Investment targets stand the test of time
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’.
Most funds set quantitative investment objectives that they make public to their members and to the outside world. Those objectives are important because fund performance is one of the three key variables – the others being contribution amounts and how long the money is invested – that will determine the size of any individual’s nest egg at retirement. That, in turn, will decide how comfortably they can afford to live and how long their savings will last.
The typical return objective for a growth fund (the default option that 80% of members invest in) is to beat inflation by 3 to 4%, say 3.5% on average, after investment fees and tax over rolling five year periods. In recent times, funds have failed to achieve that objective, and it is important to understand why.
GFC ‘black swan’ event still dominates
The answer is that the performance tables are still dominated by the damaging ‘black swan’ event that was the global financial crisis. As Chart 1
shows, the GFC resulted in a huge negative return of 21.5% in 2008, which was unprecedented in the modern era. That figure drags down the medium- and long-term averages, and will continue to do so for a few years yet. But the disappointing numbers don’t mean funds are failing their members or that their performance targets need to be revised.
Investment objectives aren’t plucked out of the air. Rather, they are the result of sophisticated modelling by the funds and their asset consultants based on historical asset sector returns, volatility and correlations together with forward-looking measures such as economic growth forecasts. So, in the light of recent experience – including the GFC – are funds revising their objectives?
No, they’re not. While average returns over the past 5, 7 and even ten years don’t look particularly healthy they still fall within the statistical range of expectations.
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.
Recent returns in 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.
Recent volatility in context
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.
Why set the bar so high?
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 also ahead of target
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.
Caution was the watchword in a tough year for shares
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.
|Asset Sector Performance (Results to 31 December 2011) |
3 Mths (%)
6 Mths (%)
7 Yrs (%pa)
10 Yrs (%pa)
|Australian Shares |
|International Shares (Hedged) |
|International Shares (Unhedged) |
|Private Equity |
|Australian REITs |
|Global REITs |
|Australian Unlisted Property |
|Global Listed Infrastructure (Hedged) |
|Unlisted Infrastructure |
|Australian Bonds |
|International Bonds (Hedged) |
|Hedge Funds |
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.
Industry funds’ asset mix helps them outperform master trusts
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.
© Chant West Pty Limited (ABN 75 077 595 316) 2013. You may only use this document for your own personal, non-commercial use. This document may not be copied, reproduced, scanned or embodied in any other document or distributed to another party unless you have obtained the prior written consent of Chant West to do so.
The information above is based on data supplied by third parties. While such data is believed to be accurate, Chant West does not accept responsibility for any inaccuracy in such data. Past performance is not a reliable indicator of future performance. The products, reports and ratings do not contain all of the information that is required in order to evaluate the nominated service providers, and you are responsible for obtaining such further information.
This information does not constitute financial product advice. However, to the extent that this document may be considered to be general financial product advice then you acknowledge that you have been provided with a Financial Services Guide
and Chant West warns that: (a) Chant West has not considered any individual person’s objectives, financial situation or particular needs; (b) individuals need to consider whether the advice is appropriate in light of their goals, objectives and current situation; and (c) individuals should obtain a Product Disclosure Statement from the relevant fund provider before making any decision about whether to acquire a financial product from that fund provider.