Investment Magazine September 2016

INTELLIGENCE FOR INSTITUTIONAL INVESTORS

ISSUE 131

SEPTEMBER 2016

Reading from

A NEW WORLD ORDER

SAM SICILIA, chief investment officer of Hostplus, says betting against the forces of demographics, geopolitics and technological advances is foolhardy

ABSOLUTE FAITH DESPITE FEE SCRUTINY, THE SECTOR REMAINS COMMITTED TO ABSOLUTE RETURN INVESTING SUPREME DECISION A RECENT COURT RULING FOUND AN NFP TRUSTEE CAN HAVE CONFLICT WITH MEMBERS’ BEST INTERESTS HARNESSING ACADEMIA FINDING THE GEMS IN ACADEMIC RESEARCH CAN HOLD MASSIVE POTENTIAL FOR INVESTORS SYSTEMATIC SOLUTIONS CONSIDERING CORRELATIONS AS WELL AS VOLATILITY IN THE DETERMINATION OF RISK

b ig d a ta

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CONTENTS SEPTEMBER 2016

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EDITOR’S LETTER Keith Barrett asks what, if low growth and low returns are here to stay, will be the things that define success.

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INTERVIEW Sam Sicilia, CIO of Hostplus, says betting against the forces of demographics and geopolitics is foolhardy, while opportunity exists in emerging markets.

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TRUST Master of Ormond College, Rufus Black, told the FEAL annual conference that the industry must increase its efforts to push for better political outcomes for all Australians.

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CAN WE LEARN FROM HISTORY?

If the world continues to be uncertain, where can we look to learn more about what may happen next?

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COHERENCE As the world moves to defined contribution structures, many questions remain about its robustness, not the least of which is how defined contribution funds deliver adequacy.

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ABSOLUTE RETURNS

ACADEMIC POTENTIAL

Faith remains in the absolute returns asset class, although with even more scrutiny on fees and other metrics, how are the challenges going to be met?

By combining the quantitative power of machine learning with the context of human expertise, a powerful approach to identify and develop the next great portfolio can be created.

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TRUSTEE CONFLICT

A recent Supreme Court decision has found that although not on a financial basis, conflict can exist between trustees of a not-for-profit and members of the fund.

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ROUNDTABLE Investors are looking to systematic solutions to manage portfolio volatility. They should be asking if their systematic solutions are considering correlations as well as volatility.

S E P T E M B E R 201 6

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\ FROM THE EDITOR

EDITORIAL MANAGING EDITOR

KEITH BARRETT / keith.barrett@conexusfinancial.com.au

Keith Barrett DIRECTOR OF INSTITUTIONAL CONTENT

Amanda White JOURNALIST

A LETTER from the editor HOW TO DEFINE SUCCESS?

Dan Purves ART DIRECTOR

Kelly Patterson GRAPHIC DESIGNER

Suzanne Elworthy SUB-EDITOR

Susi Banks PHOTOGRAPHER

Matt Fatches

matt@mattfatches.com.au CHIEF EXECUTIVE

Colin Tate

ADVERTISING

s returns stay low and fees are further scrutinised, how do participants in the industry position themselves? If you can’t point to performance that outstrips your competitors, then what is it that separates you?

The easy answer is in the high visibility work – brand development, and increasing efforts in engaging with members, to provide both relevant and useful information and a user experience that can be considered best in class. The potential though goes beyond that.

Rufus Black, master at Ormond College in Melbourne, delivered the opening address at the FEAL annual conference, and he spoke about trust. He told the attendees that their importance in Australian society isn’t simply based around what they provide in terms of retirement capability. He said that those in attendance needed to use their strength and size to work with politics, to create a better and fairer system for all Australians. To create a system that was trusted. Some funds are already on this path.

Being adaptive to the rapidly changing environment is another potential way to find that success, and as Sam Sicilia says in this edition, ignoring geopolitics and other global factors is a sure way to fail. Being nimble and capable in new and emerging areas may also be what defines one entity from another.

SEPTEMBER 2016

There are two more ways that success might be found.

Can considering history tell us anything about where the world may be heading, and thereby help in the pursuit of success for an organisation, by giving insights into future trends? Perhaps. But if you examine historical events then you might find that the precursors you expected to find before a seismic event simply don’t exist. Professor Mark Blyth from Brown University explains in this edition.

Also explored is how academic research can be mined for insights, and often this is where the nuggets of gold can be found. It’s not going to be in the heavily funded report that everyone sees, but potentially in the work of a bright young graduate, that is one of more than 65,000 pieces of academic research published each year.

This issue is not all themed about the pursuit of success though.

We gathered a group of experts together in Melbourne to discuss how systematic solutions can manage portfolio volatility, and if these solutions – including smart beta – are considering correlations as well as volatility in the determination of risk. Ñ

BUSINESS DEVELOPMENT MANAGER

Sean Scallan

sean.scallan@conexusfinancial.com.au (02) 9227 5719, 0422 843 155 BUSINESS DEVELOPMENT MANAGER

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ADVISORY BOARD MEMBERS

Graeme Arnott, chief operating officer, First State Super | Richard Brandweiner, director of investment services, First State Super | Joanna Davison, chief executive, FEAL | Brian Delaney, global head of clients, QIC | Mark Delaney, chief investment officer, AustralianSuper | Melda Donnelly, senior adviser, Conexus Financial |Michael Drew, professor of finance, Griffith Business School | Michael Dwyer, chief executive officer, First State Super | Kristian Fok, executive manager for investment strategy, Cbus | Robb Hogg, head of global strategies and quant methods, UniSuper | Sheridan Lee, principal, Shed Enterprises | Geoff Lloyd, managing director, Perpetual | Graeme Mather, head of investment consulting and retirement business, Mercer | Damien Mu, chief executive, AIA Australia | Fiona Trafford-Walker, director of consulting, Frontier Advisors

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There’s opportunity in complexity

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\ INTERVIE W

READING from a

NEW

WORLD ORDER SAM SICILIA, chief investment officer of Hostplus, says BETTING AGAINST THE FORCES of demographics, geopolitics and technological advances is foolhardy.

In this new and uncharted territory, HOSTPLUS IS LOOKING TO EMERGING MARKETS FOR growth and credit for downside protection.

By Dan Purves Photos Matt Fatches

SEPTEMBER 2016

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\ INTERVIE W

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HERE IS FABLE surrounding the creation of chess of which investors would do well to take heed, says Sam Sicilia, chief investment officer of Hostplus.

The ruler of Persia – the Shāh – was a fan of games, but disliked the element of luck. In search of a game of pure strategy, he held a contest. At this event, a peasant brought a game that simulated battles between two opposing armies on a field of 64 squares. The game was won when the piece representing the opposing Shāh was killed by being put in Shāh māt.

Impressed with the game, the ruler allowed the peasant to name his prize. The peasant asked the Shāh to be paid over 64 days in rice.

On the first day he wanted one grain of rice to be put on the first of the 64 squares, and the next day for two grains to be put on the second square, on the third day four grains of rice to be put on the third square, and so on and so forth, with the number of the grains of rice doubling with every subsequent square.

The Shāh was delighted at what he thought was a bargain, until one of his advisors informed him there was not enough rice in the world to pay the man by the time the 64th square was reached.

(Reports vary to whether the peasant was executed or raised to the kings courts for his wiles.)

“If you think about that analogy, we are somewhere in the middle of the chessboard today,” Sicilia says, in reference to Moore’s Law which states that the power of computing will double every 18 months.

“The move from position 32 to position 33 is doubling all the technology that we have today. From 32 to 64 is where you get all your grains – that didn’t happen in the first 32 squares.

“We are already struggling with what we have, but that’s the speed at which it can happen. In those factors – Moore’s law, technological advances, demographics – you would be foolhardy as an investor to bet against those forces. The world has yet to see that in its full force and that’s going to happen fast.”

Not all share Sicilia’s view. Broadly speaking, in the current investment environment, investors fall into two camps.

There are those who are longing for the ‘good old days’ to come back, meaning reverting back to same world order that existed a decade ago, with the same interest rates, the same monetary policy from central banks and the same inflation targets.

Then there is another group who say maybe this is the new normal, maybe low interest rates will be on a scale of decades, not months or years.

“I subscribe to the latter which is the ‘this is the new normal’ there is no going back to the way it was before, ever,” Sicilia says.

“You can pick up the economics textbook right now and you can pick up the finance text but there are no chapters on what we are discussing, so let’s acknowledge that we are in uncharted waters as far as planet Earth is concerned.

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\ INTERVIE W

This is the new normal – there is no going back to the way it was before, ever

“We have a lot of risks on the horizon…and the advancement in technology is exponential, and so the speed at which it arrives is exponential.

And that is a scary thought.” “[But] at the end of the day you have to put a dollar in markets, no matter what thinking you have; no matter what reading you did or didn’t do, you still need to put a bet, take your member dollar and stick it into something that hopefully generates something more than the dollar you put in.”

INVEST IN UNPROVEN IDEAS In the past, investors could afford to be choosy about investments. Put another way, there was plentiful investment opportunities and as such no need to go up the risk curve unnecessarily, particularly when there was stable cash flowproducing companies and investable assets with a long history of generating returns, revenues and profitability.

“But in a world of rapid change you are now being forced to look at things that are yet to generate a dollar – they are an idea. And [if] you wait for them to generate a dollar, that opportunity has gone,” Sicilia says.

He adds how investments are looked at in the future cannot be the Excel spreadsheet approach of the past, because these businesses (by the nature of exponential change) are unproven ideas “sitting on people’s necks in their heads”, and yet that is the future of technology.

“It’s a much more difficult environment to invest in, unless you’re prepared to depart from what you’ve grown up with as an investor. Those who are holding onto that old methodology, I’m afraid are going to be Darwin-ed out.”

A LACK OF FRAGMENTATION The rise of technology in the form of instant global communication has already introduced a new set of risks with which companies and investors have yet to fully adapt.

In the ‘good old days’ when you wanted to protest against something you would make a cardboard poster with a stick and sit on the steps of that company hoping that the drivers that go by toot their horn at you, and that was about as far as it got, Sicilia says.

“Now you can publicly shame, you can bring your case to the masses,” he says, holding up his mobile phone.

“All of us run our own newspapers. The media has lost

SEPTEMBER 2016

control of the single thing it had, which was the power to communicate; now everybody has that power.”

“Social media allows people to simply say when we’ve had enough. And we’re seeing that now politically around the world with the Trump phenomena and related phenomena around the world, maybe Brexit is one of them.”

“We’ve had enough and we are no longer a sole voice.”

He adds we will never get the Great Depression again, because people will simply say, “I won’t do this” and unite to force the political economy to change.

“Somebody will rise up and say, “I will provide everybody with a four-day working week on full pay”. There will be distortions in society.”

DEMOGRAPHICS REASON FOR TILT TO EMERGING MARKETS Technology’s exponential increase is not the only macro-trend of which Sicilia is mindful. He also identifies demographics as an extremely powerful force.

“The only way to change demographics is to wipe out a population, otherwise as time progresses they get older, they become more affluent and they want stuff. They want more protein to begin with and start eating meat, and then they want more Gucci bags and then eventually they will want services rather than manufacturing in their economy.

“Take China. Since they are decreasing their manufacturing, conventional wisdom is that it is becoming more consumer-led. And those consumers will place demands for goods and services and as an investor that gives you a clue, if you like, as to where to invest and you should be able to capitalise from that.”

This shift in China also means other countries, such as Cambodia and Vietnam, are picking up manufacturing and progressing on the industrialisation journey.

Because of these type of demographic forces, Hostplus made the call five years ago to tilt towards emerging markets in its international equities portfolio. Currently the $20 billion super fund has $5.3 billion invested in international equities, with 20.5 per cent of the total portfolio in developed markets and 7 per cent allocated to emerging markets.

However, Sicilia says the decision to tilt has yet to play out.

“Emerging markets is a place that’s begging as a cohort to get their day in the sun. So are we going to make any more investments to emerging markets?

At this stage we have four emerging market

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INTERVIE W \

managers sitting there, doing their little slice of emerging markets and so, opportunistically, as cash comes into the fund, if that happens to be a good place to invest then we will have no difficulty in doing so.”

CREDIT REPLACES BONDS The fund’s demographics around its membership are also a consideration.

“It is one thing this fund has going for that isn’t readily available to other funds is its demographics. Our young demographic means lots of money comes into the fund and not a lot of money leaves, [therefore we have a] high tolerance for illiquidity, and more unlisted assets provide downside protection in market volatility so we don’t need bonds.”

This is fortunate for the super fund, as bonds look set to continue to give low yields. As such, Hostplus has decided instead to focus on credit and have separated it out from alternatives into its own asset class.

“We don’t think we will be relying on bonds for downside protection going forward, so you need to look elsewhere for it,” Sicilia says.

“But the world still has to function in terms of capital flows and how money is lent and transferred between one entity and another, and the credit mechanism is a good way of doing that. So corporate credit and the like we think will be an ongoing feature of the portfolio.”

At the moment, the allocation to credit is about 6 per cent of the fund, which is a reasonable slice in itself and comparable to the 7 per cent for emerging markets.

“Why are we going to focus on credit?

Again, it’s an unlisted investment and we have a high tolerance for illiquidity,” Sicilia says.

“It is a diversified investment from other real assets, property, infrastructure et cetera – not fully diversified but largely uncorrelated. Thirdly, it provides downside protection to volatility of markets, which is a good thing, and fourthly it affords us yield in an environment where yield is scarce.”

“Needless to say because it’s an unlisted asset and you need a tolerance for illiquidity not everybody can fish from that pond. So we are happy to say it is a good candidate going forward.”

CURRENCY WARS Again, reading the wider macro-trends, Sicilia thinks there is more going on with negative interest rates than is first apparent, particularly concerning their effect on currency.

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SAM SICILIA / chief investment officer / Hostplus

Broadly speaking, no country really wants a strong local currency; because it makes exports more expensive, imports cheaper and inbound tourism more expensive.

However, the relative movement between currencies has been low, as central banks have been maintaining a gentleman’s agreement not to get into an outright currency war.

“So what happens next? That’s the real question. Do central banks just give up on currency? And the reality is that this probably [is] another thing in play and that is negative interest rates.”

“You’d think negative interest rates are to penalise people for storing money in a bank, so that they would go out and stick it into the market environment, to invest it.”

However, that investment and increased consumption has not been happening, arguably because the penalties are not high enough at the current rates of between zero and negative 1 per cent.

“If the rates were negative 5 or negative 10 per cent and every time you deposited money into a bank lost 5 per cent or 10 per cent of it straight away, you might not do it.

“But that doesn’t mean you are going to invest, you’re probably just going to stick it under the bed. I was thinking about that and it occurred to me that if you’re a multinational company operating in Europe or in Japan and you get

revenue, would you deposit it into a local bank?

“You don’t have a mattress to stick it under and it’s pretty risky with those volumes [of] cash to stick it into the in the back office.

“So what do you with the money? Do you repatriate it back home rather than lose 5 per cent or 10 per cent? Probably. And what does that mean? You’ve got to sell the local currency to convert it into your foreign currency. And when you sell it puts downward pressure on the local currency.”

Sicilia speculates that maybe negative interest rates are really a ploy by central banks to reduce the value of the local currency because that is the net effect of the decision.

“It will put downward pressure without cutting your own currency. In other words, the gentleman’s agreement by central banks to hold off on currency wars is being circumvented by a negative interest rate policy.

“And so maybe negative interest rates are more beneficial than what they seem to be on the surface.”

If Sicilia’s assessment is accurate, it begs the question why the Australian Reserve Bank has not done something in that in that regard. An answer can possibly be found in their worldview.

“Our Reserve Bank – at the risk of sounding political, though the bank is independent – falls into the ‘we are waiting for the old days to come back’. But they are not coming back.” Ñ

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\ TRUST

SUPER’S

ETHICAL RESPONSIBILITY TO REDUCE

MISTRUST At his opening address at the 2016 FEAL Annual Conference, master of Ormond College in Melbourne RUFUS BLACK outlined FOUR WAYS IN WHICH THE SUPERANNUATION SYSTEM CAN HELP BUILD TRUST right across the Australian socio-political landscape.

By Dan Purves

T

HE STABILITY OF the system is more important to you than virtually anybody else,” says Black, putting forward that the lack of trust in both political and financial systems could result in significant damage over the long term.

“Your ability to ensure that we have a stable, trusted, political economic system is critical to what your entire industry is about, and equally, you have obligations to people and their lives a long way down the track.

He adds that there are four areas in which the superannuation industry can fulfil its important role of reducing mistrust in the system.

Firstly, it can advocate for ways to increase the length of time people work – to support older workers to stay in the workforce.

“This is good not just for individuals, but the whole economy, because increased participation rates reduce dependency rates and help it through an era of demographic transition.”

SEPTEMBER 2016

In his analysis, the gap between when super can be accessed and when the age pension can be claimed should be closed, as according to the Financial Services Inquiry almost a third of assets are withdrawn in this time.

THE RIGHT THING’ ALSO ‘THE GOOD THING’

Black suggests that part-time work might help extend the participation in the workforce. To this end, it would help if super funds provided products with an income stream that preserves capital to enable older and lower income workers to supplement their income in that period of transition.

“This is the classic case of when doing the right thing is also doing the good thing for the industry.”

Secondly, studies across a number of countries demonstrate that periods out of the workforce make it very difficult for people to catch up. As such, contributions to low-income workers should be maintained

through periods of unemployment. In a volatile or disruptive economy, this becomes even more important to address, as periods out of the workforce are likely to increase.

“We already recognise this in part. The government address it with the low income super contribution [LISC] which is a very good notion of addressing this kind of inequality.

“That suggests we have crossed the line and can address issues of inequality, in part, through the superannuation scheme.”

As with all these type of discussions, the issue of funding needs to be addressed.

For Black, he sees it as appropriate to raise some income taxes for very high income earners and to increase taxes on capital gains.

“Other countries and economies have done a better job of not seeing inequalities undermining trust because they are prepared to do that, and I think Australians should have conversation about this.”

SUPPORTING LOW-INCOME EARNERS

Thirdly, a step that “needs to occur” is to help people move forward with their incomes. This is particularly pertinent if disruption occurs in the economy, with people needing to retrain for the higher paid jobs to avoid a glut of unemployed workers.

“Low-income earners who are retraining should be eligible during those days for superannuation support,” Black says. “It should be designed in such a way that it is more advantageous to be retraining than being unemployed, just to make sure that people engage in reskilling.” “[One of the advantages is] the ability to draw a larger stream of income in the late working life will help make sure they don’t fall behind. And that’s a real thing we have to deal with as lives lengthen.”

Finally, the super industry can play an important role in encouraging the broader business community to be tackling the issue of how to ensure people are not going backwards in their living standards.

“Even if businesses don’t see it as an ethical need, they need to think about it because there are medium-term selfinterested reasons. Flat and falling incomes have direct impact on businesses, and decline[ing] purchasing power of the middle classes is not good for consumption driven economies.” Ñ

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Market capitalisation

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Source: SSGA’s Building Bridges Report, April 2016. *The survey was conducted by the FT Remark and surveyed 400 institutional investors including sovereign wealth funds, pension plans, endowments and foundations, insurance companies and asset managers in December 2015. The survey included a combination of qualitative and quantitative questions and all interviews were conducted by phone. The results were analyzed and collated by FT Remark and all responses are anonymized and presented in aggregate. State Street Global Advisors, Australia, Limited (ABN 42 003 914 225) (AFSL Number 238276) ("SSGA Australia) www.ssga.com. This material is of a general nature only and does not constitute personal advice. It does not constitute investment advice and it should not be relied on as such. It does not take into account any investor's objectives, financial situation or needs and you should consider whether it is appropriate for you. You should consult your tax and financial adviser.© 2016 State Street Corporation —All Rights Reserved. AUSMKT -2821 | Expiry date: 31 Dec 2016

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\ COLUMN

When the future is uncertain, is the past any guide?

BY MARK BLYTH ___

Mark Blyth, Eastman Professor of Political Economy at Brown University in the USA, will discuss this topic at ASI in September.

AS SEISMIC SHIFTS OCCUR across the global political landscape, where to in the search for returns? And if the world continues to be uncertain, WHERE CAN WE LOOK TO LEARN MORE ABOUT what may happen next?

IF YOU LOOKED at the VIX volatility index for, let’s say, the likelihood of a global financial meltdown occurring in the end of 2007, you would have bought options on nothing happening for the next year. The index hit its all-time low right then, two months before the subprime crisis kicked off.

If you had then wagered that the liberal economic ideas that had governed global markets for the prior quarter century would be completely forgotten, as dusty old Keynesian textbooks were consulted on what to do in the world’s finance ministries as it all went to hell in 2008, you would have also have gotten very long odds.

And finally, when the world’s central banks began chucking trillions of dollars, euros, and yen into the global economy starting in 2010, the smart money was betting on a massive inflation being the result. Today, the world is mired in deflation instead.

Yogi Berra once said, “Prediction is hard,

SEPTEMBER 2016

especially about the future”. To which one might add, “especially when that future seems to look like the opposite of our past expectations.” So how then can we make sense of it?

There is, on the one hand, a temptation, especially with the established politics of the past quarter-century giving way to a cabal of variously: American reality TV hosts, Italian comedians, Spanish lefty-academics, and uber-posh British nationalist twits – to conclude that it’s all random and there is no way predict any of it.

RISE OF A ‘NEW FASCISM’?

On the other hand, there is a similar temptation, to harken back to the 1920s and 1930s – the last time recessions and depressions shook up established politics – to predict the rise of a new fascism in everything from Trump to Brexit, which surely generalises too much from an N of 1.

But maybe there is something in the current moment that can tell us how this new and uncertain environment was generated – and how that may play out: the lack of inflation almost anywhere that isn’t Venezuela.

This is not in the textbooks.

If inflation is, as Milton Friedman convinced us, “always and everywhere a monetary phenomenon,” then with more and more money being pushed into the global system than ever before, the lack of inflation is a puzzle. But it’s also a clue. To see why, go back to the last time we had inflation, in the 1970s.

WHAT’S CHANGED SINCE THE GFC?

The so-called “great inflation” was caused by consistently super-tight labour markets, in relatively closed national markets, pushing up wages and prices at the same time as there was a massive commodity shock. The solution to this inflation was to globalise markets, which weakened labour while boosting the returns to capital through higher real interest rates. Investors everywhere ran those rates down to zero over the next 20 years, taking on leverage all the way to make money on a declining spread. The result was a massively overleveraged financial sector that was brutally exposed in 2008.

Nearly 10 years on we still live in a world where labour cannot push up wages, both public and private indebtedness is still rising, and global supply chains and technology combine to make margins razor thin, profits harder to come by, and most shocks price negative.

What if we live in a world that is not the precursor of the 1930s, but the ‘mirror universe’ (apologies to Star Trek fans) of the 1970s? Having vanquished the forces of inflation so completely have we instead built a system that generates system deflation despite the money sloshing (very unequally) around it?

That would explain persistent low growth, super low rates, central bank impotence, a global savings glut, and, to an extent, even Donald Trump. After all, those low wages and offshored jobs didn’t come from nowhere.

So if this is minimally plausible, where can we invest in such a world? Ñ

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YOU VALUE LONG-TERM PERFORMANCE. AND YOUR PRINCIPLES. SO DO WE. Northern Trust believes that your ESG partner should share your commitment to responsibility. It’s why we made Pensions & Investments’ list of the world’s leading asset managers — as well as Corporate Responsibility Magazine’s list of the 100 Best Corporate Citizens. And why we’ve been a proud signatory to the Principles for Responsible Investment since 2009. We offer you the tools, research, shared vision and holistic approach we believe you need for performance-driven responsible investing.

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FOR ASIA-PACIFIC MARKETS, THIS MATERIAL IS DIRECTED TO EXPERT, INSTITUTIONAL, PROFESSIONAL AND WHOLESALE INVESTORS ONLY AND SHOULD NOT BE RELIED UPON BY RETAIL CLIENTS OR INVESTORS. © 2016 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S. Products and services provided by subsidiaries of Northern Trust Corporation may vary in different markets and are offered in accordance with local regulation. For legal and regulatory information about individual market offices, visit northerntrust.com/disclosures. Pensions & Investments rankings based on worldwide assets under management of $875 billion as of December 31, 2015 and are not indicative of future performance. Pensions & Investments 2016 Special Report on Money Managers appeared in the publication’s May 30, 2016 issue and online at www.pionline.com/specialreports/money-managers. Ranking information reprinted with permission, Pensions & Investments, copyright Crain Communications, Inc. Corporate Responsibility Magazine’s 2016 list of the 100 Best Corporate Citizens appeared in the publication’s March/April 2016 issue and online at www.thecro.com/category/ topics/100-best-corporate-citizens. Northern Trust Asset Management is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, and personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

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\ ABSOLUTE RETURNS

Faith remains, but less absolute A FOCUS HAS RETURNED to the costs associated with hedge fund allocations. Despite this scrutiny – the most intense since the GFC – THE SECTOR REMAINS COMMITTED TO THE IDEA OF absolute return investing.

By Ben Power

W

HEN CONEXUS HELD its first Absolute Returns Conference 10 years ago, Australia’s hedge fund industry was in relative infancy. There was still a whiff of cowboy about the local hedge fund managers who took their cue from swashbuckling US managers. High net worth and endowment investors were less demanding, and fund of funds were influential.

But then the global financial crisis hit.

Many investors turned their back on hedge funds. Others persisted, but they began increasing pressure on the hedge fund industry to become more institutionalised and provide greater transparency, operational robustness, and increasingly lower fees.

But despite those changes, many investors believe the industry still has further to go if it is to become fully institutionalised.

“There’s still a way to go for the hedge fund industry to be fully institutionalised,” says Bruce Tomlinson, portfolio manager at Sunsuper, which has $2 billion allocated to hedge funds. “There are a lot

SEPTEMBER 2016

of practices that aren’t perfectly aligned with institutional requirements. The whole industry has been happy to accept institutional capital but it hasn’t evolved enough to become better aligned with those institutional requirements.”

But now lacklustre performance and a low-return environment has put renewed pressure on hedge funds to continue to evolve to meet the needs of investors, who are pushing for further cuts to fees, greater tailoring and co-investment, and delivery of truly portfolio-enhancing strategies. That push could provide the final impetus for the industry to complete its institutionalisation.

T WICE AS MANY HEDGE FUNDS

According to the Australian Security and Investment Commission’s (ASIC) Snapshot of the Australian Hedge Fund Sector, back in 2006 there were just 234 hedge funds in the country. (Of those, 40 were funds of hedge funds.)

The number of funds doubled to 473 in the period to September 30, 2014, and included 398 single-manager funds and 75 funds of hedge funds with a total of $95.9

billion of assets under management.

Despite the growth, most hedge funds remain relatively small with assets under $50 million. But the past decade has witnessed a surge in the size and power of major institutional investors. At March 31, 2016, the Future Fund alone had $14.9 billion, or 12.7 per cent of its portfolio, in alternatives.

Hedge funds have been forced to institutionalise as they sought to attract capital from big investors.

“The industry has definitely become far more institutionalised in the past 10 to 15 years,” says Robert Graham-Smith, senior investment analyst at industry fund Mine Wealth + Wellbeing, who has been analysing hedge funds since the early 2000s. “With that comes asset growth and a change in behaviour of managers.”

There has been a much greater focus on transparency and operational risk, such as a spotlight on an underlying manager’s exposure to counterparties.

Tomlinson agrees that post-GFC, in aggregate, managers have improved their business management, including their middle back-office operational

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ABSOLUTE RETURNS \

capabilities. “We do see improvements in those operating capabilities and better business capabilities,” he says. “It’s not just investment teams, but investor relations and operations capabilities within those managers has improved post-GFC.” As institutional investors have grown, they have also become more sophisticated and have increasingly shifted their investment programs from fund-of-funds to direct investments.

FUND OF FUNDS SUFFERED UNEXPECTED LOSSES

Michael Sommers, head of alternatives at Frontier Advisors, says fund of funds suffered after the GFC. “Investors had been in fund of funds that were supposed to be pretty diversified but suffered unexpected losses as well,” he says. “Those strategies were there to provide diversification in such an event relative to equities. It’s quite likely fund of fund investors, and indeed the fund managers as well, weren’t fully appreciative of how undiversified the actual portfolio was.”

Sunsuper began its alternatives program in 2007 with a hybrid investment mix of direct and fund of funds. But it went fully direct after the GFC in 2009. “It’s

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about control,” Tomlinson says. “You can negotiate things like improved terms, transparency, and co-investments. All those things come with being direct.” The fund has evolved its strategy to be “much more than liquid evergreen hedge funds”.

It now includes closed-ended longerduration strategies, as well as liquid shortterm duration strategies.

Institutionalisation and the impact of the GFC also saw managers adapt strategies. Graham-Smith says that overall the hedge fund industry has become a bit more consensus-driven.

And larger managers are focussed on steady, incremental performance with no surprises. “They are playing to their audience of institutional investors,” he says.

“There’s much less focus on so-called key person funds, which historically have had a higher volatility and return expectations.”

But while hedge funds were getting their house in order post-GFC, a new set of challenges has emerged. Central bank intervention cut volatility and spawned a low-return environment. “It remains a challenge for investors globally: the generation of decent risk-adjusted returns has been more difficult with the backdrop of low interest rates in the past few years,” Graham-Smith says.

The low-return environment means investors are struggling to deliver on return expectations, and made it challenging for hedge funds to deliver excess returns.

Recent performance has been particularly lacklustre. According to a Barclay’s report, Against All Odds, released in August, hedge funds globally produced considerable excess returns since 1993, but that has plateaued since 2011. The report found that more than half of those investors indicated that hedge funds didn’t meet their expectations over the past couple of years.

SEEKING FEE DISCOUNTS

Barclays found the major response from investors around the world in the wake of poor performance has been to seek out fee discounts. That is being reflected in Australia, with many big investors believing managers need to cut fees.

“There is growing pressure on fees

in the industry, especially in a lowerreturn environment,” Graham-Smith says, adding there is growing pressure to change the structure of those performance fees, particularly in terms of claw backs or loss recovery mechanisms.

“Some managers are definitely coming to the party, and there is a willingness to work with investors, particularly larger institutional investors, on that basis,” he says.

Tomlinson says fees generally are too high. “The alignment isn’t appropriate,” he says. “I think there’s still too many managers with inappropriate fee structures.” That includes performance fees over zero, “particularly when there is some sort of factor or beta or spread involved.”

Tomlinson believes that performance fees should be more backended, and instead of being charged every year, they should be paid over a longer time period.

That, he says, would improve alignment, and investors wouldn’t face high fees one year, followed by underperformance for a couple of years. “If fees were paid over three years, [in the event of later underperformance] the investor wouldn’t pay the fee or pay a lot later,” he says.

The industry also needs a conversation about the fees embedded within a strategy, Tomlinson says, including administration fees and transaction costs such as brokerage and costs involved with leverage.

“Those fees are quite material,” he says.

“They can add another 100 to 200 basis points of costs depending on the strategy.

But we don’t see any pressure to bring those down. Sure, it comes out of net returns, but it’s a cost nonetheless.”

The Barclays report found that beyond fee negotiations, investors are using manager selection to adjust their hedge fund allocation. There is particularly a shift away from ‘run of the mill’ managers with undifferentiated returns and multiple sub-scale products.

Frontier’s Sommers says investors are seeking strategies that offer some stable return potential, produce outperformance when markets are volatile and/or falling, but also have relatively low fees.

Those include “liquid diversified

SEPTEMBER 201 6

15

16

\ ABSOLUTE RETURNS

falls, and are lowering fees to Australian investors.

Alternative beta is also becoming popular, with a focus on more advanced approaches to portfolio construction and is viewed as a lower-cost approach to accessing diversified returns. Insurancelinked securities may also see interest; these offer attractive risk-adjusted returns and very low correlation to other asset classes such as equities and credit.

OPPORTUNISTIC INVESTMENTS

Complexity is a now a big thing. Trustees need to understand what’s in their portfolio. Very complex strategies will struggle to get in with most clients

strategies” (also sometimes referred to as “relative value multi-asset” strategies) that take a macro view, consider trade ideas that express this view, add in some short positions to reduce common market beta (e.g. long Germany equities vs short French equities) and then add in some protection to reduce the possible size of the loss for the trade idea should they get it wrong.

In doing this, the fund manager can build up a stable return profile in “little bits and pieces as they diversify the portfolio across a number of little trades to spread the return drivers”. Sommers dubs them “macro lite.”

“They’re not expensive and not super active,” he says. “They’re a lot easier to understand for the client.” He adds: “Complexity is a now a big thing. Trustees need to understand what’s in their portfolio. Very complex strategies will struggle to get in with most clients.”

Sommers says that CTAs, such as trend followers, may generate interest because they have pretty good risk-adjusted returns, are quite diversified, offer the potential for strong returns in market

SEPTEMBER 2016

Despite the quest for reduced complexity and fees, Sommers says investors are also interested in opportunistic investments such as stressed and distressed debt, which offer returns of 10-15 per cent and, in some instances, reasonable fees. Some fund managers are taking advantage of the withdrawal of banks from credit markets and are stepping in to provide loans to mid-market companies in the US. Another characteristic that is increasingly attracting investors is the ability to partner with funds. The past decade has seen investors become closer to managers.

“We try and get very close,” Tomlinson says, adding that Sunsuper might meet with a manager on-site two, three or even four times a year.

But those meetings now often turn to their core positions and, according to Tomlinson, the prospect of co-investment, particularly in credit: if it’s such a highlevel conviction position in your fund, how can we get exposure to it in a more fee-friendly way?

Investors are seeking a “more flexible structure so you can more flexibly add capital when opportunities are there, in more of a partnership approach with managers, rather than investing passively in an evergreen fund,” Tomlinson adds.

Not every manager is open to that.

“There are still quite a few managers who say ‘this is our fund; it’s 1.5 and 20; that’s the only way you can invest in us, take it or leave it’,” Tomlinson says, adding that only around a third of funds are willing to be flexible.

Despite the challenging conditions, the good news is that in a broad sense investors remain committed to hedge funds. The Barclays survey found that only a minority of investors were planning to cut back

on hedge funds investment. It says that investors were still by and large faithful to hedge funds, even if they are disappointed by recent performance.

“One of the most important reasons is that it is difficult to find an alternative with similar risk/return characteristics.”

Barclays expects, at a baseline level, for global assets under management to remain flat at $US2.9 trillion, with low-positive returns offsetting a net $US30 billion of redemption.

CONTINUED PRESSURE ON HEDGE FUNDS

Hedge funds and absolute return strategies have contributed, and continue to contribute, to portfolios. Tomlinson says for Sunsuper they have achieved their net target of cash plus 5 per cent over the medium to long term. The fund has trimmed its allocation of hedge funds from 7 per cent of its portfolio to 6 per cent as part of a general reduction in alternatives, given issues such as fees and liquidity, but there are no plans to change that in the short term.

But hedge funds will continue to face pressure, and investors’ faith could waver.

According to ASIC, the number of new hedge funds launched each year was strong between 2005 and 2011, at around 30 per year. But that has begun to tail off. In 2014 just four single-manager funds were launched, and no funds of hedge funds.

Barclays expects the number of funds globally to shrink in 2016, with fewer launches and a rise in liquidations.

“There is definitely a recognition that hedge funds, along with other absolute investment strategies, have to justify their place at the table in terms of performance expectations,” Graham-Smith says.

“There’s a challenge across the whole hedge fund industry to start generating stronger performance to justify the fees that investors are paying,” he adds. “I don’t think that’s an unfair observation. Unless that’s forthcoming, I expect there will be some potentially significant turnover of managers and assets within the industry that could provide challenges in itself.

You’re paying high fees for what you expect to be smart investors. Unless they can justify those fees, there are big challenges ahead.” Ñ

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18

\ LEGAL

Conflict

CAN EXIST BETWEEN NFP T RUS T E E A N D M E M B E R S A recent SUPREME COURT FINDING established that although trustees of not-for-profit superannuation funds have no financial interests in the performance of the fund, personal and organisational interests could cause CONFLICTS OF INTEREST.

By Michael Hallinan

MICHAEL HALLINAN

is special counsel with Townsends Business & Corporate Lawyers and Fellow of the Taxation Institute of Australia.

hat to do when a trustee of a large industry funds considers that up to 40 amendments to its trust deed may be invalid?

Naturally make an application to South Australian Supreme Court for a court approved variation to the trust deed to, effectively, implement the changes sought to have been made by the various amendment deeds. The trustee is Retail Employees Superannuation Pty Ltd and the industry fund is the REST Fund. The trustee initiated the proceedings and was the plaintiff.

The defendant, Evelyn Pain, a member of the fund, was appointed to represents the interests of all members.

The court’s decision has just been handed down and is is fascinating for a number of reasons. First, the case concerns a $34 billion fund with 1.9 million members.

Second, the case arose because of doubts as to whether the amendment – made over a period of 25 years – infringed the restrictions on the amendment power and therefore could be invalid. Third, the court recognised that it is possible for the interests of a not-for-profit trustee to conflict with the interest of the members of non-for-profit superannuation fund. While the affected amendments are themselves not inappropriate or improper, they were mainly driven legislative changes since 1994 – and in particular the MySuper changes. Any reasonably informed fund member would have approved the amendments.

However, the trustee felt sufficiently concerned to seek the assistance of the court for the court to authorise a number of variations to the original trust deed and to modify the amendment power – to effectively validate the amendments by means of the court’s statutory power to authorise variations to trusts under s59C of the Trustee Act 1936.

The fundamental cause of the uncertainty was the text of the restrictions to the amendment power. The trust deed establishing the fund was drafted in 1987 and, it seems, the restrictions on the amendment power were based upon a precedent from a defined benefit fund. The REST

SEPTEMBER 2016

fund was initially an accumulation fund (in later years, defined benefit sub-plans were added).

Unfortunately, the restrictions on the amendment power have given rise to a number of uncertainties that affected the validity of the amendments.

In exercising the power conferred by s59C to approve the variations, the court was required to consider the variations solely from the perspective of the interests of the beneficiaries – that is, the members. The REST trustee argued that a combination of the statutory provisions of the SIS Act and the trustee’s obligation to exercise its powers in a fiduciary manner were sufficient to protect the interests of the members.

The court disagreed, noting that while the trustee does not earn remuneration and therefore has no financial interest of its own “such a trustee has an organisational interest that may involve motivations such as ambition for expansion or desire for an easy work life. That organisational interest might conflict with the interest of the beneficiaries. For example, it is human nature that officers and staff of a trustee may have personal ambitions fostered by growth when growth for its own sake might not necessarily be in the interests of the beneficiaries. Similarly, it is human nature that officers and staff of a trustee may have a preference to keep matters simple and easy when a different structure might be in the interests of the members”. (para 191).

The existence of an “agency interest” of non-for-profit trustees is recognised in the SIS Act by the obligation imposed on trustees of funds offering MySuper products as to annually consider whether there is insufficient scale to be competitive (s29VN(b)).

The “agency interest problem” abounds in many structures and organisations – whether commercial companies (director/employee interest v shareholder interest, or universities (staff interest v student interest). In the case of an industry super fund the agency interest problem existed because the directors and staff of the corporate trustee may have interests which are different to and may conflict with the interests of the members.

By way of contrast, SMSFs have a “notfor-profit” trustee but no agency issue, as the beneficiaries of the SMSF are trustees or directors of the corporate trustee.

Finally, it is interesting to speculate how many other industry funds are in similar position to REST and which were established using a similar precedent trust deed. Possibly the REST case is only the first example of an industry fund seeking court approved variations of their trust deed to retrospectively valid deed changes. [2016] SASC 121. Ñ

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Phone: 02 9448 9694 Email: amy.pemberton@tal.com.au tal.com.au/superannuation-partners TAL Life Limited | ABN 70 050 109 450 | AFSL 237848

20

\ RESE ARCH

Why

retirement income SHOULD BE

the aim of DC As the world moves to defined contribution structures many QUESTIONS REMAIN ABOUT ITS ROBUSTNESS, not the least of which is how defined contribution FUNDS DELIVER ADEQUACY.

T

If we believe the optimistic forecasts – usually thanks to commentators with a “horse in the race” – we have nothing to worry about

By Amanda White

he shift from defined benefit to defined contribution means a shift in risk pooling to individual risk bearing by individual participants. This means that adequacy on an individual level becomes the objective of retirement savings, but the question of how funds can provide retirement security for all plan participants is a more difficult one.

Michael Drew, Professor of Finance at Griffith University in Australia, says there needs to be a shift from the plan sponsor’s business imperatives to a real fiduciary focus.

In the paper Governance: The Sine Qua Non of Retirement Security, Drew and his co-author Adam Walk, question whether when plan sponsors say they are taking a fiduciary focus, they are prioritising values of the profession or doing what is best for investment clients, over the economics of the business or doing what is best for investment managers.

“Plans are concerned that the economics of the business are being prioritised over the interests of plan participants,” the authors say.

In defined contribution funds there is a real

SEPTEMBER 2016

tension between a fiduciary focus and business imperatives, and that needs to be recalibrated.

Drew questions whether those that say they have a fiduciary focus actually put it into practice.

“Do we really, hand on heart, live like that and put that into action? Simple questions like ‘what does this mean for our 58-year-old members, and not our peers?’” Drew says.

In Australia – possibly the most established defined contribution market in the world – this tension is heightened because there is no requirement to ensure a certain level of retirement income for plan members.

Regulation in Australia is focused on inputs to wealth such as the level of contributions and the investment risk, not on the outputs from wealth such as the replacement ratio or level of retirement income.

“In terms of defined contribution plan governance, there needs to be a shift from returns being the solution to being one of the inputs, not the outcome,” Drew says. “Delivering retirement income should be the headline objective of a defined contribution plan.”

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RESE ARCH \

FOLLOWING THE ‘NORTH STAR’

In this context that retirement income is the destination, and everything cascades from that “north star”, he says.

By following this north star, governance and investment decisions will be recalibrated.

“We wonder out loud if governance is below the line, for example focused on investments and returns,” Drew says. “If you reframe your beliefs as part of achieving an outcome, it leaves you with different beliefs. This is especially in the post-retirement phase where you can’t keep applying the idea that time is continuous.”

The authors say that defined contribution plan fiduciaries and the investment teams must take a more sophisticated approach to performance evaluation consistent with the investment objectives set by plan fiduciaries.

“A replacement ratio of 70 per cent of final salary is an infinitely more useful objective for a plan participant than a return target of CPI+3 per cent per annum over rolling 10-year periods, after fees and taxes.

“Once fiduciaries have set appropriate objectives the entire governance framework

A track record of reliability and we believe putting ourtheIfclients’ optimistic forecasts – usually thanks to interests first. commentators

21

and the investment complex should be directed toward this achievement. With the target properly set, the means needed to achieve it become clearer, as do the ongoing monitoring requirements.”

In a defined contribution context, Drew and Walk advocate the following investment beliefs as (nearly) universal: • Retirement income is the true measure • Investors are heterogeneous • Timeframes are finite • Market returns (or beta) matter most • Dynamism is important.

“Whatever their progress, we would recommend to defined contribution plans one overriding principle: coherence. For example, a plan that claims it is “outcomes focused” and yet only reports time-weighted returns to participants is subtly undermining its message or just using its “outcomes focus” as a slick marketing line. Claiming to be “best practice” will not suffice in the absence of both institutional commitment and tangible action – which is often costly – to evidence such a claim.” Ñ

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22

\ COLUMN

BY

BEHAVIOURAL FINANCE IS what the marketing team has to think about when they communicate with members, or for the product team when they design products.

It is what some fund managers speak about to explain irrational pricing. If this is how the CIO (chief investment officer) of a major super fund thinks about behavioural finance then they are correct. However, if that is where their thinking about behavioural finance stops, they would be missing some key insights from the field, some that relate directly to them and their roles, and that have material financial consequences. Two examples relate to group decisions (such as those made by major super funds’ investment committees or trustee boards) and the way super funds assess asset managers.

SIMON RUSSELL ___

Simon Russell is director at Behavioural Finance Australia and the author of Applying Behavioural Finance in Australia

GROUP DECISION-MAKING BIASES

Implicit in any decision-making structure that has at its apex an investment committee

What CIOs need to know about behavioural finance The industry needs to apply the same lens that it looks through at members to its own decisions and behaviour or a board, is that the group will come to a better decision than would individuals. However, social psychologists that have empirically tested the efficacy of decisions made in groups, have shown that this presumption is often false. In many circumstances, a range of psychological mechanisms result in teams arriving at decisions that are no better than individuals, and in some cases, are worse. These are decisions made by groups that are not randomly worse, but systematically, predictably biased away from optimal. Even more dangerously than merely biased, the evidence shows that in some circumstances groups can arrive at worse decisions that are actually made with greater confidence.

These effects are demonstrated by teams of investment professionals who participate in my

SEPTEMBER 2016

workshops. For example, if group members have a subconscious bias before they enter a group decision-making task (which, through the design of my exercises is often deliberately the case), the bias is then also reflected in the group’s collective decision. Consistent with the empirical literature, decisions based on these group deliberations rarely do better than their average member and, rarer still, as good as their best member. When group decisions are important, these deviations from optimal can be costly.

ASSET MANAGER ASSESSMENTS

As well as their funds’ direct decision-making biases, CIOs should also contemplate how the asset managers they employ respond to behavioural finance’s challenges and

opportunities. For example, do the asset managers think of behavioural finance in terms of vague concepts, or do they systematically identify and exploit the value of associated market anomalies? Do they consider behavioural finance insights when understanding the corporate financial decisionmaking of company CEOs and CFOs, and the associated impact on corporate governance, risk management and shareholder returns?

Super funds should also assess whether asset managers apply behavioural finance insights to themselves. Do they merely pay lip service to overcoming their own biases, or do they do something meaningful about it? Have they tailored their systems and processes, and do they foster a culture and mindset that is designed to overcome common decision-making biases?

Do they measure and test for the presence of biases, taking an empirical approach to their own decision-making efficacy? Are there hallmarks of behavioural biases demonstrated in the transactions they choose and the frequency with which they trade? Do they demonstrate an awareness of behavioural biases in the way they communicate expectations for the future and in the way they navigate complexity and uncertainty?

Undertaking a high-level behavioural audit that incorporates these types of questions, can identify where potential blind spots lie and can open the door to exploring strategies that are designed to benefit funds in a number of ways: improved returns, reduce risk, or lower costs and taxes. Based on the empirical research, those who are not aware of these effects and do not have effective countermeasures against them, should be assumed to be making decisions that systematically deviate from optimal.

These deviations ultimately translate into less desirable retirement outcomes for members.

As an industry, we are becoming accustomed to looking through a behavioural magnifying glass at members. If we want to achieve the best outcome for members, it’s time for the industry to apply the same lens to our own decisions and behaviours. Ñ

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24

\ ACADEMIA

THE ETERNAL

QU E ST for unique investment

By combining the quantitative power of machine learning with the context of human expertise, A POWERFUL APPROACH TO IDENTIFY AND DEVELOP THE NEXT GREAT PORTFOLIO can be created.

By Dan Gerard

WE MAY BE AT THE early stages of a new concept: the growth of the ‘academic portfolio’.

Although still confined to a relatively small group, a number of global institutional investors are turning to academic research papers for new sources of investment insight to generate alpha. So could the next great investment portfolio be sourced from the shelves of a university grad student?

Today, we are at an important confluence of external factors driving investment decisions. Years of global financial repression, challenging economic growth and low yields have led to an expansion in alternative investments. Research indicates that over the next three years 51 per cent of pension funds worldwide plan to increase exposure to hedge of hedge funds, 50 per cent to real estate, 46 per cent to private equity and 41 per cent to infrastructure.

Alongside this, the high costs and underperformance by the investment industry as a whole have pushed many asset owners to make more investment decisions in-house.

This is especially true here in Australia, where super funds are at the vanguard when it comes to internalising the investment function.

Under these circumstances it’s hardly surprising that good investment research is in high demand. Many institutional investors are trying to find that unique insight to give their portfolio an edge.

Quality academic papers could hold the key.

SEPTEMBER 2016

But how much economic, financial and other social science research is published each year? Well the answer is a lot. In the past 12 months alone there have been more than 65,000 research papers published on the Social Science Research Network (SSRN) website. So the real challenge is panning the golden nuggets of insight hidden within the flow of information from the halls of academia.

When you think of using academic research to enhance the research process, or to create new strategies altogether, you typically think of quantitative or systematic investing. This would, though, be unfair to many fundamental strategies. Many of the tenants within portfolio management are rooted in academic research. Everything from the Morningstar box, to the discounted cash flow models were created through a data-driven, peer-reviewed, opendiscussion, academic approach.

RESEARCH AT THE HEART OF EVERY THING

Many of these papers, however, were written decades ago. It may seem that most of the ideas have already been codified and integrated into the modern world. However, with faster and greater access to large sets of data, our understanding of risk and diversity – and the ability to take advantage of the underappreciated – is growing. The world,

and the portfolios through which we view the world, will continue to evolve.

Research sits at the heart of what we do, not only as financial professionals but also in our daily lives. Whenever we plan to buy something, one of the first things we do is jump onto Google to do some ‘research’. The internet has given us access to a library of product reviews and peer opinion. Whether we are replacing the toaster, upgrading our golf clubs or buying a new car, the access we have to online product reviews and online discussion forums means the first step is often to check what other people think.

But in the face of the vast array of information sources available to us, how do we know we are choosing the right ones? How do we assess whether to trust the opinions we’re reading? A good decision requires understanding of the choices available, an

investmentmagazine.com.au

ACADEMIA \

evaluation of those choices and importantly awareness of any bias by the author.

The same is true for investment professionals. Investment and academic research can provide useful insight, help us allocate capital, and assist us in avoiding regret. And if we are not researchers ourselves – or if we have time constraints – then we have to select and apply the ideas of others.

Here our selection criteria are key. This is especially important when the decisions we make are felt by the investors and fund members we serve.

Many of us are familiar with the seminal work by UC Berkeley’s Hal Varian (now chief economist at Google) and the late Peter Lyman, on the acceleration of information.

However we don’t need a study to tell us that the rate of information we receive has far surpassed our human ability to read and understand it.

QUANTIT Y NOT NECESSARILY QUALIT Y

So with all this information available to us, how do we know we are choosing the right sources?

Although thousands of papers are published each quarter, it is fair to say that most academic work is not suitable for use in portfolio development. Since the quantity of information says nothing about the quality of information, we need to overcome two challenges in order to build a process to use academic research.

investmentmagazine.com.au

First, we need to identify what kind of work we should be looking for when developing new ideas. Second, with the tremendous volume of research that is published each year, we need a method for identification.

How do we narrow down the potential universe of papers into a manageable selection with a high likelihood of success?

Academic papers that may at first seem appropriate for development can, generally, be characterised into three different groups.

The first we’ll call ‘academic descriptive’.

Many of these ideas can be classified as event studies and may seem like an easy place to start. They describe or quantify a contemporaneous relationship between indicators. The danger in choosing these for development, however, is that they often explain correlation rather than causation.

We can characterise the second group of papers as ‘trading predictive’. This group of papers uses robust data sets and the methodology describes how the strategy was created and how it incorporates the real life constraints of practical implementation.

The results of these papers are equally robust as they contain both in-sample and out-ofsample conclusions. Often times these papers go further and add lags to the variables used to devise the strategy. They may even discuss how to implement the strategy. This type of paper may seem ripe for harvest but they are typically written by a practitioner who has already developed and implemented this strategy, and who is publishing the work for justification or marketing purposes.

We’ll call the third group ‘academic predictive’. Rather than being written by a practitioner or an academic who is employed by an investment house, these papers are written by professors or graduate students to assess the predictive power of a model or theory they have hypothesised. These papers are the proverbial needles in the haystack.

The author may not have access to large or robust private data sets, and their analysis may be based on ex-post results that do not consider constraints and potential market impact. But the hypothesis looks promising.

By devising a method for filtering out the first two groups and identifying those with potential in the third group, investors may succeed in creating a subset of ideas with great promise.

TECHNOLOGY IS THE ANSWER

This leaves us with our final challenge: how do we know if a paper is worth reading?

No investment team, no matter how well resourced, could realistically read 65,000 papers a year. So how can we narrow down all the potential ideas into just the ones with a highest likelihood of success? The answer is technology.

The MIT technologist/futurist Andrew McAfee often says that a powerful future is one where humans and machines form partnerships, each specialising in what they’re good at. Herein lies our answer. Work is already underway to develop systems that harness this partnership to enable searches.

Dr Stephen Lawrence, who will be presenting on this subject at AIST’s ASI conference on September 6, runs a fintech group at State Street called Quantextual, which is dedicated to combining machine learning and human expertise. Computers are much better than humans at recognising patterns. Humans meanwhile can train algorithms to excel at interpreting and summarising these patterns. The key is to match the two.

There are certain characteristics or patterns that we are looking for when searching for the right academic paper.

Computers are not as good at answering questions that require context. For example ‘how practical is the conclusion?’ For this part, we need human expertise. At the same time it is impractical for humans to sift through the extent of all research published.

Furthermore, technology is not yet at a point where machines can tell us if research is good. By combining the quantitative power of machine learning with the context of human expertise, we can create a powerful approach to identify and develop the next great portfolio. Ñ

DAN GERARD is head of advisory solutions for Asia Pacific at State Street.

SEPTEMBER 201 6

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\ AIST

It’s more complicated than it should be

EDUCATING MEMBERS

One obvious area ripe for improvement is communication around insurance and managing member expectations through education. Be it from the moment a member joins a fund offering default insurance, through to a time when they may need to make a claim, there is little BY Against the background doubt that outcomes could be improved if TOM GARCIA of A LIKELY SENATE members had a better understanding of the claims ___ process and conditions of their insurance policy.

INQUIRY and increasing Tom Garcia is the chief executive From the industry’s point of view, there are attention by the media and officer at the Australian Institute also concerns about the sustainability of providing of Superannuation Trustees. other stakeholders, INSURANCE default insurance cover to fund members. This IS ONE OF THE hottest topics IN includes issues around sustainable pricing, members holding multiple policies and insurance offerings being SUPERANNUATION RIGHT NOW. gamed by advisers. While they are still very much in the minority, some industry commentators are now are a number of industry peak bodies, legal suggesting that insurance should be taken out THE SUPER INDUSTRY is rightly very groups, consumer complaint organisations of superannuation altogether, with concerns about concerned about the spate of negative stories and others investigating ways to improve the rising premiums eroding retirement balances about insurance in the media. Trustees are member claims experience with insurance.

Questions around the efficiency and sustainability very aware of their obligation to act in the best This includes a soon-to-be-launched of insurance in superannuation have also been raised interest of their members and work tirelessly insurance code of practice by the Financial by the Productivity Commission, which is currently to ensure the right outcomes are achieved.

Services Council as well as other industry reviewing the super system. The report asks if funds However, if members are not getting value guidelines and protocols in various stages are offering products that meet members’ needs and from their insurance, or worse, not getting of development. if the price is good enough for the level and type of pay outs that they are entitled to, this needs This work is critically important but there cover offered. to be addressed. is also increasing recognition that an overProviding millions of Australians with access to But there are also many thousands of arching collective approach is what’s needed affordable group risk insurance – and helping address untold stories of workers receiving payouts Australia’s under-insurance problem – is something the during their unexpected time of need. Without to address some of the big challenges the not-for-profit superannuation sector is rightly very proud default insurance in super, these workers might industry currently faces. As an industry, we must work together to continuously of. In the years before compulsory superannuation was otherwise have no insurance. These payments improve our practices, consumer outcomes a given, many workers in high-risk occupations such help take on some of the financial burden of and overall consistency. as building and construction found it difficult, if not not being able to work through to retirement Insurance is a complex product, arguably impossible, to qualify for life insurance with reasonable age due to total and permanent disability, or even more so than superannuation. As one terms and conditions. Now when a builder or any other provide support to members’ families in the of the fund representatives attending a recent worker in a so-called high-risk occupation joins their case of death.

AIST insurance working group noted, there MySuper fund, he or she automatically qualifies for The fundamental challenge is finding the are a lot of moving parts to insurance, not the default amount of Death and TPD. right balance between ensuring the insurance There is a very positive role for default insurance offerings in superannuation are sustainable but all of them under the control of funds. In the inside superannuation. It would be a great pity to see also adequate, in terms of both price and cover. case of many funds, the insurers are service providers to the ‘claims experience’. this become the exception rather than the rule. Ñ Across the financial services sector there

AIST

TRUSTEE DIRECTOR COURSE Now in its fourth year, AIST’s flagship educational offering – the Trustee Director Course – is widely recognised as being the gold standard in trustee education.

Course are available nationwide. See www.aist.asn.au for details.

WANT MORE INFORMATION? Contact AIST Education Programs Manager, Sally Graham at sgraham@aist.asn.au or 03 8677 3840

INSURANCE Tuesday 25 October, 2016 Marriott Hotel, Melbourne

Recent focus on insurance has emphasised the need for funds to ensure their insurance offering is relevant, sustainable and aligned to members’ needs. The AIST Insurance Ideas Exchange will provide you with actionable ways to build a strong and sustainable insurance offering from product design to member experience.

Topics include: • The great insurance debate: Jocelyn Furlan, Nick Sherry and Sandy Grant consider the big questions from the role of insurance within super to member rehabilitation.

• Insurance sustainability: Discover how to ensure your insurance offering is adequate, sustainable and good value for members.

• Supporting mental health claimants: Learn best practice ways to manage the claims process.

• The role of technology: See how technology and artificial intelligence can improve member experience.

LEGAL & COMPLIANCE

The AIST Legal and Compliance Ideas Exchange is designed specifically to meet the needs of in-house legal counsel and compliance staff working in not-for-profit super funds. This one-day event will contribute to your CPD requirements across ethics and professional responsibility, practice management and business skills, professional skills, and substantive law.

Wednesday 26 October, 2016 King & Wood Mallesons, Melbourne

Topics include: • What’s on the regulators’ agenda? Learn the key areas of focus for the regulatory bodies.

• Drafting disclosure documents: Discover how to best approach disclosure reporting in light of the looming RG97 implementation deadline.

• Why have trustee liability insurance and cyber insurance? Explore the different types of insurance policies and the cover available.

• Ethics: Learn practical strategies to provide useful business advice without compromising your ethical obligations.

GOVERNANCE Thursday 27 October 2016 PricewaterhouseCoopers, Melbourne

Against a background of increasing regulatory and media focus on governance and cultural practices in superannuation, the AIST Governance Ideas Exchange will provide an opportunity to hear about some of the hot issues impacting on the roles and responsibilities of super fund boards.

Topics include: • Regulator update: ASIC’s views on cultural expectations, culture within advice and robo-advice.

• Diversity and inclusion: Explore the key principles of diversity, unconscious bias and how this impacts funds at board level.

• Whistleblowers: Learn how to get the policy and process right.

• Risk management: Discover how the new risk management toolkit can ensure your fund is best meeting its regulatory requirements.

For full program details and to register visit www.aist.asn.au

28

\ ROUNDTABLE

UNENVIABLE TASK

Searching for alpha and managing portfolio risk With increased and continued volatility in equities markets, investors are looking to systematic solutions to manage PORTFOLIO VOLATILITY. But, as a group of investors at an INVESTMENT MAGAZINE/STOXX roundtable discussed, they should be asking if their systematic solutions, including smart beta, are considering correlations as well as volatility in the determination of risk.

I

n the wake of the global financial crisis, investors have the unenviable task of searching for alpha and managing portfolio risk. Many investors, including Sunsuper, AustralianSuper and Hostplus, are now increasing their risk budgets allocation for alternative assets, rather than within equities.

Andrew Fisher, portfolio manager at Sunsuper, says alternative assets is where the fund is allocating its incremental active risk budget, and this is partly due to the view that it is not a great environment for active returns in equities.

Similarly, Innes McKeand, head of equities at AustralianSuper, says most of the fund’s risk budget is used on infrastructure, property and credit.

Other funds, like Cbus and VicSuper, have taken it a step further and actually trimmed their allocation to equities.

By Amanda White Photo Mark Dadswell

bring in multiple factor risk tilts, including low volatility, Van Wyk says.

“I’m just a bit uncomfortable maybe with only having one factor, which is low volatility, because that tends to potentially expose you to the risks that are not reflected within stock prices – systematic risks, like overcrowding potentially in low volatility, or liquidity risks.”

Van Wyk highlighted the behavioural anomaly within low volatility, and that high-risk stocks are overvalued because of behavioural factors. He said he thinks low volatility might be overpriced because of the demand by investors.

But Ruben Feldman, director of business development at STOXX Ltd, says it is important to distinguish between low risk or low volatility and minimum variance portfolio construction “What I would distinguish very strongly is that constructing a minimum variance portfolio doesn’t necessarily involve being exposed to the low risk factor at all; it’s not a single factor portfolio management strategy. Instead, it gives you the portfolio that has the lowest risk. Minimum variance looks at correlations between the stocks, it also can look at skewness.

CBUS ‘ACTIVELY DE-RISKING’

“We’ve been aggressively de-risking over the past 18 months,” says Brett Chatfield, investment manager at Cbus. “All new money has been going to build up cash and then opportunities that have arisen from that.”

Within equities, Cbus has been using low volatility within global equities, and VicSuper has also used low volatility strategies to help manage portfolio volatility.

Meanwhile First State Super has hired Eben Van Wyk, portfolio manager of systematic beta, to manage factor exposures internally within the fund, and manage built-up biases, or tilt the portfolio to factors that make sense in various conditions.

“When we fully insource the management of the core fund, we can do more ad hoc or more customised portfolio construction and we can

SEPTEMBER 2016

investmentmagazine.com.au

ROUNDTABLE \

Participants SONIA BLUZMANIS

Portfolio manager, Australian equities, BT Investment Solutions KEVIN BRANTON

Portfolio manager, Australian equities, Telstra Super DMITRY CAPEL

Head of equities and governance, HOSTPLUS BRETT CHATFIELD

Investment manager, public markets, Cbus RUBEN FELDMAN

Director, market development, STOXX Ltd. ANDREW FISHER

Asset allocation analyst and portfolio manager, Sunsuper INNES MCKEAND

Head of equities, AustralianSuper JONATHAN MORGAN

Regional director, STOXX Ltd. JEFF ROGERS

CIO, ipac Portfolio Management, AMP Capital EBEN VAN WYK

Portfolio manager, First State Super KEVIN WAN LUM

Head of equities and alternatives, VicSuper

investmentmagazine.com.au

“There’s a whole slew of information that goes in there. The minimum risk portfolio goes in and out of factors. Obviously there’s a strong tendency to be highly exposed to the low volatility factor, but if you look at momentum or value, active allocations vary through time. All those risk factors are strategically allocated to, in a systematic way. Some factors get very risky just before they blow up, minimum variance actually picks that up and diversifies away from those factors.”

KEVIN WAN LUM VICSUPER JONATHAN MORGAN STOXX Ltd.

MINIMUM VARIANCE STRATEGIES

This is because minimum variance does not only look at individual stocks, but also looks at correlations and at the risk of the portfolio. In case the portfolio contains factor exposures that become risky, those exposures are reduced.

By way of example, Feldman says well-built minimum variance strategies picked up that financial stocks were moving as a group just before the global financial crisis and diversified away from that. In contrast, low volatility strategies actually “piled up on financials” because they were lower risk.

“I think that correlation is a huge component of risk,” he says. “Obviously the underlying asset volatility is important, as is the estimation timeframe and how long your risk timeframe is.

But definitely correlations are extremely important and that’s what differentiates a minimum variance portfolio to a low risk factor allocation.”

It could be said that smart beta, as a marketing term, has been almost overdone, but at its core, managing factor tilts is an important part of risk management, and alpha generation, in equities portfolios.

In recent times, minimum variance portfolios have been seen as delivering the best of all worlds, including low risk, low drawdowns and strong returns.

At the roundtable, Feldman spoke about a large US pension fund client that had recently used minimum variance to solve “multiple problems”.

“They’ve essentially reduced their fixed income allocation and replaced active managers and market cap weighted equity allocation to create a minimum variance allocation. They have thus increased their overall equity allocation, but risk has been reduced by slowly shifting their core equity allocation to minimum variance, as opposed to market cap weighting,” he says.

“Through that they’ve been able to reduce the cost because of less active management, increase total expected return on the entire fund because there’s a higher equity allocation with the same amount of risk, resulting from the shift to a

INNES MCKEAND AustralianSuper ANDREW FISHER Sunsuper SONIA BLUZMANIS BT Investment Solutions

minimum variance allocation. The pension fund is relatively large with trading capacity, but obviously the use of an index makes it very easy for them to implement in-house. They don’t even need to externalise the implementation either, so they have more transparency and more control.”

CAUTION RE DIFFERENT ENVIRONMENTS

But portfolio manager of Australian equities at BT Financial Group, Sonia Bluzmanis, expressed caution about the different environments, or markets, in which minimum variance might work.

“Generally the more efficient a market is – so if you look at the US or global blue chips – minimum variance adds less value,” Feldman says.

China A shares, by example, presented an opportunity to add value in minimum variance by reducing market cap volatility – by between 30 and 40 per cent – and producing slightly higher performance. But there are also liquidity and rebalancing issues to consider.

“We have two versions of minimum variance; an unconstrained one, and then a constrained one.

The latter constrains the minimum variance to be similar in terms of risk allocation to most risk factors, geographies and industries to be similar to the benchmark, so that the tracking error is limited. But in the end the only times when minimum variance, or at least historically, has

SEPTEMBER 201 6

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\ ROUNDTABLE

underperformed the markets, is when they have been on a sharp up. And so to underperform when you’re only making 10 per cent instead of 20 per cent is not as bad as underperforming under any other circumstances,” Feldman says.

Investors agreed that getting access to the equity risk premium at a lower risk is a bonus.

In addition, the market cap benchmark was not held in high regard.

“Market cap is the worst, most inefficient benchmark,” says Van Wyk. “It could just be that a systematic or a quantitative model is not very good at predicting alpha, whereas fundamental managers are probably the best place you can get your alpha from, from benchmark unaware, concentrated, highly skilled, fundamental managers. There’s your alpha part and at the core you might want to say, “Okay, I want a passive equity risk premium.”

Instead of a market cap tracker I can get a low volatility portfolio and it’s going to be lower risk.”

“I think the logic behind why market cap dominates is fairly easy to see, it’s the portfolio you don’t have to rebalance, you buy and hold it and there’s no transaction cost really,” Sunsuper’s Fisher says.

Dmitry Capel, head of equities at Hostplus, said it was difficult for a fund like Hostplus to change its approach, after having so much success with its strategy of high-conviction equities strategies and high allocation to alternatives.

“As an alternative to market cap weighted indices, it’s definitely worth exploring and considering,” he says. “Our equities are relatively high conviction, a lot of them are unconstrained portfolios that have historically done very well for us. It’s hard to deviate – I mean every investor and every fund is guided by its own history I suppose, but how do you make an argument for a fund like ours that’s done really well historically getting exposure to proper, active strategies? That’s the challenge I think.

“Some managers have been quite successful but how much real alpha are they adding in addition to what can be readily explained by factors that are available to us, that’s some of the work that we’re looking to do, to inform our views about should we continue to support active managers, and what can be replicated.”

STRONG ARGUMENT

But Feldman believes that the performance, and risk reduction of minimum variance portfolios is a strong argument.

“I think over the past 100 years minimum variance has significantly outperformed and delivered a risk that’s half to two thirds,” he says.

SEPTEMBER 2016

RUBEN FELDMAN STOXX Ltd.

EBEN VAN WYK First State Super

“I also think that even if you have alpha generators, that doesn’t necessarily mean that you have a good portfolio. You could have lots of stocks that provide alpha but if they all tank at the same time, you may have people getting out of the portfolio at the wrong time and never getting the alpha that is being proposed and so I think that minimum variance actually provides that.”

Fisher added that Sunsuper is looking at minimum variance as an alternative benchmark, but he had queries about whether correlations were a better indication than prices to determine the future.

“The real question is ‘is risk easier to estimate than returns’?” Feldman says. “Definitely I would say yes. The estimation of risk empirically over the past 100 years or so – where we have equity markets data available – has been pretty stable, whereas returns estimation is next to impossible.

You’re not assuming past risk is equal to future risk, there’s a whole estimation in there and you’re trying to get predicted risk, you’re not just estimating past risk, if that makes sense.”

But Fisher was concerned about the tracking error and where, or how, minimum variance would fit into the equities portfolio. Sunsuper splits its portfolio into three portions – a passive portfolio with limited tracking error, systematic factor based area with tracking error between 1 and 2 per cent, and unconstrained with tracking error of between 4 to 8 per cent.

“I mean so it could be that a minimum variance goes into the unconstrained part of the portfolio but it seems unlikely to me that it would go that path,” he says.

And as Van Wyk points out, it is important to consider not just the low volatility factor, but efficient portfolio construction.

“I know from people I speak to, some just prefer simple, arbitrary rules in portfolio construction, whereas I’ve used optimisers for a very long time, so I’m more comfortable with it,” he says.

JEFF ROGERS AMP Capital

‘TRAIN AND CONSTRAIN’ OPTIMISERS

Feldman says it is important to “train and constrain” optimisers to deliver a sensible result.

“I think you can get weird looking portfolios, unless you put enough constraints around them to force it to have enough diversification and to be sensible. You might end up with a portfolio with 20 per cent in one stock because it is producing something that will mathematically give you the best result. But it has to pass a common sense sniff test,” Feldman says.

Van Wyck identifies efficient portfolio construction as the defining criteria of minimum variance.

“I think the difference between minimum variance and this whole smart beta movement is the smart beta movement, or scientific movement, or systematic factors, whatever they want to call it, is basically just the underlying building blocks of quantitative fund management,” he says. “But minimum variance includes efficient portfolio construction including the use of an optimiser, and a premium should be paid for portfolio construction.” Ñ

For further information contact Jonathan Morgan on Jonathan.Morgan@stoxx.com

investmentmagazine.com.au

The

8th

Annual

SYMPOSIUM

Fiduciary Investors

Symposium

November 14-16, 2016

RACV, Healesville, VIC

– REGISTER NOW – fiduciaryinvestors.com.au The triumph of geopolitics Powerful underlying interests have an unassuming way of asserting themselves.

Over the past twelve months, we have witnessed the ramifications from political, economic and cultural divides between the elite and the unprotected class throughout the developed world. Adding to this complexity is the upcoming US election. All eyes will be on the new President and how they will deal with the risk of the EU unravelling, populist upheavals and two old foes, Russia and China, flexing their muscles.

What are the consequences of these events for institutional investors with a long-term horizon?

CONTACT Emma Brodie at emma.brodie@conexusfinancial.com.au or on (02) 9227 5708

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IFM Investors’ investment products are not available to retail investors. Investment can only be made by institutional investors. Past performance is no indicator of future performance. This information has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person or entity. IFM Investors Pty Ltd recommends that before making any investment decision, each prospective investor should consider whether any investments are appropriate in light of their particular circumstances and refer to the appropriate information memorandum for further information. IFM Investors Pty Ltd ABN 67 107 247 727, AFS Licence No. 284404. 15-6746/0615.