The combination of increased regulation and geopolitical risk is weighing heavily on smaller Australian superannuation funds, according to industry players. Pressure to perform is only likely to accelerate the pace of fund mergers, they say.
A major contributor to this increased pressure is the new seven-year performance testing regime from the prudential regulator APRA, designed to highlight underperforming super funds.
“The performance test forces investors to be more focused on where they are taking tracking error risk,” said Steven Carew, senior advisor at Monash Business School, at an online superannuation investment strategy session.
“So within an asset class, if you are going to appoint active managers to try and outperform the index, you have to be confident you will get that return.”
APRA is actively pushing small underperforming funds to merge with larger funds, and this is already yielding results. Seven of the 13 funds that failed the initial tests last August have since merged.
According to a study by KPMG, there were at least 15 fund mergers announced to the market in 2021, the most activity seen in a single year. But following the activity in 2019 to 2020, which was characterised by large-scale, like-for-like fund mergers, 2021 saw a greater number of smaller funds consolidating.
A PASSIVE WAY FORWARD
The funds that fare well in the test have more scope to not necessarily react to some of the issues the performance test highlights, said Suzanne Branton, chief investment officer at CareSuper. “But if you are close to failing, then your world becomes very performance test-focused. And that pressure will naturally drive funds to go passive.”
She added that this trend raises other issues. “I think there’s some structural change happening in Australia’s investment management industry. There’s less active management generally, and I think that raises questions about the efficiency of capital markets. They are being deeply impacted by some of these trends.
“It also plays into the tendency for the consolidation that is happening, leading to a large number of smaller funds where investment strategies have become more homogenous and perhaps also more passive.”
Naturally, the funds that have failed the test have mostly been smaller funds “that were probably thinking in the back of their minds about a restructuring, but this is really accelerating this process,” said Carew.
The consolidation of super providers is a concern, said the panellists, since it reduces the choice and competition among funds.
“You are getting a smaller number of very large funds. That has some advantages, because of economies of scale, but it does increase the systemic risk of the super sector becoming more like the banking sector, where you’ve got a market dominated by a smaller number of very large funds.”
Another result of the performance test is that it becomes harder to invest in assets that are not well defined in the test, said Carew.
“For example, private equity, which a lot of super funds want to invest in, is benchmarked against listed equity. So, you are taking quite a significant tracking error or benchmark risk when you invest in smaller, higher-risk companies that are often revalued perhaps once a year, against a market index that is dominated by large companies and is being repriced every minute.”
A WHOLE NEW WORLD
These issues, combined with the increasingly volatile and uncertain global political scene, present a challenge for asset owners, said Branton. How do you reposition your fund for the lower-multiple world?
“The job for us is to identify the active managers who can isolate the fundamental value companies: those companies that are relatively inexpensive in the context of their future earnings.”
This lower earnings-multiple world has implications for the structure of investment returns, she added.
“In this scenario of lower multiples, more of the investment return is going to be comprised of the profitability of a company, or the rental on their property, or the coupon of the bond. It will be driven more by those real cash flow, money-earning, tangible dynamics. And I think the greater focus on the reliability of those elements of return will be a key consequence of the changing market conditions.”
THE CHINA FACTOR
A major concern for all global investors remains not Russia, but China, she said. Chinese investment in Australia has declined 70% in the past five years, and investors have to assess what this means for their portfolios.
“China is 40% of the global emerging markets index, so it’s a much bigger exercise when you talk about portfolio impacts. I think everyone is focused on what the future holds and how to price China risk. It’s a difficult question and I don’t think the industry has solved it yet.”
Announcing its latest quarterly result on Monday — a -1.5% return to 31 March 2022, softened by a 11.8% annual return compared to the fund’s 9.1% target — the Future Fund’s CEO Raphael Arndt said the fund has been adding to its alternatives strategies.
“We continue to identify opportunities to access value from less liquid and more skill-based investments,” he said.