UK politicians are urging the country’s pension funds to invest less in UK government bonds (Gilts) and more in riskier and complex assets, including young UK companies and infrastructure. Railpen’s head of investment strategy and research, John Greaves, explains the various problems with the plan.

The asset mix of closed defined benefit (DB) pension funds in the UK has been moving more into low risk assets like Gilts in recent decades as these schemes have matured.

The sudden rise in government bond yields over the past 12 months has accelerated this trend. It’s led politicians and some industry spokespeople to look at the £1.2 trillion of assets in schemes like these (around 5,000 DB schemes) and argue it shouldn’t all be invested in Gilts and corporate bonds.

That’s a perfectly reasonable argument, but the language being used by some implies that trustees are at fault and pension fund managers are risk averse, says John Greaves, head of investment strategy at Railpen, the £37 billion fund.

This misunderstands the role of defined benefit funds, mandated essentially via a contract between employer and member to deliver a particular level of benefits in retirement.

UK pension funds support this outcome; delivering on this pension promise is a great result and it’s the responsibility of the trustee to deliver on this without taking unnecessary risk. The Pensions Regulator has quite understandably been emphasising the importance of reducing investment risk over time for these closed DB schemes to reduce reliance on the sponsor.

“We must consider the current funding positions and scheme objectives before encouraging pension funds to invest in alternative assets such as infrastructure and private equity, which tend to be higher risk. Many closed DB pension funds are well funded and do not need to take this added risk to deliver the returns required,” he continues.

Additionally, for those schemes that wish to change their investment mindsets and take on more risk, Greaves notes that the wider regulatory and legal frameworks play a significant role in shaping the decisions of trustees, too. The idea that trustees are risk averse because many pension schemes own a material amount of Gilts is not true, because Gilts have a vital role to play in a portfolio to deliver on the pension promise mentioned before.

“I believe the issue lies elsewhere, particularly in regards to the low member engagement and contribution levels in the UK,” he says.

The relatively recent democratisation of pension saving, in the form of auto-enrolment, and the low levels of both employer and employee minimum contributions have created a wealth gap compared to other pension systems.

Auto-enrolment is moving in the right direction, but the UK is still a long way behind other countries. For example, in Australia, employer contributions are moving to 12 per cent minimum. In the UK, employer contribution minimums are only 3 per cent, and members contribute 5 per cent.

“We are not yet contributing enough into our pensions,” he says.

The UK has an unfunded state pension system and many larger public sector schemes are also unfunded. There is also a proliferation of private sector schemes and individually invested plans with an emphasis on member choice and flexibility, rather than scale and investing for the long-term. There is not a big pot of institutionally managed money, sitting in the accumulation and growth phase of investing, available to deploy.

risk management Benefits

Railpen manages around £37 billion of both open and closed DB pension funds, and also DC. Most of the fund’s assets back the liabilities of open pension schemes. Even in open DB schemes, government bond assets have an important role to play, providing diversification (although this varies when inflation is high) and today a reasonable return by recent history, even after inflation.

Bonds can provide shelter for open DB schemes in times of volatility – like a growth shock – or a shift in market and economic regime – like a potential return to the low yield world of only 18 months ago. If the return drivers in a growth portfolio stall, government bonds can help manage that risk.

“For Railpen’s open schemes, bonds are an important risk management tool, even if we don’t invest as much in them as the closed DB funds we manage. Of course it’s possible to find secure assets that have many of the same characteristics as government bonds over the long-term, like infrastructure and other real assets, where we invest a significant amount of the schemes money – around 12 per cent, mostly in the UK, with ambitions to move higher,” he says.

Ultimately, a trustee board, with support from advisors, is best placed to decide the right asset mix to deliver on a pension fund’s goals, concludes Greaves.

“We work closely with our trustee to continuously review our asset allocation and risk profile to deliver the best outcome for the 350,000 members that entrust us with this responsibility.”

The State of Wisconsin Investment Board, the $143 billion asset manager of state investment funds including the Wisconsin Retirement System has just launched a new Best Ideas active equity allocation.

The concentrated portfolio that will eventually comprise around 50-70 stocks, focuses on companies providing unique and interesting solutions that capture idiosyncratic, stock specific risk missed by the market.

“We are attracted if our idea is different to the market. That’s the opportunity,” enthuses Susan Schmidt, head of public equities at SWIB, overseeing the portfolio which will range from between $4-$15 billion depending on the opportunity in a highly selective, “choosy” strategy that takes advantage of SWIB’s long-term approach.

A month in, she says returns are already pleasing. “It’s ahead of benchmark and the portfolio is doing well.”

The new allocation was born out of a conviction that SWIB’s talented active equity team could hone a more creative and differentiating approach, she continues. A strategy that focused on specific company situations, delving into the weeds to expose individual opportunities at a company specific level would add more value than an all-market, cross-sector, allocation primarily concerned on beating MSCI AQWI returns.

Capital light

Strategy is capital light whereby SWIB invests with a long position, but also puts a short position against it, using less committed capital to fund the portfolio. Short positions are a way to increase exposure and raise cash, allowing SWIB to go long with the total amount that includes the cash raised in the short positions, she explains.

“It gives us more breadth. We think this capital light structure is a more efficient deployment of many of our assets and helps us get a better return,” says Schmidt.

Most of the Best Ideas allocation is invested in the US, mirroring the geographic allocations of the MSCI World to achieve a 70:30 split between the US and global markets.

The portfolio investments are focused on developed markets.

SWIB will continue to run its small cap portfolio, an allocation that has beaten the benchmark over multiple years.

Portfolio managers, all covering different sectors, find ideas and develop an investment thesis. Next they present a fully-fleshed out idea to the entire team, who then discuss the merits and risk of inclusion, and timing. Very high standards govern what companies come into the portfolio, she says. “There is a lot of debate back and forth in a process that is meant to ensure a truly best in class portfolio. Every investment is made with a high degree of conviction and seen as a true opportunity.”

Old school

It’s a strategy shaped around old school, fundamental analysis where the team take time to think through and identify unique situations. They meet companies, look at business models, dig through financials and talk to competitors and customers in a quest to understand the business and assess key influences on corporate cash flows going forward. “We get an idea of what will happen to a company.”

Moreover its an investment process she’s convinced can still add real value.

The skill of the team, strategy, and SWIB’s unique investment culture can unearth opportunities that the market misses. “Capital markets can be very efficient, but the market also misses things; markets can’t tell the entire story all the time. We have the breadth and depth to exploit when the market is missing things.”

It’s a deep dive approach that doesn’t come at the cost of being nimble. “We had an idea presented yesterday that everyone thought was good and it’s in the portfolio today. There can be a quick turnaround,” she continues, attributing such fleet of foot to the relatively small number of names in the portfolio (it will always be capped below 100) and the small (10-person) cohesive team where communication is a by-word. “It’s meant to be concentrated,” she says.

Technology allowing data collection and team collaboration is a vital contributor to speed.  An interactive platform ensures the availability of data and real-time communication between different teams. “The ability to look and share data with other teams and using technology to make sure we have the same knowledge, is a big part of why we can be as nimble as we are.”

As other investors pare back public equity or switch to cheaper index strategies, Schmidt is convinced the allocation adds value.

“Fundamental investment in public equity is still very important and economies of scale are in our favour at SWIB because it is cost effective. It brings another diversification tool to the table for the portfolio.”

She’s also undaunted by the fact that more companies are staying private for longer. To her this simply means that fewer people are looking in public markets – and there is more opportunity for SWIB. “Private equity is a great asset class and SWIB invests there too. For my team it’s great because if our competitors are diverting funds to private equity it means that they are not competing with us in the public space and aren’t in our way!”

Communication

In another nod to old fashioned skills, Schmidt prizes the ability to communicate amongst her team as highly as any expert analytical skills. Many people are good at analysis by themselves, but it is harder to recruit talent that is good at interacting around that analysis and sharing knowledge, she says. “Star players are great, but that is not our model.”

Communication is also vital if her team are to tap into SWIB’s huge resources and knowledge base. From credit analysts in the fixed income team to the quantitative expertise of the risk team, ensuring the portfolio doesn’t have any unintended exposures or hidden risk like an unseen large exposure to a single currency, is crucial. “The risk team are there to help us highlight things and make sure we don’t miss them.”

Communication also ensures that cohesion is needed to act quickly. “We don’t want to get bogged down. When we find an opportunity, we need to act.”

The other ingredient is passion. She believes fundamental equity investment requires a unique type of passion because it demands gruelling, long hours. “You are never off work,” she reflects. “There is never a moment when things are quiet. If you don’t love it, you will hate it because it takes up all your life.” Is her passion undimmed? “I love what I do, I learn something new every day, and although I’m frequently frustrated I’m never bored.”

Market outlook

SWIB’s launch of a Best Ideas portfolio follows one of the most torrid years for public equity. Last year was the worst year in public equity since 2008, and today volatility continues to characterise the market.

Equity markets remain in the throes of uncertainty because there is no clear data directing the market one way or another. It’s leaving investors unable to predict when central banks will win the fight against inflation and stop hiking up interest rates.

“At the moment, markets are dominated by emotion and indecision. Ultimately the Fed will stop raising interest rates, but the market is determined to try and micromanage the timing.”

Still, volatility is oxygen for her portfolio, revealing the opportunities at a company level where the market is mispricing shares. “We look for what’s changing in a company and what makes it special,” she concludes.

 

For investors struggling to develop better ways to measure private equity fund performance, researchers at GPIF suggest an alternative measurement model in a recent working paper.

Authors Koichi Miyazaki and Kazuhiro Shimada propose a measurement method that compares the performance of private equity funds and traditional assets more accurately than previous methods via a so-called Spread Based Direct Alpha methodology. The authors note that the performance measure is also applicable to other alternative assets such as infrastructure and real estate.

As of the end of March 2022, the total value of GPIF’s private equity allocation stood at ¥306.6 ($2.2 billion) in a jump of ¥245.6 billion ($1.7 billion) compared to the end of March 2021. Although still only a tiny portion of total assets under management at the giant ¥193 trillion ($1.5 trillion) pension fund, GPIF has been rapidly building out the portfolio.

The market value of the entire private equity portfolio increased due to new investments made through discretionary asset managers as well as market value appreciation of portfolio companies and foreign exchange fluctuations, says the fund in its 2021 annual report, published last July.

IRR v PME

While the performance of traditional assets such as stocks and bonds is often measured by time-weighted rates of return, the performance of alternative assets is generally measured by the internal rate of return (IRR) since inception. The report authors argue that when measuring the performance of private equity funds, the IRR and investment multiple, which measure the absolute value of the investment, is typically observed. While these are excellent for the purpose of understanding the absolute return of each PE fund, they are not suitable for comparing the performance of PE funds with that of traditional assets, they write.

Public Market Equivalent (PME) measures a private equity fund’s performance relative to the listed market. Various kinds of PME methods have been proposed, but the “direct alpha method” is widely assumed as the best. The PME methodology assumes that, at the point of a capital call, the same amount in question was invested in the benchmark and the performance is compared with that of the real PE fund.

“For the valuation of excess return against benchmarks, among the major PME methods, the direct alpha method, which has no mathematical defects and does not require any artificial corrections, is considered to be the best method for measuring PE fund performance at present,” write the authors.

The study proposes a measurement method that can compare the performance of PE funds quite accurately with that of traditional assets by splitting the performance of private equity funds into a beta portion, which is the market performance, and an alpha portion, which expresses the pure investment skill of PE funds, by way of the spread based direct Alpha (SBDA) and the alpha amount based on SBDA.

The alpha portion, which expresses the pure skill of the PE fund, should be extractable, and the performance relative to the MSCI ACWI ex Japan, the GPIF’s policy benchmark for foreign equities, should be measurable. Whether or not the double mandate is actually met in practice will need to be examined from various perspectives in the future. In the process, it will also be essential to improve the SBDA and the corresponding alpha amounts.

GPIF private equity portfolio ranges from buyout funds, growth equity funds, venture capital funds, turnaround funds and private debt funds. “GPIF makes diversified investments in PE funds of these type,” says the fund’s latest annual report.

Strategy includes a co-investment agreement with DBJ and the International Finance Corporation to invest in private equity in emerging markets, set up in 2015. In fiscal 2021, GPIF appointed additional external asset managers for a  Japan-focused strategy to capture domestic investment opportunities. Through a range of fund-of-funds, GPIF also invests in diversified PE funds, mainly in developed countries.

The breakdown of portfolio by region shows North America with the largest share at 77 per cent, followed by emerging countries mainly in Asia. By sector, information technology accounted for the largest share (37 per cent), while other investments were diversified across a wide range of industries, including consumer discretionary and industrials.

The IRR from the entire PE investment stood at 11.85 per cent in dollar terms (as of the end of March 2022) since its inception of in-house investment in investment trusts in June 2015.

Over the last ten years GPIF has steadily increased exposure to alternative investments (infrastructure, private equity, and real estate) seeking greater portfolio diversification, efficiency and to further ensure the stability of pension finance. As of the end of fiscal year 2021, the market value of alternative assets exceeded ¥2 trillion. Still, that only accounts for around 1 per cent of total assets – well below the funds 5 per cent threshold allocation to alternatives.

 

Governance processes at $76 billion Alaska Permanent Fund Corporation (APFC), the Juneau-based sovereign wealth fund, have been under scrutiny ever since board members unexpectedly ousted former executive director Angela Rodell at the end of 2021. Now, as a probe of its policies continues, trustees have turned their focus to strengthening the processes around how they evaluate their new executive director. Deven Mitchell replaced Rodell as executive director in October 2022.

Although APFC trustees have an evaluation policy in place (for their executive director) it is complex and distinct from peer funds with a similar AUM, said governance experts from boutique advisory firm Funston Advisory Services. Funston has been mandated since February to oversee APFC’s governance practices and suggest recommendations in an iterative process that has included gathering governance documents and executive feedback from within APFC.

At funds with the most robust governance, executive director performance is measured relevant to set goals over a period of time. Trustees typically evaluate their executive director in terms of compliance with governing documents, gaging where the executive director is doing well and where there is a need for improvement.

Following meetings with the executive director for feedback and discussion, findings are published. In this example, oversight also includes a process whereby the executive director provides a self evaluation to the board.

Staff and trustee contact

APFC could also sharpen its governance around trustee contact with staff members outside board and committee meetings. Ideally, an executive director should always know the workload and requests for additional information generated by board members of staff. Every board member should be copied on requests for information from staff, working off a well-managed list.

Neglecting these types of processes risks undue influence and ethics violations via behind-the-scenes trustee contact with staff members about which other board members are unaware. Funston recommended a policy stipulating the logging of all information regarding contact and requests between staff and trustees.

Something that becomes increasingly important when it comes to referrals with service providers around investment opportunities, ensuring that regular standards of due diligence apply. This provides transparency to the board and ensures a level playing field, they said.

More trustees

APFC’s governance could also benefit from an increased board member bench. APFC only has six trustees compared to an average of nine board members at peer funds. Having more board members would create more support for trustees around burgeoning workloads and also support succession planning. Trustees heard that expanding the size of the board is a chance to add different perspectives and skills.

Funston executives also counselled on the importance of having a majority of board members with investment expertise and discussed the value of term limits. A large minority of peer funds have term limits of two to three consecutive terms for board members in a strategy that strengthens independence.

APFC’s trustees include the Commissioner of Revenue and the head of another state government department. The other four trustees are public members, appointed by the governor, who serve four-year staggered terms, so one is replaced each year.

Board self-evaluation

Board and committee member self-evaluation processes is another pillar of strong governance.

Typically, board evaluation involves a governance committee chair or external facilitator developing a questionnaire that elicits input and reactions from the board. Typical questions would include how well trustees think they set clear policy and direction, or how well they oversees due diligence and performance and use of board powers. An important element of the process involves the board ensuring that recommendations from the self-evaluation process are acted upon. Self-evaluation also helps highlight skills trustees need to develop and can be tied into educational programmes.

Funston also suggested APFC revisit its succession plan around executive director and CIO roles. Although the fund has an emergency succession plan, the advisory firm recommended it develop a long and short-term succession strategy. Moreover, although the CIO reports directly to the executive director, Funston suggested the executive director also confer with trustees in that CIO evaluation process, incorporating their input too.

Other high priority board recommendations included improving stakeholder communication and crisis management plans and developing clear and expanded compliance monitoring and reporting responsibilities.

 

 

PFZW, the €266 billion scheme for healthcare workers in the Netherlands, has kept a lid on costs and expenses for another year. The country’s second largest pension fund reports its costs fell in 2022 to 0.42 per cent, comfortably below its target of no more than 0.50 per cent of assets. Over the past five years, the average cost of asset management at PFZW expressed as a percentage of the average invested capital amounts to 0.49 per cent.

PFZW has tightened its commitment to low costs in recently honed investment beliefs where it states low costs are “the starting point” of its investment strategy and stipulates that high costs are “only acceptable if they are in the interest of the participants”. Asset management costs, under a bright spotlight in the Netherlands, come via the fund’s third-party service providers and investments in fund of funds, as well as its sizeable allocation to private assets.

PFZW follows the Recommendation on Implementation Costs of the Pension Federation when presenting its costs, distinguishing between pension management, asset management and transaction costs. The pension fund reports that although its management fee increased from 0.22 per cent (€583 million) to 0.27 per cent (€644 million) compared to 2021, the performance-related fee fell from 0.53 per cent (€1.3 billion) in 2021 to 0.15 per cent (€363 million)in 2022. Last year private equity managers accounted to two thirds of PFZW’s fee payments and pushed asset management costs above target.

Five aspects of the investment policy influence the amount of asset management costs. These comprise investment mix, scale, the degree of active or passive management and internal or external management, plus if an investment is direct or indirect.

Although PFZW says it takes costs into account when deciding on the investment mix, it states that adjusting the investment mix for the sake of cost reduction is not an end in itself. “The aim is to reduce asset management costs while maintaining the target return.”

Expensive private markets

The report notes that the pension fund’s economies of scale make it possible to negotiate lower costs for services from external asset managers. In addition, the larger share of direct and co-investments contributed to lower costs within private markets compared to peers.

Investments in private markets accounted for approximately 30 per cent of the investment mix in 2022, up from 22 per cent in 2021. The division between private markets and public markets in the investment mix is ​​influenced, among other things, by the returns achieved.

Although private markets are responsible for 86 per cent (2021: 91 per cent) of all PFZW’s costs, PFZW believes that the return expectations of private investments outweigh the higher costs. With an average net annual return of 8.3 per cent over the period 2008 to 2022, PFZW’s private market investments delivered a higher return than the Liquid Benchmark of PFZW’s public market investments, which yielded an average net return of 6.2 per cent.

Scale advantages

The scale of PFZW offers advantages and the report notes that comparisons with other Dutch pension funds with less invested capital reveal the extent of those scale advantages. Another way to lower costs includes expanding direct investments, and PFZW reports that its share of direct investments, such as projects with one or more co-investors, has expanded in recent years within private markets.

The share of indirect investments by PFZW, such as participations in investment funds within the private markets, has correspondingly fallen in recent years. Investments in mutual fund structures are often more expensive and PFZW avoids them where possible.

Transaction costs

PFZW strives to limit transaction costs when it comes to rebalancing the portfolio according to its strategic investment mix. Transaction costs amounted to €241 million in 2022, 0.10 per cent of the average invested capital, on a par with 2021 levels.

However, within fixed-income, transaction costs spiked mainly due to higher spreads in 2022. The pension fund distinguishes three categories within its transaction costs: entry and exit costs in investment funds; purchase and sale costs for direct investments in investment titles and acquisition costs.

In 2022, PFZW achieved a historically poor return of -22.6 per cent on its investments, thanks in the main to a sharp rise in interest rates hitting fixed income. However, because the value of liabilities decreases when interest rates rise, the funding ratio improved. Despite the negative return, PFZW reports it is financially better off than a year ago.

PFZW targets 20 per cent of its investments contribute to the United Nations Sustainable Development Goals (SDGs) by 2025. Via so-called 3D investment, it allocates according to risk and risk as well as impact. “In doing so, we seek a balance between good results and a sustainable world. A good pension requires a world in which life is pleasant,” says the report.

As the Australian superannuation funds evolve and get bigger they face a question of whether to copy the organisational structures of their bigger, more sophisticated Canadian counterparts, or find their own way that more adequately befits some of their unique features and better serves members. Amanda White looks at the Australian superannuation market evolution and what it can learn from Canada.

The Canadian pension fund market, with its concentration of large, sophisticated, governance-first, internal investment-driven funds, has been a pinup for other markets as their own pension systems mature.

In Australia, a raft of regulatory and market forces has resulted in fast-paced consolidation of superannuation funds and a vastly changing market. It is only natural that as the funds mature they look to their Canadian counterparts for clues on what happens next.

The number of superannuation funds in Australia has fallen from 185 in 2014 to 97 in 2022 and, like the Canadian market, assets are now concentrated in only a handful of very large funds. Five funds in Australia have assets of more than $100 billion, compared to only two funds five years ago, and they make up 34 per cent of the A$3.4 trillion market. More than half of the superannuation system’s assets overall reside in just 16 funds, each with assets of more than $50 billion.

As the Australian marketplace goes through these changes at a rapid pace, it gives pause to ask whether big is necessarily better, whether members are better off, and whether these funds have the essential organisational structures and technologies necessary for success.

New research by Geoff Warren and Scott Lawrence, Do Superannuation Fund Members Benefit from Large Fund Size? importantly puts the fund members at the centre of the conversation. The paper looks at the advantages, disadvantages and challenges of Australian superannuation funds operating at large size. Their conclusion: it is not fund size per se that matters, but how size is used.

The authors are keen for the Australian conversation to shift away from the “size is good” mantra towards a keener focus on ensuring members benefit from increasing concentration. The paper suggests particular attention needs to be paid to whether the boards and management at the large and growing funds are establishing the capabilities to succeed at size.

“Implementing effectively at scale is the key,” Geoff Warren, research director at The Conexus Institute, says in an interview with Top1000funds.com.

Big is better, Canadian-style

It is commonly accepted that there is a size pay-off when it comes to institutional investment.

The consolidation of 89 local government funds in the UK into eight pools is a recent example of success, with the pools driving hundreds of millions of pounds in cost savings, access to better investment opportunities, and better returns. One fund alone, the London Pension Partnership has saved £113 in costs million since inception in 2016.

Toronto-based CEM Benchmarking has long researched the benefits of scale among pension fund clients, with analysis of its database of large asset owner cost and performance data revealing larger funds add value over smaller ones. CEM says the advantages of scale most prominently manifest in the ability to implement private asset strategies internally, resulting in lower fees.

Instead of going through fund of funds or even co-investments, having large internal teams means funds can go direct, which not only decreases costs but increases the chance of higher returns. CEM says that the median costs of internal management for private equity is 25 bps, while externally it is 165 bps.

Internalisation also gives teams more flexibility. Typically, the governance structure of funds with large internal teams have more delegated authority to make decisions allowing for more flexibility with allocations and faster decision making in response to markets.

The Canadian funds do all of these things. They are not just big, they are also sophisticated. They have supreme governance models with clear delegated authority. They have large, highly-paid internal teams with the best technology in place for trading, portfolio analytics, risk management and portfolio completion. And importantly, they invest a significant portion of their assets in direct private markets. Investments are managed with a total portfolio approach, and a key factor in their success is how the funds allocate nimbly right across the capital structure.

Ontario Teachers’ Pension Plan, for example, has generated a total-fund net return of 9.6 per cent a year since the plan’s founding in 1990. It has always been actively managed, with more than 80 per cent of assets in-house. And the governance structure, and the delegated authority, means it has an ability to be agile. (See OTPP: Positioning the fund for the next decade)

CPP Investments, known for its total portfolio approach is conducting a study on its best organisational and investment design as it approaches $1 trillion of assets.
Chief investment strategist at CPP Investments Geoff Rubin who is leading the project says funds of enormous scale will require a new cross-disciplinary approach, and innovative incentive and rewards schemes to foster the organisational culture needed as it looks to move beyond a total portfolio approach to a “one-fund” approach. (See $1 trillion funds need new incentives and investment styles)

With the large internal teams, access to direct deals and complicated organisational structures with big budgets, payrolls and technology spends, also comes larger executive compensation packages that require well thought out incentive plans and can cause complicated communication issues with stakeholders. (See OTPP makes paying well pay off)
Funds need to grapple with all these issues as they mature their organisational design.

Australia’s unique challenges

The Australian funds, it seems, are trying to replicate the Canadian model, according to the Conexus Institute’s Warren.

But there are a couple of peculiarities in the Australian market that will prevent them from being successful in exactly the same way.

The defined contribution structure and the Your Future Your Super (YFYS) legislation, and its resulting performance test, both impact liquidity and constrain the ability of Australian super funds to invest in private assets the same way the Canadians have.
Australian funds, like the Canadians, were early investors in infrastructure but have much lower allocations to private equity and in total average around 30 per cent in private markets, compared to above 50 per cent for the Canadians.

As defined contribution funds, the Australian funds also have much higher member-servicing requirements.

“With DB funds you have one client; in DC you have hundreds of thousands, and you have to interface with them,” Warren says. “The Australian funds are the most expensive funds in the world and there is a reason for that.”

The Australian funds are the most expensive funds in the world and there is a reason for that.

Warren and Lawrence’s paper outlines how large size can bring efficiencies in administration and the delivery of member services to achieve economies of scale that may reduce costs as percentage of AUM, and deliver economies of scope that can lead to better services.

But it also points out that while larger funds can be beneficial for customisation – most relevant in retirement – size does not necessarily help deliver a personalised experience.

“We view enhanced capacity to deliver customised retirement income strategies as a significant advantage of large size, as funds move to meet their obligations under the Retirement Income Covenant,” the Warren and Lawrence paper says.

“Properly catering for the diverse needs of retired members will require a large shift in product structures at superannuation funds. Significant changes will be needed in the investment capabilities of funds, and the ability to dovetail them with drawdown strategies and longevity risk pooling where it is utilised. Funds of large scale will be most able to assemble the governance structures and resources to fulfil this transition.”

Building effective teams, going offshore

The paper says that to be effective, Australian funds need to develop an investment program that leverages the advantages of size. A key element of that is the capability to operate effectively in private markets.

Many large leading funds around the world have set up multiple offices. CPP Investments alone has nine locations. Canadian funds, and large Dutch funds, have offices in NYC, London, San Francisco, Singapore, Hong Kong, Mumbai, Luxembourg, Sao Paulo and Sydney.

Australian funds are starting to set up overseas offices and invest in their own structures, with AustralianSuper, the country’s largest fund, located in Melbourne, Shanghai, London and New York.

But still, the Australian funds are disadvantaged by their Australian head office locations that come packaged with a difficult time zone and a weaker dollar. The Australian funds are also competing against well-established brands in the guise of their asset-owner peers, and investment managers.

“There is an implementation challenge of taking an Australian fund overseas and maintaining the culture and competing for talent in a market for people who are good at what they do who may not buy into the purpose,” Warren says.

“There are challenges of salary, cost and coordination.”

Size also speaks to the complication of adding complexity to investments and organisational structure which may not translate to better outcomes.

“It is surprising that when you get bigger you might not get economies of scale as much as you think,” Warren says.

“As you get larger you add in more stuff like operating across all jurisdictions, back-office, regulatory regimes, as well as new teams. It’s a new layer of operations and complexity but doesn’t necessarily mean better results.”

Australian funds have the competitive advantage of a mandated system where fund flows are regular, guaranteed and large. But a danger as the portfolio gets bigger is a need to “fill it up”, but that comes with its own complexity, not the least of which is the ability of additional investments to add value.

Many of the larger funds globally, like CalPERS, gave up on hedge funds years ago because the value added at the total portfolio from those allocations was minimal.

“The degree of difficulty is high, and my gut feel is some Australian super funds will do well and one will stuff it up eventually, but the big thing will be how the management handles it,” Warren says, adding governance will be key.

“All stuff-ups have a governance issue behind them somewhere,” he says.

The paper’s authors acknowledge that the degree of difficulty in what the Australian super funds are trying to do is high: they are growing very quickly and transforming themselves from a cottage industry into professional, global investment organisations.

Warren says there’s a high chance funds will make mistakes.

“My sense is governance and culture is critical. Not only do you have to have the governance structure around it to make sure it works and people have the right responsibilities and accountability, but [also] that the culture is encouraging an approach where everyone is in it together to generate the best returns for members and they don’t break into silos.”

Warren says that as the Australian funds get larger there is a big opportunity to do something well.

Deploying large asset amounts, retaining flexibility and resilience requires bespoke operating models. With their unique challenges, Australian funds have the opportunity to create their own way, borrowing from their more-established markets, but tailoring for their own challenges.

The key, says Warren, is to implement effectively.

“Members might be better served if industry participants such as policy makers, regulators and the funds themselves start to ask whether operating models are being configured to succeed at scale, rather than pushing for size for its own sake.”

For more information on the structure of the Canadian and Australian markets and to learn about the individual funds visit the Global Pension Transparency Benchmark and the Asset Owner Directory.

Disclaimer: Amanda White is a member of The Conexus Institute’s advisory board.