The GFC proved to be a wake-up call, especially for older members. Many of them decided they were uncomfortable with their fund’s default option and switched to something more conservative. They would be viewing the market turmoil in the early weeks of this financial year and being thankful their accounts have fallen by ‘only’ 1 or 2%, not the 4 or 5% declines suffered by many default options.

The great majority of members, however, remain in default options that on average have about a 75% allocation to growth assets and are experiencing severe volatility.

Funds need to think seriously about how best to manage those members’ expectations. Apart from reviewing their communications and educational material, this may be an opportune time to revisit those default options, or at least review their risk profiles.

Most risk profiles are expressed in terms of the probability of a negative annual return. While those probabilities are forward looking, they do take into consideration long-term historical data. It is too early to say whether more volatile markets will lead to more negative returns, but maybe the way risk is expressed needs to be re-examined in the light of modern-day market reality.

This heightened volatility is illustrated in Chart 1, which plots the median monthly returns of our growth fund (61% to 80% growth assets) universe over the past 15 years. The chart clearly shows the increased volatility of monthly returns since the onset of the GFC in November 2007.

A similar picture emerges when we look at how the pattern of volatility has changed over time. Chart 2 plots the standard deviation (observable risk) of both growth and conservative funds (21 to 40% growth assets) over rolling 5 year periods. Again, the heightened volatility in recent years is plain to see. The chart shows that for growth funds, the observable risk has increased sharply over the past four years from about 4.5% per annum to about 8% per annum.

It’s true that there have been only 3 negative financial year returns in the past 15, but all of those have occurred in the past 10 years and the 2002/03 return was effectively flat, as shown in Chart 3. So while the typical risk objective has been met (a negative return once in every 5 or 6 years on average) it probably doesn’t feel like that to the average member.

Market commentators generally agree that the debt crisis confronting Europe and the US is likely to play out for years, and that the heightened level of volatility will continue while it does. We have already seen dramatic examples of that in the early weeks of the 2011/12 financial year. Whether it results in another negative year remains to be seen.

Meanwhile, members will soon be opening their 2011 statements and looking at positive returns which, within the growth category, ranged from a low of 6.6% to a high of 12.5%. The median growth fund return was a respectable 9.2%. Every fund category, from all growth to conservative, produced a positive result over the year, as shown in Table 1.

Over the 2010/11 financial year, industry funds as a group outperformed retail master trusts (for the eight time in the past ten years), returning 9.5% versus 9.0%.

Over the past ten years, the outperformance amounted to a significant 1.3% per annum (5.6% versus 4.3%). This can be attributed largely to industry funds’ preparedness to invest significantly more in unlisted assets such as property, infrastructure and private equity (19% versus 3% for master trusts). These unlisted sectors have outperformed listed markets over the longer term and again delivered solid returns in 2010/11, as shown in Table 2.

Industry funds are able to invest more in unlisted assets because they have more stable memberships and relatively stronger cash flows than master trusts. Industry fund net contributions represent about 8 to 9% of their average net assets, compared with 4 to 5% for master trusts. Industry funds inflows are also more stable, with over 80% coming from compulsory contributions, compared with about 50% for master trusts.

Apart from asset allocation, currency strategy was a key factor in determining how funds performed over 2010/11. The Australian dollar rose sharply against most major currencies, as shown in Chart 4, and this had a serious negative effect on returns for Australian investors.

Based on our most recent asset allocation survey, and applying that to the hedged and unhedged market returns, we estimate that the currency effect detracted about 3% from the typical growth fund performance over the year. Some of the better performing funds were those that took out more currency protection by hedging a greater proportion of their international share exposure.

In our most recent Actual Asset Allocation Survey which includes 55 growth options, we found that the percentage of international shares hedged ranged between 0% and 65%, with about 75% of funds having a hedge ratio between 20% and 50%, and the average being 30%.