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After a disappointing 2011, which resulted in the second negative calendar year return in only four years, super fund members can be forgiven if they start to question their fund’s publicised performance targets. While funds will naturally be wary not to over-promise, they need to get the message across that, while recent returns have been unusually bad, they don’t necessarily signify a ‘new normal’.

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We talk regularly to funds and their asset consultants, and while their medium-term forecasts may be tempered by the current climate, we do not believe they are significantly changing their long-term risk and return forecasts.

What they are doing, however, is making medium-term asset allocations changes with a view to increasing the likelihood of those objectives being achieved. We’ll comment on that in more detail later, but first it may help if we put the recent returns into a longer-term context.

Performance objectives are set for the long term, and to judge whether funds are meeting those objectives we really need to look as far back as we can. The earliest reliable data we have dates back to the introduction of compulsory super in July 1992.

Chart 1 shows the median growth fund performance for each of the 19 full calendar years since 1992, together with the average return and average CPI increase over that period.

The annualised return over that period was 7% and the annual CPI increase was 2.7%, giving an average real return of 4.3% per annum. So the return target of CPI + 3.5% has been exceeded over that 19 year period.

That knowledge may provide some reassurance that the target is achievable. More comfort may be drawn from the fact that the disastrous 2008 year will gradually work its way out of the picture. It has already dropped out of the 3-year averages, and over the next few years it will drop out of the 5- and 7-year averages as well. In time, we would expect the performance numbers to be more ‘normal’ and to align more closely with the funds’ stated objectives.

Chart 2 shows how rolling 5-year returns compared with CPI + 3.5% and highlights how underperformance against stated objectives is likely to continue for some time.

In addition to return targets, funds also have risk targets. Typically, for a growth fund, this would be to post a negative return no more frequently than one in every 5 or 6 years on average. Chart 1 shows there were four negative years out of the 19, which averages one year in almost five, so the risk objective was very nearly met. Again, it’s worth noting that three of the four negative years occurred in the past decade, which included both the GFC and the ‘tech wreck’. Of the previous nine years, only one was negative. So when we talk about objectives like ‘a negative return once in every 5 years’, it’s important to remember that we’re talking averages, not a predictable regular occurrence.

An average return of CPI + 3.5% is quite a challenge, but it is necessary if workers are to achieve a modest standard of living in retirement. Australia’s retirement system is much admired, but even so most current workers will end up with a ‘savings gap’ and will have to rely on the Age Pension to supplement their retirement income to some extent.

An increase in the Superannuation Guarantee rate from 9% to 12% will help younger workers achieve their desired retirement nest egg, but achieving this still requires that default growth funds produce real returns in the order of 3% to 4% per annum, on average.

That requires them to invest substantially in growth assets, typically with a growth / defensive assets mix of about 70/30. While that mix hasn’t changed much in recent years, what has changed is the nature of those assets. One notable development has been the increased exposure by industry funds, in particular, to unlisted and alternative assets, partly as additional sources of return but also for their diversification benefits which help to reduce risk.

The benefits of that diversification were clearly evident in 2011. Although both Australian shares and international shares fell, by 11% and 5.3% respectively, by being well diversified across a wide range of growth and defensive asset sectors, the loss for the median growth fund was limited to just 1.9%. So although shares remain the main drivers of growth fund performance, funds do have the means to ‘smooth out the bumps’.

Conservative funds have done even better in terms of achieving their return targets. Chart 3 compares the median conservative fund (which has a 21 to 40% exposure to growth assets) with its typical objective of CPI plus 2% per annum after fees and taxes over rolling three year periods. It shows that these funds have been ahead of target most of the time over the 19 year period. Because of their 3 year timeframe, the 2008 year has now dropped out of the equation, so performance has again moved above the target line.

Over the 19 years there have been two negative returns, in 1994 and 2008, meaning that the risk target of no more than one negative year in every 10 has also nearly been achieved.

The 2011 calendar year favoured cautious investors who limited their exposure to the world’s share markets. While most super fund members will have experienced negative returns, those who chose more conservative options – most likely because they have shorter investment timeframes – fared somewhat better.

The median growth fund was down 1.9% for the year, mainly on the back of negative returns from shares. Given that Australian shares fell 11% and international shares fell 5.3%, these funds actually did quite well to restrict their losses to the level they did. As mentioned earlier, that’s largely because of their diversification into other growth assets beyond listed shares. In 2011, unlisted property, unlisted infrastructure and private (i.e. unlisted) equity all produced quite strong positive returns which helped to counteract the negative returns from listed markets.

The median conservative fund posted a modest gain of 3.0% in 2011, largely due to healthy returns from Australian and international bonds, which both delivered double-digit returns. The steady performance from conservative funds is especially important for the many retirees and near-retirees who, quite sensibly, have moved their money to risk-averse investment options that are more suited to their stage in life.

The table below shows the performance of the main asset sectors that funds invest in. We have used market indices for all sectors other than for private equity and unlisted infrastructure. For those categories, we have used the returns of a major fund in our survey that are representative of those sectors.

The key points to note with regards to asset sector performance for the 2011 calendar year are:

• Of the traditional asset sectors, Australian and international bonds (hedged) were the strongest performers, returning 11.4% and 10.5% respectively
• The Australian share market was down 11%
• International shares were down 5.3% in both hedged and unhedged terms
• Listed property was mixed with Australian REITs down 1.6% and global REITs up 1.4%
• Unlisted assets continued to see upward revaluations throughout the year, and posted near double digit returns.

Unlisted assets clearly had a stabilising effect on fund returns in 2011. These are assets that are revalued regularly but not frequently, and those valuations tend to lag what’s happening in listed markets. Future valuations will be affected by whether listed markets recover – and if so how fast – from their current troughs. If they recover quickly, then unlisted asset values may only dip slightly, if at all.

As we’ve explained, 2011 was a year when it paid not to have too much exposure to listed shares and property. That worked to the advantage of industry funds compared with master trusts. Industry funds, on average, are 53% invested in listed shares and property compared with 62% for master trusts. This was an important factor in them outperforming master trusts, returning -0.7% versus -3.1%.

Over 10 years to the end of 2011, industry funds outperformed master trusts by 1.4% per annum, returning 5.3% against 3.9%. On a year by year basis, they have come out on top in six out of those 10 years, with one year (2006) resulting in a tie.

The difference in performance between the two groups is closely linked to the movement in listed share markets. This is illustrated in Chart 4 , which shows the inverse relationship between share market performance (which in the chart is based on a 50/50 split between Australian shares and unhedged international shares) and the industry funds’ outperformance.

Over the longer term, the strategic allocation policies of industry funds have served them very well. Not only have they benefited from their lower exposure to listed shares, as we have seen, but also their higher allocations to unlisted assets such as private equity, unlisted infrastructure and unlisted property (20% versus 3% for master trusts) have added to performance and reduced volatility, or risk. This investment mix does mean slightly higher investment costs, but those extra costs have been more than justified by the added benefits.