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.
2. 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.
3. 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.”
4. 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.
5. 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.
6. 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.
7. 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?’
8. 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.
9. 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.