Superannuation funds on a slow road to recovery

Superannuation fund returns have moved back into positive territory over the past eight months but, as Damon Taylor reports, many fund executives believe there is still a need for caution.

Australian investors, both institutional and retail, have undoubtedly witnessed both ends of the returns spectrum in recent years.

This time last year, optimism was a rare commodity, but much can change in 12 months. The share market has rallied over the back half of 2009 and, on that basis, super funds seemed cautiously optimistic about a positive 2010.

Yet having come from the lofty heights of double digit returns, the road to recovery could seem a long hard one, and for Elio D’Amato, chief executive officer of fund manager and research house Lincoln Indicators, patience is the name of the game.

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"One of the things that always astounds and amazes me is people’s short-term focus on performance," he said.

"Investors can look at the share market, see a significant drop, and all of a sudden the world is going to end.

"Their focus is now, now, now, but equities markets aren’t like that," D’Amato continued.

"They’ve been around a long time and the reality is that what we saw through the global financial crisis, in terms of market behaviour, has only been seen three times before.

"It’s something we don’t expect to see again anytime in the near future."

According to D’Amato, there are simply too many pluses in the Australian and global economies to warrant investors being overly concerned.

"The sub-prime mortgage crisis and its fallout was an unknown," D’Amato said. "No one knew how much money was tied up in it and investors tend to panic when an unknown of that magnitude impacts upon the market.

"What we’re seeing at the moment though is a return to risk appetites," D’Amato added.

"Investors are feeling more comfortable in their own skin and that kind of feeling should ensure that we won’t see the same sort of lows anytime soon.

"You could say that the market’s been shored up and we think it should form the basis for good returns in the future."

Joseph Brennan, chief investment officer for Vanguard Investments in the Asia-Pacific region, said domestic equities performance had obviously seen quite a bounce back during the latter half of 2009.

"Looking at the 2009 returns for Australian equities, you’d have to say that the market finished the year in quite a good position," he said.

"Australia was fortunate in that it never really entered an official recession. It avoided the worst consequences of the financial crisis and just as we saw valuations peak and come off their highs, we’re seeing the reverse of that now.

"The economy seems to be in decent shape and, as a consequence, the market is anticipating and pricing in an improving picture."

Echoing thoughts expressed by Brennan, Tony Cole, Mercer’s Asia Pacific business leader for investment consulting, said one had only to look at the state of the Australian economy to get a good indication of how much the domestic equities market had recovered.

"With respect to the Australian economy, the recovery has been very well established and it’s been quite strong," he said. "Most of the numbers coming out have been surprising on the up side, with recent wages data being particularly strong.

"So for domestic equities the trend has been one of ironing out the ups and downs," continued Cole.

"And that process has been well justified by what’s happening in the economy."

The view Mercer was taking, according to Cole, was that the domestic equities market was fairly well valued when looking at growth rates, profitability and Australia’s underlying economic strength.

"The news is obviously a lot less positive overseas," added Cole.

"In many cases, what we’re seeing abroad is still not much more than green shoots and, if the stimulatory environments they’re working in are removed, it could quite easily burn off.

"Our story is different because our economy and other economies in the region are looking good. We’re very fortunate."

Challenges

But while the recovery may well be underway, there remain significant challenges market participants would be well advised not to underestimate. Fortunately, there is likely to be opportunity as well.

Commenting on what hurdles investors, both institutional and retail, might have underestimated, Geoff Driver, general manager of business development and investor relations for the Australian Foundation Investment Company (AFIC), said they were almost all economy-related.

"The hurdles have got to be what happens in the Australian economy," he said.

"We’ve gone through a severe dislocation in all financial markets and businesses have had to pay close attention to their balance sheets, to cutting costs and so on.

"Australia is well placed based on its proximity to Asia but interest rates, the reaction of consumers to a rate hike and the cost of capital are all likely to have an impact on domestic equities."

Looking at both sides of the coin, D’Amato said while challenges were indeed present, they were also a known quantity.

"There are always opportunities no matter how the equities market is shaping up," he said.

"At the moment, there is some concern out there over sovereign debt, but the thing with sovereign debt is that investors know how much it is and they know how much risk it implies.

"It isn’t like sub-prime where the debt was a huge unknown."

Giving an insight into how Australian super funds might have handled their domestic equities weightings through the financial crisis and into recovery, Cole said that most funds would now be returning to their benchmark allocations.

"What we saw during the global financial crisis was quite a lot of concern over liquidity, particularly from the Australian Prudential Regulation Authority, regarding funds’ exposure to unlisted assets," he said.

"Our clients had only a moderate exposure to unlisted [assets] but they were still looking to monitor liquidity and to build up cash so that they could handle any redemptions.

"Most got somewhat underweight but not a lot underweight to domestic equities," Cole continued.

"And, fortunately, we didn’t have any client needing to quit unlisted assets. Some were even able to take advantage of the discounts available as a result of other funds’ liquidity problems."

But in terms of market re-entry, Cole said Mercer had advised its clients to move overweight sooner rather than later.

"We advised that our clients go overweight equities in November 2008," Cole said. "Obviously the market didn’t come back until March this year but we left those weightings in place and I believe most funds are back to their benchmarks now."

Yet while Mercer’s advice to push back into the domestic equities market proved to be a fraction premature, hesitation could be even more costly and, according to Cole, super fund executives were well aware of this fact.

"I’ve heard people talking about it so it must have happened in a small number of cases but, having said that, I don’t think it was widespread," he said.

"Most people recognise history, that markets turn around before economies, and I think most investment consultants would have advised that these were unprecedented circumstances and that a recovery had to happen.

"Looking around the world at China, at Singapore, at India, a recovery always looked likely," Cole added.

"It had to happen but there was also a lot to think about outside of the domestic equities space."

Alternatively, Brennan said that while there had undoubtedly been some instances in which institutional investors had missed the recovery, it was possible that there had been good reasons behind their delay.

"Those sorts of decisions can be driven by many different reasons," he said. "And liquidity is just one of them.

"An investor could have a high level plan in place and yet be nervous about pulling the trigger at the right moment and at the toughest time."

For his part, D’Amato said investors missing the domestic equities recovery had been somewhat inevitable.

"When the bottom fell out of the bucket, everyone went to cash," he said. "But from that point it was an exceptionally rapid recovery, and I think many investors have been left still holding cash.

"On the other hand, most super funds wouldn’t have moved too far from their mandates and so they wouldn’t have lost much ground," D’Amato continued.

"But it was a lot more of a problem at the allocated pension and self-managed super fund level.

"Unfortunately, it’s the first steps back up the mountain that are the longest. They’re shorter once you reach the top."

Certainly the consensus from most industry participants seemed to be that the worst of the financial crisis was well and truly over. Yet while memories could be short they were not so short as to have forgotten the pain caused by mismanaged stocks, and for D’Amato investment habits have changed as a consequence.

"I think they had to," he said. "Debt wasn’t even considered in early 2007. People would have attributed income stocks as being safe stocks when, being geared up to the eyeballs, they clearly weren’t.

"So in the short term, yes, I think there will be changes to investment habits, but in the long term, zigs and zags and mistakes will again be made," D’Amato continued.

"And getting through that is simply a question of holding the best stocks."

On the other hand, Brennan said it was fund managers’ investment habits that would have changed rather than those of super funds’ investment teams.

"Super funds end up allocating to managers in broad swaths so they’re less aware of individual stocks," he said.

"The experience of the last couple of years also wasn’t stock specific. I don’t think there was any particular equity that funds, fund managers or investors could point the finger at."

However, while Brennan couldn’t see super funds’ investment habits changing as a result of recent experience, he had seen and anticipated further changes to operating models and risk management policies across all sectors of the financial services industry.

"There’s always an increased focus on risk management after the industry’s seen a big risk," he said. "It’s inevitable. In counter party risk and securities lending we’ve got issues that are in the spotlight for the first time in a long time.

"These sorts of risks aren’t talked about until they end up biting you," Brennan continued. "So they’re a huge focus now, and for good reason.

"When times are good the antenna goes down, but it’s back up now and higher than ever."

Talking to risk management at the stock level, D’Amato said that one had only to look at various companies’ corporate governance statements to see a common thread forming.

"When you read the corporate governance statements of a number of shares, their policies around gearing and debt have changed dramatically," he said. "It’s a pretty standard mantra, so people are obviously asking for it.

"But while people may have changed their behaviour and will be doing this kind of thing in the short term, I can’t help but see similarities with the bushfires we saw last year in Victoria," continued D’Amato.

"Twenty-five years ago we saw the same thing and people did their back burning and formulated emergency response plans in the months that followed. But time passes and people want trees next door for the outlook, and it happens again.

"What we want is for people to remember these experiences and to heed the lessons learned. But when risk appetites run hot and emotion kicks in, there’s simply no telling what will happen."

Of course, when it comes to Australian domestic equities and market performance, the key factor to be considered is often the interest rate policy of the Reserve Bank of Australia (RBA). But with rates already at low levels, D’Amato said the domestic equities market had bigger issues to contend with.

"Historically, equities don’t do so well in a high interest rate environment but they’re incredibly low at the moment," he said.

"The bigger issue is likely to be companies’ access to debt.

"That isn’t to say that we want that access to be free flowing," D’Amato added. "But for good, well-costed projects, it’s something that could significantly impact their ability to get good returns in the short term.

"You can find good or bad reasons coming through from rising interest rates, so while they may be a dampener in the short term, they’re still nowhere near the 8.5 to 9 per cent levels we saw pre-global financial crisis."

Cole said that the most important thing for the equities market remained the Australian economy.

"Our economy loves growing profitability but it hates inflation," he said. "So the RBA is being supportive of the equities market by slowing things down if and when that growth is too strong.

"In all honesty, the earnings figures released in February were a bit disturbing in that they indicated the economy could perhaps be growing too strong," Cole continued.

"But just as it’s great that China has been seeing growth of around 10.5 per cent, it’s too fast and I’m concerned that we’re getting pretty close to that point here as well.

"It’s normal after a recession to have a period of above trend growth, but it needs to be very short."

Comparing Australia’s economy with others globally, Brennan said there was always a lot of focus on the actions of the world’s central banks.

"In Australia, the RBA provided liquidity to the system just as central banks around the world did," he said. "But by virtue of Australia’s better position, it was perhaps done for different reasons and to a lesser degree.

"So if we look at what’s being priced into the equities market at the moment, we’re talking about 25 basis points in the next three months and 75 basis points in the 12 months after that," Brennan continued.

"But it’s a very different picture in the United States, where there’s nothing priced in for the next six to nine months.

"It’s a matter of perspective, but I can’t see interest rates having a huge impact on domestic equities investment any time soon."

Naturally, it is not without significance that Brennan compared the Australian and US equities markets.

Indeed, there have long been views that the Australian market is somewhat intertwined with that of the United States, but according to Brennan, it is getting increasingly difficult to make this claim.

"More and more I’d say we’re seeing the Australian economy and market equating to Asia and other emerging markets rather than the US," he said.

"And obviously the rebound in Asia has been a huge positive for the market’s recovery.

"But I think the macro themes moving forward are ones that have yet to be played out." Brennan continued.

"China in terms of its direction and recovery, the US Federal Reserve System and how it and other government entities remove themselves from the world’s financial systems and the US jobless rate remain key issues.

"The US jobless rate, for instance, is twice that of Australia and it has a connection to both inflation and consumer spending, and I think there will be a lot of global economies tested by the withdrawal of the US consumer."

According to Cole, the reality of globalisation was that all economies were somewhat intertwined.

"The US used to provide the lead and have a domino effect on the rest of the world but nowadays what we’re talking about is the growth economies in Asia, and growth is only accelerating," he said.

"At the moment, 70 per cent of Australian exports go to Asia and, with investment from that part of the world increasing as well, our future is much more dependent on what happens within our own region.

"What happens in the US isn’t irrelevant, but what happens in Asia is just a lot more relevant," continued Cole. "And that’s something few would regret because it’s going to be a very difficult time for the US economy, not just now, but for several years to come."

Similarly, D’Amato said that while the United States was home to the world’s largest equities market and largest source of capital, he could see an increasing propensity for the Australian market to stand on its own two feet.

"There’s a complete decoupling of our exchange when we’re feeling confident about ourselves," he said. "But when we’re feeling a bit nervous we tend to follow the US almost as though we’re looking for guidance.

"Currently, we’re in the very early stages of that decoupling process, but it will happen again," continued D’Amato. "At some point we will again look to the US as the shining light due to its sheer size."

However, D’Amato hastened to add that the economic story was somewhat different.

"In terms of economies, our story is in Asia," he said. "But while we’re primed for growth, there’s a word of caution.

"Investors shouldn’t expect returns that run straight north east — there will be dips."

Yet as Australia’s domestic equities market continues along the road to

recovery, it seems certain that there are still lessons and experiences to be learned. For Cole, however, it is almost too early to figure out what those lessons would be.

"Coming out of the global financial crisis, one of the few things we know is that the regulatory rules of our investment environment are going to change," he said.

"We just don’t know what that change will be or how keenly we will feel its impact, and it’s a bit difficult to work out how we should change when we don’t know how our environment is going to [change].

"With respect to investment strategy and rebalancing, the reality is that we were in an acute crisis," Cole continued. "And there was a short period in there in which all asset classes went to hell except for very pure government bonds and cash.

"That says that diversification was of little use but, fortunately, I think time has proven the effectiveness of a long-term view. If you’ve stuck to diversity then you’ve come through well."

D’Amato said despite recovery’s windy road, investors should remain optimistic.

"I don’t think we’ll be seeing or talking about the Australian Stock Exchange reaching the 6,800 levels that we saw in 2007," he said.

"But with the strengthening of our economy and those in the region and the return to growth of some our traditional trading partners, there will inevitably be a flow through to profit statements.

"The momentum is likely to remain positive and we certainly won’t be retesting such severe lows anytime soon."