(pictured: Laurence Wormald)
The evolution of Australia’s superannuation industry has had many twists and turns. Many of them have been of a policy or regulatory nature, but some major trends have reflected demographic and market shifts. Take the insourcing of investment management capabilities as an example.
Each of the top 10 not-for-profit super funds by asset size (which are the 10 with assets of more than $18 billion, according to the latest APRA figures from February this year) has a degree of internally managed investments. Many smaller funds have also insourced some of the active portfolio management of their assets in recent years.
A lot has been written on this topic, including about the main drivers of the insource decisions and what are the new risks which should be managed. One thing is certain: a lot more thought has to go into the governance of investment selection decisions and operations in an insourced environment, from front office through to middle office and to back office.
Some big funds have been actively managing money for a long time and have more recently widened the asset classes which are not outsourced. Some have switched from passive to active and others the other way.
All APRA-regulated funds must take responsibility for their members’ investments, however, whether outsourced or not. For most funds that have retained all portfolios in outsourced manager relationships, this still means a small team of investment professionals to oversee those relationships alongside their asset consultants and, perhaps, specialist advisors.
There’s even an interesting debate as to whether those who oversee external mandates should be separate or a part of the internal team of portfolio managers. That’s how complex super fund investments have become.
According to Lounarda David, the head of investment operations at Sunsuper, there is no one organisational design appropriate for all funds, so developing the right model and structure is critical to implementing and managing the ongoing costs and risks of an organisation, in such a regulated environment. “But, building an effective operating model within an appropriate governance structure will challenge many funds that in-sourcing their investment functions,” she says.
Before joining Sunsuper in 2014, and after leaving Mercer Sentinel, of which she was regional director, Lounarda was an independent consultant helping the fund and other financial institutions to identify suitable operating models, design structures, define responsibilities, develop procedures, build processes, develop internal capabilities, identify and manage risk factors and establish lines of accountability.
“The role of internal management at funds will change,” she says. “They will be split between fund manager and fund manager controller. And the role of the service providers will change. Their relationships will be tested.”
For instance, she says, “Custodians have built their capabilities to support internal trading, be it by a manager or a fund. But funds need help at both the business level and the execution level.
A good question is: who will do the due diligence on a fund’s internal investment team? External managers tend to be held to a high standard and level of accountability and subject to detailed due diligence scrutiny. Will this be the same for an internal team?”
Peter Curtis, the head of investment operations at AustralianSuper, has similar views. He was the inaugural chair of the committee overseeing the insourcing of up to 30 per cent of AustralianSuper’s (current) $100 billion under management, starting in 2013. Curtis told a custody conference in Shanghai that year that, while the savings from internal management for such a fund would be in the hundreds of millions of dollars, there were all sorts of new risks to be assessed, including cultural as well as operational risks.
Ian Silk, AustralianSuper’s chief executive, tells an interesting story that he and CIO Mark Delaney had met with some trustees of a big US university endowment prior to making their decision on insourcing. He says that the university staff, including professors, had protested against a big remuneration package afforded the successful investment staff of the fund. “You have to be prepared to write a cheque for $5 million [for bonuses],” he was told. You also have to be prepared to assess the internal staff with the same rigour you would show with external fund managers.
According to risk expert Dr Laurence Wormald of FIS, large super funds, like other pension funds and institutional investors around the world, are taking on many of the responsibilities previously the preserve of wealth managers, who make up the bulk of his customer base.
“Wealth managers are good at telling the story and then crafting products that help achieve that,” he says. “We can help because we give them a model that can scope out various scenarios. As super funds become more active in this space like wealth managers they will need more sophisticated tools across all asset types.”
Dr Wormald is head of research and quants for FIS’s asset management business globally, joining the firm prior to its acquisition of SunGard APT last year.
Australia is the market with the heaviest concentration of defined contribution (DC) schemes in the world. DC funds make up about 90 per cent of all super fund assets. This tends to give funds a risk profile which is not too dissimilar to big fund managers, even though their membership bases will tend to be a lot younger.
The main regulator for big funds, APRA, has been particularly vigilant in watching the liquidity of public offer super funds since the global financial crisis, but issues guidance rather than prescriptive regulations on liquidity. A rule of thumb, which depends to a certain extent on a fund’s cash flow through Superannuation Guarantee contributions, is that a public offer super fund should be wary of having more than 30 per cent of its portfolio in illiquid assets.
With an increasing demand for yield investments in the past few years due to very low, or negative, interest rates, there is concern that some super fund fixed income assets may not be as liquid as they have been historically.
A research report by Willis Towers Watson, the global asset consultancy, this year warns a crisis could be looming in the credit markets. The paper, titled ‘Capital Markets Liquidity’, says there is a concern that the supply of liquidity is no longer capable of satiating demand.
“This will become obvious and painful during periods of market stress where investors seek to re-position or realise cash from commingled funds offering overly generous redemption terms,” the paper says.
Daniel Kennedy, FIS Global sales director for asset management in Australia and South East Asia, says: “While Australia’s super funds are among the most sophisticated in the world, with experience across all asset classes, many are relatively new to in-house portfolio management, which introduces a range of new investment risks.”
They are also relatively new to middle office analytics and reporting which, in the past, may have been outsourced to a custodian but which are now being required by the front office professionals and the regulator.
The introduction of member direct investment options has introduced a new layer of complexity in investment choices, where funds may even consider the underlying manager’s “brand” for a consumer-driven marketplace as well as its investment capabilities.
The major demographic trend of an aging population is also being felt by the investment teams of super funds who are being asked to assist in the provision of a new range of retirement products for members.
Investment strategies required in the retirement phase of a member’s life, or as he or she gets close to it, are different from those required in the accumulation phase. Capital preservation, outcomes orientation (rather than benchmark orientation), sequencing and longevity risks all come into play in retirement.
With every authority, Dr Wormald says, regulators set out what is the most essential risk information…. but typically regulators are more interested in a process than a number. If you can show them the everyday monitoring of risk measures, such as VAR [value at risk, a standard measure], you can see if there are exceptions and have a process you can report back on.
“Some of our clients have built the ability for end users to create their own scenarios over the internet,” he says. “They can set up a prospective set of parameters and test it against real proprietorial and public information.”
The possible areas covered include: liability-driven investment, multi-asset-class risk management, portfolio optimisation, market volatility and integrating critical risk information into the investment process.
Since the global financial crisis, tail risks have taken on a greater emphasis in market risk assessments as big funds attempt to identify the next potential ‘black swan’. Liquidity is an important aspect of all stress testing, as advised by APRA.
But risk management also covers the more mundane issues of medium-term expectations in a low-growth environment and the relative asset allocations across both internal and external fund management teams.
“There’s a universal requirement to get a handle on the risks you need to know as a sponsor,” Dr Wormald says. “You have to look for opportunities to outperform. You have to match liabilities, search for alpha and interplay the risk information that’s fed back to the investment professionals as well as the regulators.”
– Greg Bright