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Long-term investors fail to reap their natural advantage

Last month, I discussed the over reliance on liquidity of defined contribution (DC) asset allocation compared with other long-term investors. Despite similar objectives, the proportion in alternative and less liquid assets is much lower, possibly because Australian superannuation funds confuse liquidity with safety. Here I outline some other justifications for liquidity but address why it is still not preferable.

Possible causes of the liquidity focus

  1. Member choice

There is a belief that the introduction of super fund choice prompted the industry to remain liquid because members can move money on a daily basis requiring daily liquidity for underlying investments. In reality the number of members engaged with their super journey is very low – approximately only 10% actively switch each year. A fund with regular contribution flows has the advantage of developing a liquidity policy that allows it to invest in less liquid assets. It behoves the industry to educate members on how other long-term investors manage their money and why a patient, long-term approach is appropriate.

  1. Regulation

The Corporations Law which governs retail fund products states a certain proportion of their investments must be saleable within a specific number of days for regulatory compliance. This should be contestable as the regulator should not want to make DC investors ‘second class citizens’ and it is open to reasoned argument.

  1. Agency risk

Agency risk is a constant affliction in financial services. For advisers to demonstrate that they earn fees they may generate activity and frequent switching rather than buying and holding, which requires a liquid approach. In his latest Berkshire Hathaway Annual Report, Warren Buffet states investors should create the best results by “not falling into the trap of trying to time markets” and that forming macro opinions and listening to market predictions is a waste of time. He believes investors should focus on what they own, buy and hold, and diversify for long-term investing: “those people who can sit quietly for decades when they own property too often becomefrenetic when they are exposed to a stream of stock quotations and accompanying commentators. These deliver animplied message of ‘Don’t just sit there, do something’ which can turn liquidity from a benefit into a curse.”

  1. Conflicted business models

The super industry is predominantly home-grown with a local investing bias. Many funds management businesses predominantly sell products that they create in-house, generally local equity and fixed income funds. Our industry is surely creative enough to produce longer-term products with suitable lock-ups across different areas. I am puzzled as to why these alternative structures are not offered in DC plans, especially as member ‘self-select’ options with suitable lock-up periods.

  1. Size

The lack of size, scale and resources for smaller super funds may also play a role. Is there a certain scale above which funds feel able to broaden their horizons? There may be some truth in this for SMSFs and smaller retail funds but this is countered by the Wharton Global Family Alliance 2011 Survey of Single Family Offices, which shows funds as small as US$50 million still maintain around 51% of their allocation in less liquid assets.

  1. Inflexible asset allocation framework

Maybe fund advisers (and/or regulation) strangle opportunism by forcing funds into too rigid definitions for asset allocations. The desire to maintain assets in pre-defined ‘buckets’ which are easily explained in Product Disclosure Statements may reduce the flexibility to take on new assets in an opportunistic manner. As DC fund advisers are largely the same ones who provide advice on strategic asset allocations to endowments, DB funds and sovereign wealth funds, it is bizarre that the investing outcomes are so different.

  1. Lack of trust and desire for control

Many investors don’t trust the industry or are spooked by high profile disasters or involuntary locks. Graham Hand vividly recounts this lack of trust in his article, ‘Does the public hate us?

  1. No illiquidity premium belief

Maybe some super funds lack belief in the illiquidity premium and so keep everything liquid. This is undoubtedly true in some areas at certain times (currently seen in infrastructure) but taking an opportunistic approach provides dozens of strategies with potential for broader investment spheres.

  1. Peer group risk

The industry has a preoccupation with peer group risk. If other funds are all liquid then ‘daring to be different’ involves career risk. Industry funds should be applauded for their (almost unique) focus amongst super funds on less liquid assets, but many have concentrated dual portfolios of direct property and infrastructure (bringing different peer risks). The retail industry’s introduction of lifecycle funds is a refreshing departure with some forecasts predicting these will represent 40% of the market in a decade. This too will hopefully substantially reduce the impact of peer group risk.

10. Fees

The perennial issue of fees in isolation versus net of fee outcomes may be a causal factor but it does not do our industry justice if we cannot better educate members. It is important to focus on the risk adjusted net of fee outcome over a meaningful period of time (ideally seven years given risk levels of most default funds). Presenting league tables of super funds ranked on fees or returns alone similarly detracts, instead leading to cheap funds full of market beta. These require excellent market timing to perform well but unfortunately not many investors are expert at this.

Regardless to whether some or all of these reasons are involved in the liquidity focus of Australian superannuation funds, they all involve education to convince investors otherwise.

The advantages of closed ended investment vehicles

Generally less liquid assets are offered via closed ended or ‘locked-up’ investment vehicles delivering four advantages. Firstly, they eliminate the investor reliance on market timing. A closed-ended vehicle where funds are called down periodically means the skilled manager does not have to select the perfect time to invest all monies. Drawdowns occur over time and assets can be sold at an appropriate juncture, often delivering better risk-adjusted returns. Secondly, with no timing mismatch between assets and liabilities, managers can make judicious use of tools like shorting or leverage with no risk of re-financing in difficult times. Plus there is no danger of forced exits from strategies caused by others ‘panic selling’. Thirdly, performance fees are only payable once fund assets have actually been sold and a particular hurdle rate of return paid back to investors; and finally there is usually better alignment of interest. Typically managers invest in locked-up products alongside investors (often the largest single investor) feeling real ownership as opposed to just managing ‘other people’s money’.

Why might an investor require a liquid portfolio?

This brings us full circle. It is sensible to maintain a liquid portfolio if the investor has a short-term time horizon orgood market timing abilities. Unless approaching a retirement crystallation point, superannuation is certainly not short-term. So do DC investors have good market timing abilities? This is an empirical question but evidence from mutual fund investors is not good.

Lamenting how ‘yesterday’s winners become tomorrow’s losers’ in his book ‘The Little Book of Common Sense Investing’, Vanguard founder, John Bogle warns against reliance on market timing. To demonstrate the pitfalls, he explains what happened to late investors into previously top equity performers. During the telco, technology and media equity bubble (1997–1999), the top ten US mutual fund equity market performers (out of 850) each generated an average upside of 55% per annum. But when the bubble burst, each plummeted into the bottom 60, losing around 34% per annum in the three years following. They were outperformed by 95% of the market and substantially underperformed the broad market over the entire six year period.

The future is diversity

There are many structural and anecdotal reasons why there is too much focus on liquidity in Australian superannuation DC schemes. Nevertheless investors must instead focus on their investment horizon and take advantage of being long-term, patient investors. Otherwise they risk becoming ‘second class citizens’ compared to other long-term investors such as family offices or global pension schemes.

As an industry we have the ability to counter this liquidity obsession. Super funds can focus on unique member characteristics and educate their constituency on the importance of net fee outcomes, why risk adjusted returns matter, and why having diversified portfolios with less liquid investments is suitable for long-term superannuation investing.

Bev Durston has over 25 years’ experience in implementing investment solutions for pension funds, sovereign wealth funds and fund managers. She now runs her own advisory business for institutional clients, Edgehaven Pty Ltd.

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4 Comments

Super Fund Board Member

August 26, 2014

David,

if you want the Commissioners to take your submission seriously you need to do the work for them. You are wasting your time pointing them to other research and telling them to trust you, reading it will be worth while.

You have to write a submission that makes the arguments clearly to them. Refer to your sources, but if they can't get the main points and evidence from your submission they will ignore it.

I happen to disagree with you. The fund that I'm involved in has looked at the evidence you point to, but also to lots of other analysis. That plus our own experience tells us that illiquid assets, properly managed, are a source of value add for long term, patient investors.

You are miles off the beam when you suggest that Australian super funds cannot access the best asset managers in the world. They actually are very keen to talk to us. Also, as it happens, in the illiquid asset space - especially infrastructure - some of the best asset managers in the world are Australian! In fact, some have pioneered global infrastructure investing.

David Marks

August 24, 2014

I'll be submitting something like the following to the second round of the FSI. It would be interesting to hear your thoughts on it:

The Financial System Inquiry has highlighted portability requirements as a driver for high allocations to liquid assets within the Superannuation system,
“High demand for liquidity from superannuation funds may be reducing after-fee returns to members. The mandatory inter-fund portability timeframe of three days is contributing to higher allocations to liquid assets than the system requires.”

There is an assumption in this quote that illiquid assets have higher after-fee returns. In terms of the returns actually achieved by the median manager or average investors the literature suggests this assumption is likely not true on a risk-adjusted basis.

Andrew Ang’s excellent new book (1) includes a summary of the recent literature,

“After taking into account biases induced by infrequent trading and selection, it is unlikely that illiquid asset classes have higher risk-adjusted returns than traditional liquid stock and bond markets. On the other hand, there are significant illiquidity premiums within asset classes. Portfolio choice models incorporating illiquidity risk recommend only modest holdings of illiquid assets. Investors should demand high risk premiums for investing in illiquid assets.”

I recommend reading the draft chapter on illiquid assets as well as chapters on hedge funds, real estate and private equity. For the sake of brevity, some key points from Ang and the papers he cites include:
• Illiquid asset returns are inflated by survivorship bias, infrequent sampling and selection bias.
• “[T]he average hedge fund and private equity fund, respectively, provide zero expected excess returns. In particular, after adjusting for risk, most investors are better off investing in the S&P 500 than in a portfolio of private equity funds.”
• “There is no “market index” for illiquid asset classes…While this large amount of idiosyncratic risk can boost returns in some cases, it can also lead to the opposite result. Returns to illiquid asset investing can be far below a reported index.”
• “You cannot separate factor risk from manager skill…investing in illiquid markets is always a bet on management talent”
• “[I]nvestors face agency issues and need skill to evaluate and monitor managers”. As William J. Bernstein suggests in his review of the book2, “It belongs on the front shelves of pension and endowment managers, who should read and reread the chapters on hedge funds, real estate, commodities, and private equity until they realize that unless their name is David Swensen, they are the patsies at ludicrously expensive poker tables.”
• “Illiquidity Markedly Reduces Optimal Holdings” of illiquid assets: Ang’s modelling suggests with a baseline calibration of 59% in a risky asset which is continuously traded (e.g. an allocation to shares as would be common for a diversified fund), for an average turnover between liquidity events of ten years, illiquid assets should optimally be rebalanced to a 5% weighting. Infrastructure investments have a typical turnover time far longer than ten years.
• “Investors Must Demand High Illiquidity Hurdle Rates”: In a stylised model, Ang estimates a required illiquidity risk premium for an average turnover between liquidity events of ten years at 6%p.a.

There is no reason to believe that superannuation managers in Australia have comparable access to the best asset managers as influential US endowments. Rates of return to fund members from infrastructure, hedge funds and private equity in Australian superannuation funds do not appear higher than equity returns, even putting aside issues such as infrequent valuation and survivorship bias. Alpha – risk adjusted excess return – goes to the managers: as with many financial innovations the “winners” of a move towards substantial allocation to illiquid, typically less transparent assets in retail superannuation funds would inevitably be asset managers, consultants and investment banks. I do not begrudge them a profit where they add value, however the evidence is against them in this case. At most, only a small allocation to illiquid assets can be justified as in the best interests of fund members.

References
(1)Ang, Andrew, Asset Management: A Systematic Approach to Factor Investing, 2014, Oxford University Press. The quote is from a draft of chapter 13 on Illiquid Asset Investing made available for download by the author at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2200161
(2)Bernstein, William J., Book Review: Asset Management: A Systematic Approach to Factor Investing, CFA Book Reviews, January 2014. http://www.cfapubs.org/doi/full/10.2469/br.v9.n1.15

Bev Durston

August 23, 2014

Hi Sulieman,

Thanks for your comments. It would indeed be a pity if retail investors don't access less liquid investments because of the lack of trust and a belief that managers move the goal posts on them over time. I don't see any reason why retail should get a worse deal than other long term investors in less liquid investments. In fact quite the opposite - smaller investors often get "a good ride on the coat tails" of terms that are improved by larger investors (as long as they are in the same product). They may pay higher base fees due to their smaller size - but in most of the investments that I make (closed ended funds) they get the benefit of exactly the same terms from the manager and can opt into side letter terms that others have been able to negotiate. This is the benefit of the closed ended fund structure in my view.

You seem to be highlighting the situation where retail investors have been separated and are given lesser terms. I agree that this should generally be avoided. Of course minimum investment sizes apply to many closed ended vehicles as well but once this has been reached closed ended vehicles are generally a good way for smaller investors to benefit from the negotiating power of larger investors.

Sulieman Ravell

August 22, 2014

I would argue its primarily a lack of trust in the industry. Product providers have continued to demonstrate their ability to royally screw things up to the detriment of investors.

Investment mandates that are initially created to be beneficial for investors are abused or stretched at times and the adviser community have put faith in a provider to manage money in the same way they had initially set out. However, times change and managers move on, and compliance gets stretched and investors are left stuck in an investment that no longer resembles its initial intentions.

Theres a whole argument about investors having the right to change this but its a much steeper hill than for a family office or institutional investor who can usually dictate the mandate at outset.

Illiquidity is therefore a much greater risk for retail investors


 

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