Asset Valuations. editorial roundtable. What is your firm s funds under management and how much is allocated to fixed income?

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1 editorial roundtable Asset Valuations A s the OECD country with the highest proportional allocation of superannuation assets into equities, and therefore with comparably low allocations to fixed income, Australia has been facing heated debates on whether its allocation pattern needs to be changed. In a series of interviews, super funds and one asset consultant talk to KangaNews about their views on equity and fixed income valuations, and the development of the domestic bond market. i n t e r v i e w s B y S o n i a H a n Participants n Jonathan Armitage Chief Investment Officer MLC INVESTMENT MANAGEMENT n Stewart Brentnall Chief Investment Officer ANZ GLOBAL WEALTH AND PRIVATE BANKING n John Pearce Chief Investment Officer UNISUPER n Scott Tully Head of FirstChoice Investments COLONIAL FIRST STATE n Sue Wang Senior Associate MERCER What is your firm s funds under management and how much is allocated to fixed income? n Pearce UniSuper has approximately A$33 billion (US$34.5 billion) of assets under management. For our balanced default option, roughly 30 per cent is in fixed income. We ve always had 70 per cent of default assets in growth assets and 30 per cent in defensive assets. n Tully The FirstChoice multimanager portfolios have more than A$20 billion in funds under management. Overall, we have 25 per cent in fixed income and 5 per cent in cash. n Armitage MLC Investment Management has around A$35 billion of assets under management. In terms of allocation to fixed income, it depends on the funds you are talking about. Our mainstream Horizon 4 portfolio allocates about 28 per cent to fixed income, with the rest in growth assets. We also have products where the fixed income component is higher because they have different objectives. n Brentnall ANZ Global Wealth has A$35 billion of assets under management. In our default fund 25 per cent is allocated to fixed income, which is split between domestic and international and also between nominal and inflation-linked fixed income securities. By comparison, equities are slightly over 50 per cent, with the rest being listed property domestic and international and 15 per cent of liquid alternative assets. n Wang At Mercer, the proportion of the total assets allocated to fixed income is very client dependent. The share of fixed income is typically lower than 30 per cent. Meanwhile, the vast majority of growth assets are made up of both global and domestic equities. Does the predominantly defined contribution system in Australia (see chart on facing page) result in a higher allocation to riskier assets? n Wang I don t believe that simply being a defined contribution Australian equities have performed well in the last decade and Australian super funds and their members have benefited from equities over the longer term. Superannuation is a long-term investment and having a relatively large allocation to equities is a rational strategy. Scott Tully Colonial First State 10 kanganews february 2013

2 system means you need to have a higher allocation to equities. Current allocations are due to long-term assumptions in modelling expected returns. When we first put together what a defined contribution portfolio might look like, we determined a desired level of long-term returns and reached a conclusion that we need to have an allocation that has a split based on historical returns by different asset classes. Defined benefit funds are required to immunise their liabilities by holding longer-dated bonds rather than equities. n Tully The defined contribution system removes the need to immunise defined benefit liabilities by holding long-dated bonds rather than equities, as required in some countries. However, in terms of our investment offerings, our members can choose anything from very defensive to 100 per cent equities and match this to their risk profile. Many members don t make an active decision on where to put their superannuation and a typical default fund would have 70 per cent in growth assets and 30 per cent in fixed interest and cash. n Armitage I don t think allocations are necessarily driven by the system itself. Allocation to equities should be driven by what outcomes people want from their investments, which will depend on age and also their attitude to risk. It s not about the culture, it s more about whether equities will provide the types of returns that help us achieve certain sets of outcomes. At any one time that will depend on how equities are priced. The super industry in Australia now allocates around 50 per cent to equities and low doubledigit figures to fixed income (see chart on this page). This compares with the OECD average of around 50 per cent to fixed income, and makes Australia the only OECD country to allocate around half its super fund assets to equities. Why the huge difference in Australia compared with peers? n Tully Australian equities have performed well in the last decade and Australian super funds and their members have benefited from equities over the longer term. Superannuation is a long-term investment and having a relatively large allocation to equities is a rational strategy. n Pearce The vast bulk of the funds we manage, outside our defined benefit option, are in the default option. This is a balanced option which has a 70/30 split between growth and defensive assets. Given current valuations this is a very rational decision. I m firmly of the view that everything depends on valuation, and it is valuations that justify the current higher equities allocation in Australia. Lobbying for reallocation into fixed income is the wrong advice to be giving at the moment. Looking at where valuations currently sit, I think it is wrong for so-called experts to come out and advise people to move their money out of equities into bonds. It is setting people up for a potentially disastrous outcome. There is not a lot of upside in the bond markets. OECD NATIONS SUPERANNUATION SYSTEM TYPE, 2011 PROPORTION OF ASSETS (PER CENT) Greece Denmark Source: OECD 2012 Source: OECD 2012 Defined contribution Italy Australia NZ US Defined benefit/hybrid-mixed OECD NATIONS SUPERANNUATION ASSET ALLOCATION, 2011 PROPORTION OF ASSETS (PER CENT) Shares Cash and deposit People see the global financial crisis as a failure of asset management. But it is actually the failure of the advice industry as much as anything. People should have been advised not to put all of their money in growth assets if they can t withstand volatility. If volatility causes you to lose sleep, just put your money in defensive assets. If, however, you are able to withstand volatility, you have to look at relative valuations. Our bond options were one of the star performers in the 12 months to late 2012, up 10 per cent. But I want to caution people that there has been a spectacular run in the bond market and that bubbles don t just apply to the equity market. Before the financial crisis was the time people should have been advised to allocate away from equities not now. My view is equities will outperform bonds over the long term as long as investors pay no more than fair value to buy them. Right now equities are certainly not expensive. Korea Portugal Canada Germany Bills and bonds Other Australia US Finland Netherlands Canada Norway Switzerland Austria Portugal Italy Luxembourg Denmark Spain Japan Greece Korea Finland Norway Switzerland 11

3 editorial roundtable n Wang One of the lessons Australia has learnt in the last five years, since the global financial crisis, is that super funds did not have enough pure fixed income in portfolios. Performance through the last two crises the global financial one and the European sovereign debt crisis has clearly been patchy. These are once-in-a-lifetime types of crises so typically we do not expect members to experience this level of volatility again in our lifetime. Our industry can never predict this type of event. However, if we had more innovative products that took into account different needs of different members, and in particular life cycle products, we would have been able to better insulate different types of members from the crises. It is true that fixed income is expensive right now relative to historical valuations. Should clients pour money into fixed income at a time when it is expensive? It is a hard question to answer. However, the extended sluggish global growth environment we are in is supportive of lower government bond yields for longer. n Armitage Our starting point is to look for the best way to achieve the objectives our clients need to meet, rather than to take a view on asset allocation. As a result, investment in any asset class should depend on the price and the potential attractiveness of the return you will receive. Safe assets as a whole are currently priced expensively but it depends on geographic location and asset type. Investors have been risk averse during the last three or four years. There is no doubt that part of the fixed income market looks expensive, which does not mean that it can t get more expensive. There are also parts of the equity and real estate markets that look pretty expensive so we can t take a blanket view. Equities provide returns that help us achieve a certain set of outcomes, and so at any one time allocations will depend on how equities are priced. n Brentnall Views on the definition of risk need to be updated, if equities are simply defined as riskier assets. Historically, risk has been measured by volatility. But it should be looked at on the basis of valuation too. Although equity is a more volatile asset class than fixed income, there are times when that volatility and allocations to it are justified by a much lower valuation. Undoubtedly in 1999 and 2008 high-quality corporate and government bonds performed strongly when equities did not. However, we are approaching the juncture where a greater portfolio presence for equity is absolutely justified for many investors. Domestic corporate earnings are sound, cash flows are good, and many companies are continuing to pay high dividends. Overseas equities are also showing signs of recovery on the back of improving economies in the post-global financial crisis world. Is it appropriate for a 70-year-old to have the same high allocation to equity as a 25-year-old? Will the average asset allocation mix in Australia change as the baby boom generation continues to move into drawdown phase? n Tully By and large a 70-year-old shouldn t have as aggressive a portfolio as a 25-year-old. I expect that, as the population ages, the overall mix of assets will become more conservative. n Pearce At UniSuper we are moving on a better integration of the advisory service within the asset management business. We are telling people that, at a certain point in their life, they need to consider the volatility of their assets. n Armitage Australia is not the only country where people are living longer and this puts pressure on superannuation assets. Allocation to equity has to be appropriate to the age group you re investing for, the outcome you want to achieve and the amount of money investors need to have. MLC Investment Management has a variety of products with higher fixed income components, which are seen as more conservatively managed and more appropriate for people in the drawdown phase. Products that have a higher weighting to fixed income assets may well be suitable for somebody in the later stages of superannuation growth or in retirement. n Brentnall There is a price for every risk. Static allocations for an investor, over his or her life cycle, to high levels of either fixed income currently very expensive or growth assets currently much less expensive are unlikely to be appropriate. At ANZ Global Wealth and my prior employer I have been involved in developing investment options which adjust the exposures to growth and income assets over the term of an investor s accumulation and decumulation phases known as life cycle products. A dynamic approach to risk allocation is much more appropriate for most investors. n Wang Age is only one determinate of allocation. The market is very focused on the fact that older people should have a very I want to caution people that there has been a spectacular run in the bond market and that bubbles don t just apply to the equity market. Before the financial crisis was the time people should have been advised to allocate away from equities not now. John Pearce UniSuper 12 kanganews february 2013

4 I don t think allocations are necessarily driven by the system itself. It s not about the culture, it s more about whether equities will provide the types of returns that help us achieve certain sets of outcomes. Jonathan Armitage MLC Investment Management different-looking portfolio from younger people. But Mercer s view is that there are other factors we need to consider. The majority of super members in Australia are, unfortunately, unsophisticated investors, and evidence has shown that they typically enter the default super option, which usually is a balanced or growth portfolio. Individual super funds should provide education to members. There are options but it is not easy for members to choose and they re not always aware that they can change into other types of allocation. The super industry should also try to make things simpler for its members to make the choice between the types of funds available, without having to spend a lot of time on paperwork. The super industry needs to move into the direction that creates new life cycle products, which follow members for their entire life cycle, from working through to post retirement. That s where we lack innovation and product choice. It is fair enough to have different products with different risk profiles, but then to expect unsophisticated members to make an active choice may be too much. We know for a fact that they are not actively making that choice. In the latter stages of a life cycle, and certainly in the post-retirement period, fixed income products that have low principal volatility but can deliver some attractive regular income can play an increasingly important role in members allocation choices. Arguably, early on in a super member s life you may want to build up an allocation which allows you to take on more risks. But certainly, as we have more baby boomers entering retirement, fixed income should play a larger role in the investment landscape of those members. The current fairly static allocations in the design of super funds do not manage sequencing risk well at all. I think allocation to fixed income is not enough in most members portfolios with below 20 per cent pure fixed income excluding cash Australia is at the very low end. Mercer is working on developing life cycle super products. The current structure of super funds doesn t necessarily serve the needs of all members and certainly default options that have low allocation to fixed income wouldn t suit older members and those in post retirement. The super industry is at a crossroads. It needs to assess some of the assumptions the industry has held for so long in designing the asset allocation of super funds. Clearly those assumptions, which are typically based on very long horizons, have failed us in the most recent crises. It needs to take into account the different needs of members throughout their life cycle as opposed to assuming they are the same. With more and more noise being made around the ending of the mining boom, a slowing down of Chinese demand and dropping commodity prices, does the forward profile of company earnings over the next decade endorse a high allocation to equities? n Pearce Equity is not a homogenous assets class. The end of the mining boom won t have an impact on certain industries shares. No-one is suggesting that China will collapse, and the world s second-largest economy growing at 7 per cent is pretty impressive to me. China s demand for commodities will continue to increase, albeit at a slower speed. Development capital is shrinking but it is not a necessarily a bad thing for a mining company to be cutting capex. n Armitage The focus should be on finding companies that have sustainable earnings and growth within the equities landscape. Obviously some Australian equities market earnings prospects are tied to what goes on in China, but that s not true for all equities. We need to find those companies that are more immune from what s going on in China or Asia as a whole, and look for businesses with future earnings growth that is less volatile and tied into other drivers in the economy. Although there were signs of improvement in 2012, there still appears to be a circular problem in the development of Australia s domestic corporate bond market. Many corporates choose to issue offshore because they don t think local investors can support their required volume and tenor, but further allocation is suppressed in part because of lack of diversity in supply. What do you suggest can be done to break the circle, and is it important for you to see the domestic bond market developing? n Tully Our fixed income portfolio has a benchmark which is 50 per cent UBS Composite Bond and 50 per cent Citigroup Broad Investment Grade. Within the UBS component, fund managers are free to buy onshore or offshore bonds. 13

5 editorial roundtable TAKING IT TO THE HOUSE Intermediaries have noted a growing trend for super funds to be direct buyers of investment product, managing their own asset management rather than using third-party fund managers. While the trend is limited in scale so far, super funds say it has inherent value and may grow. What is your view on the trend among some super funds to have inhouse direct investment capabilities, including in fixed income? Tully It can be a difficult thing to do. You need to have a well-developed governance model and all the structure around that to ensure you are appropriately managing your members assets. Armitage We manage money both in-house and externally. Having direct investment capabilities gives us greater flexibility in areas such as private equity. It also helps us to produce cost-effective products in other areas. As such, where we feel it is appropriate from an investment perspective, it is something we will continue to look at. Pearce In-house direct investment reduces costs and gives the fund the ability to better tailor its portfolios for specific needs. For example, we have conducted large private deals with various counterparties which would have been far more difficult to fit into a limited-sized mandate. We do outsource but there is an agency risk for us. UniSuper is also actively enhancing its advisory services. We are developing a much stronger integration of the advisory service with the asset management business. We are using certain triggers to engage proactively with our members, discussing the appropriateness of their asset allocation for their specific circumstances. Brentnall The industry will continue to see more inhouse managed investments, driven by the realisation that achieving exposure to a market can in most cases be achieved cheaply. Historically, funds haven t had the expertise or governance to have in-house investment management. Investors consider their cost budgets rather carefully, but in fact they look at three variables: a gross return, investment cost and risk rather than just net return and risk. As super funds get bigger, they are finding that operationally they can bring in the expertise to invest directly and build the governance process and the systems to give their trustees sufficient comfort. At the end of the day, inhouse management of some investments will lower the investment management cost without sacrificing a large amount of return. The industry will continue to see more in-house direct investments, driven by the realisation that achieving exposure to a market can in most cases be achieved cheaply. In-house management of some investments will lower the investment management cost without sacrificing a large amount of return. Stewart Brentnall ANZ global Wealth If a fund manager believes buying a US dollar bond is more attractive than buying an Australian dollar corporate bond, we expect to see the manager buying the foreign currency bond and hedging back the currency risk. The presence of a local corporate bond market is nice, no-one would argue against it. But I don t think the allocation within fixed income necessarily needs to be Australian or AUD bonds. n Pearce I am not worried one bit about an Australian corporate going offshore to raise funds. As an equity investor in the company we want businesses to raise money for the longest term at the cheapest cost. Even though we are also a potential bond investor, we don t want the business to raise expensive funding in the domestic market, and potentially comprise our equity returns, if offshore funding is a better option. In addition, Australian corporates offshore funding takes a lot of strain off the domestic banks. The big Australian banks are effectively funding the current account deficit if you work through the flows. Australia has a much higher loan-to-deposit ratio than its peers across the globe. Offshore banks don t do as much institutional lending in their domestic markets. Their corporates are accessing the bond markets to a greater extent. n Brentnall We will see a natural shift from government to high-quality corporate bonds. We will also begin to see a more balanced corporate bond composite index, and continued issuance from supranational, sovereign and agency borrowers into Australia going forward. The size of super funds is growing every year in Australia through contribution and net inflows. Undoubtedly we will see a bigger pool here to fund more new domestic issues, probably accelerated by banks increasingly careful attitude to allocating their precious capital to lend to corporates. n Armitage I think more AUD-denominated corporate bonds will be issued, which will help achieve market depth. n Wang I see benefits of a developed domestic bond market Australian corporates have an avenue to issue debt domestically so it is an additional funding source for them. From an 14 kanganews february 2013

6 The super industry needs to move in a direction that creates new, interesting products that follow members for their entire life cycle. It is fair enough to have different products with different risk profiles, but then to expect unsophisticated members to make an active choice may be too much. Sue Wang Mercer investor s point of view, though, there is a vast universe of fixed income outside Australia which my clients can easily tap into. Getting the domestic bond market going does not necessarily mean I want to invest in it. It has to be attractive relative to other options out there. We won t consider it purely because it is an available option. Even if it grows substantially, the domestic bond market is still very small compared with the global markets. The majority of Australian super inflows to fixed income are likely to go offshore. At the end of the day, I don t think the low allocation to fixed income in Australia hurts the domestic bond market because if we got more money into that sector it would not necessarily be invested domestically. Last year also saw significantly increased issuance of retail-accessible debt securities especially hybrids. What is your view on the hybrid asset class? n Armitage For investors the focus has got to be on the outcomes and objectives we want to achieve, based on client needs. It comes down to each individual instrument, it depends on the issuers and it depends on the price. For example, hybrids like other investments and Australia like any other market need to be fully examined to see whether the pricing and the risk is correct. n Pearce UniSuper has recently bought heavily into a few wellstructured and fair-priced fixed income hybrid bonds namely Woolworths and Caltex s issues. Investors need to examine closely the structure of certain fixed income products. Some hybrid securities are structurally flawed. For example, the absence of a dividend stopper in some issues means dividends can still be paid even when interest payments are withheld. In these circumstances debt is effectively subordinated to equity, which is totally unacceptable. The other point to bear in mind is that the price volatility of hybrids, during times of crisis, is more akin to equity than debt. So you are taking equity-like risk with debt-like returns. Fixed income liquidity dynamics, especially in a relatively small market like the Australian one, are clearly different from mainstream equities. How do you think about liquidity in fixed income? n Armitage Liquidity is important for any asset class in which we invest. It is important for us not only to be able to buy assets, but also to be able to sell them when we need to. If you look at any asset class right now you will find that liquidity is too low. n Brentnall More liquid fixed income securities will typically mean lower returns so we shouldn t expect a free lunch. Rather, we need to continue to structure our portfolios carefully to make sure that at any one time no one risk, or lack of liquidity, dominates. n Wang I would argue that the Australian corporate bond market suffers from patchy liquidity it is not as liquid as, say, the US or global corporate bond markets. Having said this, it is not entirely illiquid. Even so, if the market becomes more liquid it will provide an extra alternative for domestic investors. But the lack of liquidity is not necessarily a hindrance as long as you are paid for the illiquidity. Liquidity will come as the market develops. The market is small and lacks depth and diversity, which does not stack up well in terms of relative value opportunities. I do not see it as the Australian super funds responsibility to help foster the Australian domestic corporate bond market. Our responsibility is to our members, to find the best attractive investments around the world and to judge Australian domestic bonds in that context. is this your copy of KangaNews? Subscribe today to keep abreast of the trends making headlines in the Australian and New Zealand domestic, Kangaroo and Kauri fixed income markets. CONTACT: JENNIE WRIGHT SUBSCRIPTIONS MANAGER m jwright@kanganews.com 15