We acknowledge the performance of a number of our investment options has lagged similar investment options from other super funds. We’re disappointed with this. The following provides an explanation for this, problems we’ve identified and what we’re doing to ensure performance is in line with our expectations to give you confidence we’re on track to deliver medium to long term returns.
Feedback over the years has been that ‘cash’ is ‘cash’ and as such, there’s no appetite for an enhanced investment style to deliver potential higher returns than what would normally be expected.
Therefore, we’ve taken a defensive portfolio construction approach. In keeping with this, we don’t have a significant amount of credit risk in the portfolio, ie exposure to assets such as high yield and investment grade corporate bonds, which many other funds use to enhance the performance of their cash portfolio.
These assets have experienced increased returns in recent times, partly fuelled by the ongoing narrowing of credit spreads. The risk premium or credit spread (the margin over and above the risk free rate) on a bond is a reflection of the compensation investors need for the risk that a company may default on their obligations and the risk that an investor may then get back less than their initial investment on maturity. As a result of investors being less sensitive to credit risk and chasing returns as a result of quantitative easing (see explanation of this below) and the associated flood of cheap money into the market, credit spreads have generally narrowed, generating additional returns.
These types of assets, however, have higher risk and are therefore not appropriate for our cash portfolio. Therefore, while our performance has been in line with our expectations, some other funds have enjoyed an additional short term performance boost from their overweight exposure to credit.
Bottom line – our cash portfolio is in good shape. It’s deliberately managed defensively with a low risk profile and will continue to perform in line with expectations.
Our bonds portfolio has performed well over the year and is above the median super fund over the medium and long term.
The defensive nature of our bonds portfolio means it has less exposure to investment grade credit and very little exposure to high yield credit, placing us at the more conservative end of bond funds. This means other super funds are likely to have more high yield and investment grade bonds in their portfolio. In addition, we had a medium to long term Australian inflation protection strategy, which has been a good contributor to performance in the past, however, over the past year it’s been a drag on performance. This is because low economic growth, which led to the sustained quantitative easing around the globe, has meant investors haven’t been concerned about inflation. As a result, investors haven't seen value in holding inflation protection and these bonds have therefore underperformed other bond investments.
Our bonds portfolio performed well despite rising interest rates as investment managers used flexibility provided to them in reducing their exposure to rising interest rate risk.
Bottom line – our bonds portfolio is in good shape and will continue to perform in line with expectations.
The way individual super funds invest in property can be very different. Some funds invest only in unlisted direct property, such as shopping centres, office buildings and other commercial premises. These are more defensive investments, as they provide secure regular income as well as modest capital growth over time. Other funds invest only in listed property shares, both Australian and international. They tend to be less defensive investments. Some funds invest in a mix of both.
Over the past year, along with large gains on international and Australian share markets, listed property shares performed strongly, returning approximately 20% globally and approximately 30% in Australia. In comparison, the average return from unlisted direct Australian property was approximately 8%, generally in line with longer term expectations.
Our property portfolio has approximately 70% of its assets invested in unlisted direct property and 30% in listed property. The key driver of investment performance for our property assets over the year was therefore this asset allocation. That is how much we had invested in listed property versus unlisted direct property, rather than the individual investment managers’ performance. This asset allocation has been modeled based on our medium to long term investment objectives. The high weighting to unlisted direct property is a more defensive approach, as it outperforms in down markets.
The recent underperformance of our property portfolio compared to other super funds is a result of this asset allocation, with some other super funds having a much greater exposure to listed property shares. In the past this has led these funds to experience extremely volatile returns, with some suffering losses in excess of 50% to 60% during the Global Financial Crisis. However, we maintain our conviction that over the medium term, the portfolio will meet its return objectives. Our long term property portfolio is sound and delivering returns in line with expectations. There is no plan to change our strategic asset allocation.
Bottom line – our property portfolio is in good shape and will continue to perform in line with expectations.
Australian shares portfolio
The Australian Shares investment option underperformed other super funds, the benchmark and our own expectations over the year.
While the portfolio is diversified across the Australian share market and investment managers, each with their own individual approach or investment style, performance was significantly impacted by underperformance from one manager. This manager is our longest serving Australian shares manager, managing investments for us for over 11 years. For the first 10 years this manager significantly outperformed. The manager's view coming into the start of July 2012 was that resources stocks would continue to do well on the back of the China growth story and its economic growth of 7% to 8%. The manager’s portfolio was therefore overweight resources/material stocks, given China’s strong demand for resources and materials, and underweight industrial and financial stocks.
However, investors re-rated the China growth story and aggressively sold down resource stocks, while buying industrial and financial stocks. Because the manager had such a large holding of resource stocks and the price of these stocks reduced significantly, the manager suffered large underperformance relative to the benchmark.
We were in regular contact with the manager throughout this period and believe his investment philosophy is sound, notwithstanding the performance of resources shares. Therefore, we don’t believe it’s in members’ best interests to sell down our investments with this manager and lock in losses. However, it’s taken longer than expected for the market to correct itself and we’re only now starting to see this manager's performance recover, though it still has some way to go to regain the underperformance of the past year.
Given the magnitude of this manager’s underperformance was unexpectedly large, we’ve re-examined how we build the Australian shares portfolio. Research is well advance to add additional strategies and managers to the portfolio to improve the diversification of styles and lower the individual managers’ weightings to ensure this type of underperformance doesn’t happen again. We believe this manager will recover their underperformance over the next six to nine months.
International shares portfolio
This investment option was affected by two events, explained below, which led to lower-than-expected performance for the financial year relative to other super funds. However, longer-term returns remain on track and consistent with expectations.
Each day when calculating the unit price for an investment option, a best estimate amount is set aside as an accrual for tax. The actual tax position is determined at the end of the financial year, when the financial statements are finalised. Reconciling the daily tax accrual to the actual tax payable to the Australian Taxation Office (ATO) occurs throughout the year, however, the process becomes more accurate as we get further through the financial year. Because tax accruals are calculated throughout the year, they can be subject to revision.
The first event
The first event affecting returns in 2012-13 was an additional 1.75% tax liability levied by the ATO for the 2011-12 year. The second event occurred when a tax calculation error of 0.9% occurred in June 2013. This error was not found until after the financial year ended and so is reflected in the performance for the 2013-14 year. The impact was -2.65%. However, this was a timing matter between years not an actual loss. Therefore, if you were invested over the whole period you’re not impacted. It does however mean that the one year return to 30 June 2013 is higher and the return in the following year is lower as the tax payments are amended.
What are we doing to improve the way tax is managed?
Over the past year we’ve been working to improve the quality of the tax information we receive from our service providers and create and implement an improved tax monitoring and reporting process. This work has been completed and the new process is now being used. We expect this will mean our best estimate tax accruals will be more accurate so future revisions are much smaller and the opportunity for errors less likely.
The second event
The second event affecting returns was the impact of currency. The International Shares investment option comprises a portfolio of international shares purchased in their local currencies. There are two factors influencing the return from international shares:
- The individual return of the share itself.
- How the currency the share is issued in performs relative to the Australian dollar.
In the past, 50% of our foreign currency exposure was hedged into Australian dollars to reduce the impact of currency related returns and fluctuations in currency values overwhelming the returns from the shares. Financial modelling has determined this level of hedging over the medium to long term generates the best outcome.
Over time this position has added value to the investment option’s returns and has in our view been consistent with how other super funds have managed their currency hedging over the medium to long term. Recent research, however, indicates that over the past year, with the Australian dollar averaging above 100 cents against the US dollar, many super funds have reduced the amount of hedge they had in place, with some funds having no currency hedging in place on their international shares portfolios.
With the most recent move in the dollar over the past two months of the financial year, which saw the Australian dollar fall in value by approximately 10%, the short term performance difference between having foreign currency exposures half unhedged and fully unhedged was approximately a 4% gain for funds with no currency hedge. We didn’t benefit from this because we maintained our 50% hedge during the period the dollar dropped in value.
What have we learnt from this experience and what will we do different in the future?
The historical 50% hedge we’ve applied to our international shares portfolio has added value to performance over time and lowered overall volatility, however, it had a negative impact in recent times.
The management of currency continues to develop across the industry and we believe we can further improve returns by moving to a more dynamic currency hedging approach. This will allow us to change the amount of currency hedging we have in place when the relative attractiveness of the Australian dollar to other currencies changes.
We plan to increase the range of hedged and unhedged foreign currency we use by using a currency overlay specialist. This specialist will be able to alter the hedge to capture short to medium deviations in currency fair value.
In summary, our performance was impacted by a number of issues. Some of these required us to make hard decisions and significant changes to how we manage the portfolios. These changes will ensure we continue to deliver long term returns.
Others issues are par for the course. They flow from the defensive nature of our portfolios, which look to limit the downside of negative markets, as we did during the Global Financial Crisis, but means we sacrifice some of the upside in strong markets. This is what we’ve always said we do and this is what we’ll continue to do to remain consistent with our objectives.
We believe this is the best way to deliver the best outcomes for members over the longer term, that is: to advance the lifelong prosperity, financial security and quality of lifestyle of our members through creating, building and protecting member wealth for, and in retirement.