Ones and Zeroes: AustralianSuper tackles correlations

In the final days of the hedge fund boom, the A$30 billion ($27.8 billion) AustralianSuper stepped up its investigation of the market returns embedded within the alternative strategies. Now, two years and a devastating financial crisis later, the big defined contribution fund has cut back its hedge fund program and begun analysing the true power of beta in its portfolio. SIMON MUMME reports.

For Mark Delaney, AustralianSuper’s chief investment officer, the financial crisis was not a thumping defeat of diversification. The market collapse was within the range expected over a long-term investment horizon, and apart from these severe market collapses, diversified portfolios guard investors against more common market fluctuations.

“The scope of the market declines weren’t outside the sample of what you would expect for equities or balanced portfolios on a 10- to15-year view,” Delaney says.

“Only two groups of assets – government bonds and foreign currency – had a meaningful impact on diversification. So there are limits as to what you can get out of diversification.”

Throughout the crisis and initial recovery, the return drivers and behaviour of investment strategies and instruments became clearer to Delaney and his team.

Hedge funds were not so defensive, but were also not fully correlated with equities.

Corporate debt and mortgage-related securities proved to be more cyclical than expected.

Infrastructure -Â and private equity, too, due to the use of mark-to-market valuation methodologies – dutifully followed the direction of public markets, although at a lag.

Such observations spurred a study of the return drivers in these assets, and the market conditions in which they are triggered or rendered ineffective.

“It’s encouraged us to think that we have to be very conscious of what the implicit market risks in each of these asset classes are, and how they relate to each other in different circumstances.”

Delaney now concludes that hedge funds are not absolute return vehicles, but a mixture of equity and credit strategies. Opportunistic property, meanwhile, “is really core property with a lot of gearing”. The fund has begun reducing its allocation to absolute return strategies, but aims to access their embedded betas more cheaply in other parts of the portfolio.

Resultantly, the fund’s exposure to hedge funds has been clipped back from 3.5 per cent to 1.5 per cent of its portfolio, and it is “carefully” assessing its allocations to property and infrastructure.

For future investments in alternatives, such as hedge funds and infrastructure, the fund will seek truly talented managers deploying these strategies, rather than carving out space for a specific program and then “find funds to put in it,” Delaney says.

Earlier this year, the fund undertook a major rationalisation of its Australian equities portfolio, reducing the number of mandates with active managers from 30 to six, and indexing $4.1 billion -about half of the portfolio -with a domestic manager. The mandates were not withdrawn as a result of the managers’ performance, but due to the concentration of the Australian market, which forced the managers to buy similar risk positions in the largest stocks. The fund found that many small-to-moderately sized investments with local managers delivered an index-like return and unnecessary trading among the larger stocks.

AustralianSuper’s analysis of beta in hedge fund strategies was undertaken shortly after the US subprime mortgage debacle shook out some of the more spurious managers and began to affect equity markets. Amid this uncertainty, the fund began directing all new contributions to vanilla cash. In the months to come, this would cause a decisive tilt away from equities, an asset class it saw as a little overheated.

“This lesson came out of our experience in the late 1990s, when technology stocks became really expensive. There seemed no point in having a large weighting in stocks at this time,” Delaney says, since any pullback would depress returns.

“You have to be prepared to move asset allocation around if you’re facing a significant event, particularly if you’re in the early phase of a significant event.

“For example, if equities look risky, we reduce our weighting to equities and identify which managers can do well in that environment.

“Things might be okay in the long run, but the long run might be too long.”

This stockpiling of cash made the liquidity squeeze in the months following the Lehman Brothers collapse a little more bearable, as many fund members switched from the fund’s balanced option – which has a 33 per cent allocation to domestic equities, 23 per cent to international shares, in addition to smaller investments in infrastructure, property private equity – to more conservative strategies.

While the fund’s investment team were armed with the reckoning that the financial crisis was a feasible market event within a long timeframe, most of its members “haven’t had that experience”. Some feared a financial Armageddon.

“We were able to look at the data, but they couldn’t. The volatility spooked a lot of people…[and] we had a lot of switching.”

The fund began investing the remnants of this cashpile in April. But even with more than 18 consecutive months of inflows, it was eroded by the tide of member switching.

“We never had as much as we’d have liked.”