Media Super, an industry fund for those in the media, creative and digital sectors, recently announced that it was investing in a financing facility for local film production. It is interesting to think this through, and lifecycle theory (see article in Cuffelinks 1 for an introduction to this subject) is a useful framework to apply.
In short, lifecycle theory is about maximising a lifetime of consumption and leisure. Our work, saving and consuming, and investment choices are the levers at our disposal. Of course there is much randomness as we don’t know how our lives and the world will pan out. However we can manage the risks we see. The alternative is the typical portfolio construction approach (commonly using mean-variance style techniques) where we focus on the portfolio outcome ignorant of other features of our lives.
One risk to consider is how our investment portfolio interacts with other risks in our lives. A key aspect is our income. It may be exposed to shocks, in particular unemployment, and part of the growth in our income will be linked to the performance of the employer, the sector and the economy as a whole. And income is important as it affects how much can be contributed to superannuation and other forms of savings.
Given that it is impossible to perfectly hedge risks to our income it makes sense to diversify such risks. Rather than focussing on the optimal way to diversify, let us first consider the three most obvious ways.
The first way would be to not invest in shares of the company you are employed by. If the company performs poorly your funds for retirement will be adversely affected at the same time that you may be exposed to the risk of being laid off or not experiencing pay increases. An unfortunate example of this comes from the US. In the US corporate 401(k) pension plans (their retirement savings vehicles), companies commonly had their own stock as an investment option. Many employees of Enron (the energy and commodities firm which turned out to be a major fraud) lost their jobs, entitlements and much of their retirement savings as they invested their 401(k) plans in company stock. This practice is still allowed in the US and in some cases employees continue to make large allocations to their own stock.
Why? A possible reason is behavioural: many people take comfort in the fact that they at least know their own company, although the majority of employees know little about valuing and buying their own company’s shares. In superannuation, people with their own SMSFs have the opportunity to directly manage this risk. It may be an area where financial advisers can add value to their clients, and it is an issue that trustees of corporate superannuation funds should think about.
Of course an alternative view is that executives should have ‘skin in the game’ and owners of small businesses will probably put most of their capital into their own business. These are special cases where either there are additional benefits (participation in high wages, bonuses, options etc), or small business owners have substantial inside information. For the average worker, their insight into the company they work for will not be significant.
A second approach would be to avoid investing in shares in the sector in which you work. For instance consider someone who works on the resources sector, where there is a high correlation amongst stocks within the sector. There is a risk that a collection of your investments may perform poorly at the same time as you experience income risk. Media Super is but one example. CBUS (an industry fund for construction and building services) and HOSTPLUS (hospitality, tourism, recreation and sport) both have investment exposures to the industries their members work in. I do not know of a single industry superannuation fund which has a policy to not invest in the industries from which their members draw their income. And yet this seems to be the best thing to do in terms of diversifying a key risk to lifecycle outcomes (and indeed a wonderful opportunity for industry funds to differentiate themselves from their retail counterparts who draw members from various industries).
Why doesn’t this occur? Well, industry funds may want to be seen to be supporting the sectors in which their members work. I remain unconvinced on the merits of this. Any individual industry fund represents a small amount of the total capital in the world and is unlikely to make a significant difference to the economic outcome of a sector. And if it is being done to be seen to be supporting the industry, then this is unjustified relative to the extra lifecycle risk being imposed upon members.
However the sector investments may be justified if they come with a higher return potential based on insights gained through the fund being associated with sector specialists. For instance, Media Super Chief Executive Ross Martin, with respect to the film industry investment, was quoted as saying,
"Members have earned a competitive return from this unique portfolio and the assistance from our industry partners has been invaluable for the scoping and due diligence required for this kind of alternative investment."
This benefit may well compensate for any increased concentration in risk to lifetime financial outcomes.
A third technique is to re-allocate from domestic equities to global equities. Academic research has shown that such an approach may be justified because the returns from global equities are less related to Australian economic conditions and thus a better diversifier to income risk. However Australian equities remain the largest asset class exposure across most superannuation default funds. Australian superannuation funds exhibit a home country bias, as do many retirement systems around the world. Once again there are reasons to explain this, some acceptable, some less so. One acceptable reason is the benefits of franking credits (as discussed by Chris Cuffe in Cuffelinks Edition 1). Another reason may be taking comfort in the familiarity of Australian companies, but having some familiarity with an investment doesn’t offset its risk, and greater financial education may assist here. The final reason commonly cited is peer group risk, that it is risky to act differently than the peer comparison group. This is not acceptable as there is little evidence that managing peer group risk enhances member’s retirement outcomes.
This is an interesting example of how lifecycle theory, where we think about all the factors which may affect our outcomes, should lead to different portfolios for people working for different companies and industry sectors. And while I relate it back to theory (that’s the academic in me), it is all just common sense. Don’t put all your eggs in the one basket, or to stretch the idioms, don’t get your butter from where you earn your bread. In superannuation, SMSF’s have the greatest ability to specifically manage this risk, as they have complete investment flexibility. Financial planners should incorporate it into their risk assessment. This is an important issue for corporate superannuation funds to consider. And there is an exciting opportunity for industry funds to be more member-focused than retail funds.