AustralianSuper’s chief liquidity officer Chandu Bhindi has publicly proposed the idea of allowing some super funds to directly use leverage, enabling them to better manage liquidity requirements in crisis situations rather than being forced to sell assets at stressed prices.

The idea has some merit, both theoretically and in practice. But it also raises a collection of issues and potentially shifts the risk profile of the superannuation system. We are unconvinced of the need. Credit is due for re-visiting the idea, but tread carefully.

Benefits of leverage and its use overseas

Leverage can be beneficial in theory. An important contribution made by the likes of Nobel prize winners Harry Markowitz and Bill Sharpe was to first find the optimal portfolio from a risk-adjusted return perspective, and then either blend this portfolio with cash or leverage to meet the risk profile of the investor. Better in theory than the common approach of moving along the efficient frontier by changing the asset mix.

There are both theoretical and practical challenges to this approach, such as how to measure risk, the costs and risks of leverage, transaction costs, and so on. But it stands as a valuable reference for portfolio construction.

But this is not the idea that AustralianSuper is floating. Rather, they are suggesting that the ability to raise debt can reduce ‘risk’ by assisting with managing liquidity in stressed market environments. The argument is that this avoids having to sell assets at unattractive prices.

The opportunities to enhance portfolio optimisation and liquidity management have seen many pension funds globally use leverage as part of their investment programs. However, these are mostly defined benefit (DB) funds with meaningfully different characteristics from super funds.

Leverage settings in Australia

Limited leverage has been an underpinning feature of Australia’s superannuation system. In our research on systemic risk in superannuation and risks of severe liquidity stress, we conclude that the risk of a major liquidity stress event is low. An unleveraged defined contribution (DC) system helps underpin this view.  Market returns are passed through to members, while the lack of leverage removes what could be a major source of liquidity demand in stressed markets.

It is not quite true that Australian super funds cannot use leverage. Funds can access leverage through limited recourse borrowing arrangements.

The call to extend borrowing ability is not all it seems

AustralianSuper’s core idea is that access to lines of credit would assist in managing liquidity demands and avoid selling assets at unattractive prices. They also refer to cutting back on cash to limit return drag. On closer examination, however, this amounts to creating an ability to leverage up into falling markets.

A key context point is that super funds can sell their liquid public market assets to meet liquidity demands, noting that a three-day redemption cycle provides an adequate window. There is also nothing stopping funds holding thin cash levels if they build mechanisms to readily access liquidity elsewhere, e.g. holding a portion of equity exposure in collateralised futures or ETFs.

This motivates an interesting connection between liquidity risk and working capital. Traditionally, especially in banks and insurers, cash (first) and fixed income (second) are viewed as the core instruments of working capital.

Super funds have mostly upped their exposure to growth assets (such as equities) over time, reducing aggregate holdings in cash and fixed income, While the reasons are moot, the point is that equity markets also provide a source of readily available liquidity and might qualify as a type of working capital in the context.

The central issue is thus not meeting liquidity demands, which can be satisfied through multiple channels. Rather, it is avoiding being forced to sell public market equities at depressed values during periods of market stress.

So what choice are we confronting here? Selling into market weakness. Or not selling and leveraging up instead. Here it is important to keep in mind that the portfolio being leveraged may already be ‘out-of-shape’ with regard to the balance between liquid and illiquid assets. Which approach works better will depend on what markets do next. AustralianSuper is effectively asking to be able to leverage up a bet that markets will rebound.  The merits can be debated, but that is where the argument sits.

Stepping back and taking a system view

Let’s say super funds are given and use the capacity to rely on borrowing lines and cut back sharply on their cash holdings. This would alleviate the pressure on super funds to sell in times of stress, making it more likely that they help stabilise markets rather than compound the weakness. While this could have systemic benefits, it could also shift the systemic problems elsewhere.

Super funds are a significant funder of the banking system, holding a large portion of bank bills. If they hold much less cash, they would no longer be playing such a key role. But consider the possibility that the super industry becomes a net borrower during a crisis, competing with the banks and others for funding when it is most needed.

There are many crosscurrents here. And we are not sure that the situation would work out well for the financial system and the economy if the price for financial market support is mounting stress elsewhere.  

The question of capital

In Australia, institutions such as banks and insurers that use leverage or make promises to counterparties or customers are required to put regulatory capital aside. Any conversation about leverage within super needs to consider capital as well. Why should super funds be exempt from holding capital if they are allowed to borrow against fund assets? 

Member switching  

AustralianSuper also queried the benefits of being able to switch across super funds in three days. This challenge is merited in a system framed as a long-term savings and retirement income program. It is another debate worth having, largely because illiquid assets are in the mix rather than the capacity to meet redemptions.

However much – and possibly the majority – of the switching can be between investment options within the same super fund rather than between funds. If a fund is looking to significantly improve its liquidity management, this should be on the agenda as well.

Further, this issue could split the industry as some funds carry portfolios with unlisted and illiquid assets, while some funds only offer liquid investment options and view the ability to switch between investment options as a core part of their offering.

Final thoughts

Overall, we consider current leverage settings as providing sensible natural bounds on the amount of investment and liquidity risk that funds can take. We view these settings as fitting for a DC system where outcomes are passed through to members. It is totally appropriate for a liquidity risk management executive to call for additional tools to help manage liquidity risk. But we are not convinced there is a compelling need for the capacity to borrow, and there are broader ramifications to consider.

We agree that it might be time to review appropriate settings for switching: perhaps trustees should be given some latitude within a principles-based framework. However, allowing leverage could even increase, rather than decrease, the systemic risk profile of the system.

David Bell is executive director and Geoff Warren is research fellow at The Conexus Institute, a not-for-profit organisation philanthropically funded by Conexus Financial, publisher of Investment Magazine.