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When good defensive investments go bad

The 2017/2018 financial year was a bumper time for many fund managers, but something else jumped out at us when reviewing performance figures. When the worst equity manager returns 5%, you know it has been a near-perfect year. It’s the same in all classes with balanced super funds doing 10%+ and small cap funds returning between 10% and 35%.

But what really stands out is the best-performing Australian equity managers (Bennelong, Platypus and Colonial First State) achieved between 23% and 26%. In our experience, widespread 20% returns usually signal the ‘start of the end or the end of the start’. It’s not quite 2006 and 2007 when the median super fund returned 14% p.a. or 1987 when some equity funds hit 50% returns, but we’re reaching the stage where markets are in that swampy area between complacency and hubris. When things go pear shaped, everyone will say that it was oh so obvious.

Great year(s) fellas!

Manias affect all investors to some extent, so it’s unfair to point out individual examples, but the 2007 - 2010 period produced some wonderful examples of what happens at the end of complacency. MTAA was a large industry superannuation fund which had made a more extreme asset allocation than its peers. It was heavily weighted to alternative assets such as private equity and infrastructure. The fund was only 4% invested in traditional defensive assets. Everything else was either ‘growth’ or ‘alternative’ with 45% of the portfolio in illiquid assets (alternatives, PE, property etc.) with a large derivative overlay. It was working well too. By 2007, the fund had returned 17% p.a. for the previous four years. Maybe the investment team thought illiquid and alternative assets were safe, or maybe they thought it would never end. We remember contacting them (or their advisers) and were told politely that they only invested in assets that generated returns greater than 10%.

It didn’t work out for long though. The Fund generated a -23% return in FY2009 (and it was worse intra-year) and it took five years to generate returns higher than the low single digits, by which time equity markets had generated 20%+ gains. The investment return for the decade to 30 June 2017 was a meagre 2.4% p.a.

When good assets go bad

You would have expected the ‘true’ growth assets like equities to get shredded by the GFC, but they recovered quite quickly. What really killed MTAA was the exposure to alternative assets which were, or still are, considered ‘safe’ investments. The table below shows the capital gains and losses (in $ million) attributable to the alternative asset classes for each year.

Alternative and illiquid assets

Alternative and illiquid assets

Source: MTAA Annual Reports.

There were a couple of pertinent points:

  • The divergence between the domestic and international versions of the same asset classes is enormous. Australian infrastructure bounced quickly (which is what you would expect as interest rates fell), but international infrastructure was still generating losses almost five years later. Similarly with property. While the Australian version was fine, international property was double digit negative.
  • Given the point above, it’s interesting to speculate on why Australian ‘alternative’ assets in the post-GFC period did so well. Maybe they are genuinely low risk, maybe they were saved by the lack of a real recession or continued cash inflows into the sectors meant that prices never fell. We’ll find out the real reason some time in the next decade when markets falter.

The biggest saviour

The only reason MTAA did not end up a total rout was that the fund maintained its cash inflows. This was a combination of the super guarantee cashflows which are virtually impossible to turn off, and super fund reporting, which is well after the event. For most super fund members, the reporting comprises a colourful brochure once a year and which most recipients either don’t understand or throw in the bin. Few people withdrew their money from MTAA, which meant that the capital losses in 2008, 2009 and 2010 were spread out on a wider denominator and the 22% loss was much smaller than it otherwise might have been if their liabilities were more liquid.

Investment drivers

Investments are driven by factors which will determine their ultimate return outcomes and how messy the path is. For example, investment-grade bond returns are driven by duration and how likely an investment-grade company will default (not very often). The path is also influenced by sentiment. So, the ultimate returns of investment-grade bonds are stable and the path variability is driven by the duration.

Alternatively, equity and infrastructure value is driven by the economy and management and wars and politics and demographics, etc. Sentiment and risk aversion drives the path, and because they are very long duration, both the ultimate value and messiness of the path are highly variable and unknown. The example in the MTAA case is the offshore infrastructure which lost money for at least five years.

The implications for hybrids

We believe hybrids are closer to investment grade bonds with respect to ultimate returns, but they have other factors of not only default risk but near-death experiences with the issuer that will affect return outcomes. Their path is also affected by sentiment, but because of their shorter duration, they are far less volatile than equities. Which is why in the past 20 years, hybrids have had bad years, but they have tended to only last one year.

The other read is that investors should demand big premiums for illiquid investments, but they don’t receive premiums except in the immediate aftermath of a crisis. They then get hit by the next crisis and either scratch their heads or complain. It’s a non-trivial outcome as can be seen by the MTAA post-decade return of 2.5% p.a. driven by their exposure to illiquid assets at the wrong time of the cycle. Hybrids were more liquid than Australian corporate bonds in the last liquidity crisis and arguably more liquid than high yield bonds are now.


Campbell Dawson is Executive Director at Elstree Investment Management Limited. This article is general information and does not consider the circumstances of any individual investor.


Long-term investors fail to reap their natural advantage


John B

August 11, 2018

Particularly good discussion on the points raised by Warren and similarly Graham.
I'd like to support both points of view.
On reading the original article I'd didn't feel that Graham was casting aspersions directed at MTAA for what it's worth.

Warren Bird

August 10, 2018

Can I ask why the article has been given the title that it has? Infrastructure and private equity are not "defensive" assets. So how can they be regarded as 'good defensive assets gone bad' ? As I understood MTAA's strategy at the time, they held these assets as part of an intentionally aggressive portfolio, built for long term objectives. A quick re-read of their 2011-12 annual report (from their website) confirms that these assets, held in their Target Return Portfolio, were always described as 'high risk'.

The Board and Executive at MTAA weren't and aren't quite so silly as to regard the highly illiquid assets they held as playing the sort of role in their portfolios that the term defensive usually implies. That doesn't mean they got the right mix of assets or that they were sufficiently diversified to manage the risks as well as they might have, but the implication in the article seems to be that they somehow misled their investors and that assets that were meant for one purpose didn't deliver what was promised. That's not correct.

If one player in our industry is going to cast aspersions on another, it should be done more accurately than in this article. Though my preference would be for articles that neither promote the author's own products nor denigrate someone else's products.

Graham Hand

August 10, 2018

Hi Warren, the article is a discussion of what constitutes a 'defensive' asset, and whether some assets which might be considered defensive if equity markets fall indeed have 'defensive' characteristics. These include alternatives, private equity and property. As it turned out in the GFC, they were not as defensive as some expected, at least in the near term. The heading says what might be considered a 'good' defensive asset can turn 'bad' in a crisis like the GFC. Most investors were surprised when correlations on all asset classes went towards 1.00.

Geoff F

August 11, 2018

Have always had concerns about classifying "private equity" as an asset class itself, I think there has been at least one Cuffelinks article on this.
Surely the asset class of the private equity vehicle is dependent on the assets inside the PE vehicle.

Warren Bird

August 12, 2018

Classifying assets like those as defensive when they shouldn't be and then pointing out that they're not defensive is a straw man argument.

I'm also not sure why MTAA's portfolio was singled out, when as far as I can tell MTAA didn't call these assets defensive. They had a tough time with them, for sure, but not because they had them in the wrong risk bucket.

And yes, the GFC was an awful time for all assets except government bonds. Even cash looked a bit shakey until governments stepped in with guarantees on the banks. What's the point of an article that says when everything goes sour don't expect anything to perform? Especially one that then tries to argue that one asset class, which in my view is risky as well, should be looked at favourably. There is not link to that argument whatsoever.

John G Bone

August 11, 2018

Good afternoon Warren.
Intelligent reply.
Would you be willing to comment upon an old response to Roger Montgomery.
Thank you for allowing further communication
I enjoyed reading your article of 11th August 2016.
You wrote:
Paragraph 5. Continued buying of US government debt issues has taken the average bond yield on US Treasuries from around 1.5% two years ago to 1.1% now, but this has been demand from the market, not the Fed.
My question:
The US government sells debt ( bonds?) to the market. Does this mean that there is a reduction in cash in the economy and an increase in yields? Why would the bond yield fall?
Thanks in advance.
John Bone

Warren Bird

August 12, 2018

From memory, my point in that response, John, was that yields had fallen because there was sufficient demand for the bonds that were issued that their price was bid higher/yields bid lower. This happened even after the Fed had stopped buying, so yields weren't low merely because of central bank activity. Private investors in bonds had their own reasons for being happy to acquire them even at all time low yields.

IFA Adviser

August 13, 2018

Back in June 2007 I prepared a pre retirement plan for a new client couple. Between them they had super with Asset Super, First State Super as well as an existing SMSF and they were seeking super consolidation advice. I recommended consolidating into their existing SMSF and diversifying further (had only commercial property and ASX shares). One member was keen on their SMSF but the other wanted to go with MTAA. They both had balanced risk profiles. MTAA had been chosen simply due to it being the top performer by a country mile. When I tried to talk them out of MTAA by explaining why they were outperforming and the risks that meant, they declined further advice. As I suspected, they were severely burnt by the MTAA experience. One of the biggest issues we have as advisers with industry funds is the misleading labelling of investment options. I can guarantee you that high risk was not on their website fund descriptions in 2007. I fear consumers have not learnt this lesson and we will see unlisted assets drag down performances again.


March 13, 2019

Warren, from clients burnt in MTAA and still clients of mine since 2011. I can guarantee too that MTAA in 2011 did not label the Target Return Portfolio as High Risk - some exact wording from MTAA includes: Target Return Portfolio Asset Clusters - "Infrastructure investments generally deliver annuity returns underpinned by ongoing public use, often in circumstances having monopoly characteristics. Unlisted infrastructure assets include airports, toll roads, marine ports and utility assets".
To use wording like Annuity Returns is incredible deceiving and trying to label high risk Infrastructure as acting like defensive annuity assets.
Hostplus has 15% out of its so called 25% Defensive Assets in Property, Infrastructure and Alternatives and then the 5% of the so called Defensive Credit assets include High Yield and Structured debt. (Remember the GFC?)
So by my Asset allocation and also what you are saying Warren, these are not Defensive assets. So how about go check out these ongoing ISA Fund problems as i think there are some big issues to play out in the next down turn.
And yes indeed some Industry Funds are guilty of passing off Unlisted and Alternative Assets as Defensive Assets.

SMSF Trustee

August 09, 2018

Without the income levels, then data on capital gains can be misleading. Hence Geoff F's question.

If those losses in enhanced cash were less than the income, then that means they still made a positive return. During a year when risk assets (anything but cash and government bonds) got smashed, that would be a very acceptable outcome from cash-enhanced products.

If those losses were more than the income, then that could still be OK if the specific product or mandate made clear that it took enough risk that a negative year during a 'tail risk' event was possible, in the pursuit of cash-plus returns over time. If, however, the product wasn't meant to get hit that hard, then that's a potential issue.

What beats me about this article is how it gets turned, without any justification at all, into a marketing spin for hybrids! Show a bunch of misleading data, let people infer that the strategy of one fund proves something about a whole asset class, and then say that a concentrated exposure to another asset class would be better - sorry, I don't buy that at all.

campbell dawson

August 09, 2018

The amounts are the realised and unrealised capital gains from each asset class listed . They don't include the realised and unrealised capital gains from the "non alternative" asset classes ie domestic and international equities and fixed interest. It also doesn 't include the income from those assets.
The amounts include the realised gains/ losses for investments sold that year and unrealised gains/losses on investments held at the end of the year.
As it happens they had >$600m of realised and unrealised capital losses from equities in 2008. This resulted in net capital losses in 2008


August 09, 2018

That table of returns for alternative assets – is that their (ie MTAA) $ returns from those asset classes? – or their benchmark returns?

· If it is the former – you mean they had a $28m loss from ‘enhanced cash’ funds

· But in 2008 the $250 gain from ‘Derivatives” more than outweighs the losses from all other sectors – so the net return was positive (?), but wasn't it a negative year for their fund returns

· Are they mark to market gains/losses – or are they net changes in values (including sales, etc) ?

Campbell Dawson

August 08, 2018

Geoff: Enhanced Cash funds usually had cash plus credit type investments. which were floating rate, so were immune to changes in bond rates. This resulted in a higher headline yield than pure cash. However lots of credit investments cheapened in the aftermath of the GFC and then reverted in value.

Geoff F

August 11, 2018

Thanx Campbell, I suspected as much.
I guess one lesson is that if an investment option has more descriptors/words in the name than "Cash" alone, then it may well indicate that the investment option also holds non-cash assets, implying that in a significant downturn, even a supposed "cash" option could be negatively impacted. Always read the fine-print ...
In the past month or so, there have been several articles in the "Australian" newspaper on this very issue.

Geoff F

August 07, 2018

How did "enhanced cash" go so negative in 2008 and 2009? What was the cash "enhanced" by?!


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