Swings and roundabouts – how quickly fortunes can change
As we approach the second anniversary of the onset of the global financial crisis, what have we learned – apart from the fact that markets are inherently volatile? One lesson is that we should never jump to conclusions about the superiority of one investment approach over another. Heroes can quickly turn into zeros in the fast-moving world of investment.
Markets move in cycles, and so do the fortunes of those who invest in them. We have seen an extreme demonstration of that over the past couple of years. Starting from November 2007, listed share and property markets around the world plunged as the GFC and its consequences took hold. All super funds were affected, but those that fared worse were the ones with the highest allocations to listed assets. And for the most part, that meant the commercial master trusts (or retail funds).
Their competitors, the not-for-profit industry funds, also invested in listed assets but to a significantly lesser degree. In our December 2007 strategic asset allocation survey, we found that the average master trust growth fund (defined as having 61 to 80% in growth assets) had a target allocation to listed shares and property of 67%, against 57% for the average industry fund.
Industry funds allocated more of their portfolios to direct property and infrastructure and private equity – 18% against 2%. These unlisted assets are priced on fundamentals, with none of the emotion that drives listed markets, and they are also valued infrequently (typically, annually or quarterly) and in arrears. So when fear took hold and listed asset prices plunged, their unlisted equivalents were barely shaken.
The most telling example is property. From the end of October 2007 to the end of February 2009, Australian listed property securities fell by a massive 70.5%. Unlisted property, over the same period, actually rose by 5.3%.
While there are some technical differences (particularly the much higher gearing level of listed trusts, which accounted for a material part of the performance difference), we are essentially talking about comparable properties held in different vehicles and valued in different ways.
As shown in Table 1 below, with their higher exposure to listed markets, master trusts as a group were trounced by their industry fund rivals over a 16 month period that only ended when those markets bottomed out in February this year. The median master trust growth fund lost 31.5% between the end of October 2007 and the end of February 2009, while the median industry fund lost ‘only’ 22.9%.
But then, the pendulum started to swing back
From the beginning of March this year listed markets have staged a remarkable recovery – and so have the fortunes of the beaten-up master trusts. In the seven months from the end of February to the end of September, the median master trust rose by 24.1% against 15.7% for the median industry fund. These gains are, of course, from a low base and there is still a long way to go before we get back to pre-GFC levels. Nevertheless, they are impressive, and would be even better but for the strength of the A$ which dampened the returns from unhedged international assets.
To show how far the pendulum has swung, when we look at the one year returns, we can see that master trusts are not only back in positive territory but have also overtaken industry funds – by 1.5%. They can hardly wait, either, for the October 2009 returns to come in because the 12 month data will then drop off the October 2008 numbers. That was a dreadful month for master trusts in which they lost 8.5% against 5.5% for industry funds. A 3% differential in a month is unprecedented, and reflects just how hard master trusts were hit when world sharemarkets ‘fell off the ledge’ after the collapse of Lehman Brothers.
| Table 1: Returns over the past 23 months (%) |
| Segment | 16 months (31 Oct 2007 to 28 Feb 2009) | 7 months (28 Feb 2009 to 30 Sep 2009) | 23 months (31 Oct 2007 to 30 Sep 2009) | Return still required at 30 Sep 2009 to recover to 31 Oct 2007 levels |
| Industry Funds | -22.9 | 15.7 | -13.0 | 14.9 |
| Master Trusts | -31.5 | 24.1 | -13.9 | 16.2 |
Note: Performance is shown net of investment fees and tax. It does not include administration fees or adviser commissions.
If we assume both groups deliver similar performance in October 2009, the removal of the October 2008 data would see master trusts ahead by over 4% over the one year period, as shown in Chart 1.
Looking ahead over the next six to 12 months, it is quite possible that master trusts will continue to outperform. That is because the performance of unlisted assets may continue to trend down at the same time as listed markets trend up. We believe the downward revaluation of unlisted assets still has a little further to go, possibly bottoming in the next six months, so this will be a drag on industry funds’ performance for some months yet.
“We told you so”
Master trusts would argue (and are arguing) that the tide was always going to turn in their favour and it was only a matter of when. Trustees who have sat through countless uncomfortable meetings with their master trust managers are now hearing, in one form or another, the message “we told you so”.
That is not to say that master trusts have just sat idly by and waited for listed markets to recover. Many of them have started to go down the path of including some unlisted assets in their investment mix. Whether they will do so as successfully as industry funds remains to be seen. They generally have less experience in that type of investment, and there is also the question of whether there are enough good quality assets available to buy at a reasonable price. So while the intention may be there, the execution could take some time.
Master trusts are ‘changing their spots’ in another way, too, by showing a preparedness to be more active with their asset allocations. Some of the outperformance of industry funds over time can be attributed to them making medium-term ‘tilts’ to their allocations when they have judged that particular markets were significantly over- or under-valued. Most master trusts, on the other hand, have tended to set strategic allocations with fairly tight constraints and regularly re-balance back to those allocations. That’s starting to change now, and they too are beginning to be more active. Although, it could take some time to build up the necessary expertise.
Longer term, do industry funds have a sustainable advantage?
If we shift from the short-term swings and roundabouts and focus instead on the long-term picture, we find that industry funds have a history of stronger performance. Over 10 years to the end of September 2009, they outperformed master trusts by just over 1% per annum, returning an annualised 6.5% against 5.4%, as shown in Chart 2. The Chart also highlights how strongly industry funds have performed in a relative sense when listed markets were spiralling downwards – for example, at the height of the tech wreck and the GFC.
The key question is: Where has that outperformance come from and is it likely to be sustained?
While the differences in approach between the two camps are narrowing, there is an argument for thinking that industry funds may still have an advantage over the long term based, in a sense, on the way they think.
First, they and their asset consultants tend to be ‘early identifiers’ of new sources of return and diversification (although, with the latter, this is mostly valuation lag and, thus, illusionary to some extent). Second, they are likely to be more active with their approach to asset allocation (particularly medium term ‘tilting’). Finally, they will probably continue to be less constrained than their master trust counterparts by concerns about liquidity. That is, they will benefit more from the ‘illiquidity premium’.
Master trusts and their institutional owners are generally more sensitive about liquidity because they have more experience of what problems a lack of liquidity can bring. They also believe that investors value liquidity highly. Whether it is memories of unlisted property trusts in the 1980s or more recent redemption freezes in credit-backed funds, they just know that illiquidity is something to be avoided. For that reason, they are unlikely ever to go as far down the path of investing in illiquid, unlisted assets as have industry funds.
To that extent they will miss out on some of the illiquidity premium that those assets deliver – maybe 0.5% per annum – and also their diversification benefits. If we bear in mind that diversification reduces risk and allows you to divert some of your risk budget to other sources of return, there is an argument that a significant exposure to unlisted assets is likely to result in superior returns over the long term. We would say, for most funds, the maximum exposure should be 20 to 30%, and perhaps a little more for funds with particularly strong cashflows and a relatively young membership.
Based on the form guide, therefore, industry funds may well continue to outpace master trusts by a small but meaningful margin over the longer term. What we do know is that master trusts will be doing all they can to prove the form guide wrong. We know of several that are just waiting for the right time to invest in alternatives, which isn’t far away. Meanwhile, as Table 2 (on page 4) shows, the recovery to pre-GFC levels still has a long way to go. The Australian share market, for example, has risen nearly 47% since the end of February but still has to improve by another 30% from here to reach its October 2007 level.
| Table 2: Market index performance over the past 23 months (%) |
| Asset sector | 16 months (31 Oct 2007 to 28 Feb 2009) | 7 months (28 Feb 2009 to 30 Sep 2009) | 23 months (31 Oct 2007 to 30 Sep 2009) | Return still required at 30 Sep 2009 to recover to 31 Oct 2007 levels |
| Australian Shares | -47.6 | 46.6 | -23.1 | 30.1 |
| International Shares Unhedged | -32.8 | 9.3 | -26.6 | 36.2 |
| International Shares Hedged | -50.9 | 42.1 | -30.3 | 43.4 |
| Australian Listed Property | -70.5 | 52.5 | -55.0 | 122.2 |
| Global Listed Property Hedged | -65.0 | 65.3 | -42.2 | 73.1 |
| Unlisted Property | 5.3 | -9.5 | -4.7 | 5.0 |
| Australian Bonds | 15.5 | 0.5 | 16.1 | n.a. |
| Global Bonds Hedged | 10.6 | 7.3 | 18.7 | n.a. |
| Cash | 9.6 | 1.9 | 11.6 | n.a |
Note: Performance is shown in gross terms.
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