ever.
MySuper defaults consist of disengaged members and members who actively trust that this option is the most appropriate for them. Is it appropriate for such options to perform the banker role?
Perhaps this is something for the regulator to consider when licensing MySuper options. However, this is probably harder than it sounds because licensing conditions are enacted in legislation.
I would encourage the 15 or so super funds to review the design of their singe sector options. A simple exercise would be for the directors of these funds to discuss and document their answers:
- Do I want to offer single sector options which can only exist through the assistance of a banker arrangement?
- Do I want to offer single sector options with potentially sizeable unit price inequities?
- Do I want my MySuper members to perform the role of banker to support the active choices of other members?
If I was a director I wouldn’t be comfortable – it just doesn’t sit right with me.
David Bell is the executive director of the Conexus Institute.