With growing scrutiny being placed on the financial services industry, what can superannuation funds do to help re-establish trust and foster a sustainable future for both the investment industry and for fund members? TIM HODGSON reports.
It can be argued that today’s investment world has been built by the intermediaries, for the benefit of the intermediaries. To quote the late Barton Biggs, ‘investment is indoor work with no heavy lifting. And the pay and rations are quite good too’. In short, the financial services industry has grown too large relative to the real economy, the servant has become the master. The value proposition for the super fund member is not as strong as it should be.
A THOUGHT EXPERIMENT
A simple thought experiment quickly exposes some simple home truths about the investment industry. Put all of the world’s assets inside a giant warehouse, and let a fork-lift truck emerge periodically with a whole pile of cash — the dividends, coupons and rents. That cash is the return on savers’ investments.
They can trade their rights to ownership of the assets in the warehouse as furiously as they like, they can expend as much intellectual energy as they wish in creating the ideal portfolio, but the creation of wealth is done by the users of the capital within the warehouse.
The wealth is passed to the investors in the form of the cash carried by the fork-lift truck. In the short term, the valuation of the ownership rights will move around adding complication, but over any sensible time horizon (choose a number of decades), the return is determined by the cash.
So what can be learned from this?
Among other things, the thought experiment shows that, for investors in aggregate, there is only the market return (yes, an individual investor can get lucky, or skilful, but not all investors). It also shows that the more of the cash investors pay out to the intermediaries, the lower their return and the more slowly they compound their wealth over time. And, because the macro-consistent reality described by the experiment is rarely talked about, it implies that the intermediaries are not being totally transparent with the investors.
A recent Towers Watson paper, entitled Our Industry Has a Problem, described the results of a survey. In it, a large group of investment managers were asked for responses to the statement: ‘The investment industry is primarily designed to help the ultimate beneficiaries rather than the agents working within it’. Only 48 per cent agreed!
ISSUE 1: LACK OF TRUST
There is a problem with trust in financial services. This is clearly demonstrated by, first, the sheer number of financial services inquiries conducted in developed nations over the last decade or two, with the Australian Financial Services Inquiry being but one example.
Second, it is demonstrated by the Edelman Trust Barometer. The results for 2015 showed financial services ranked third from bottom of the 15 industries, in terms of the level of customer trust, having been bottom for the two previous years. Given that the trust survey polls 33,000 people in 27 countries it is tempting to conclude that the end investor realises that, at some level, the investment industry has not been built for their benefit, so trust needs to be rebuilt.
Trust will be evident where alignment is present, and there are strong incentives for agents to do their absolute best for the end investor.
Trust supports the well-being of the system, and is also a source of wealth generation. This can be achieved directly, through a less costly system (with less need for expensive regulation and intermediation) and indirectly through a more effective engagement process.
But, how well are super funds aligned with their members’ interests? Are they in the business of producing high, long-term money-weighted returns for existing members, or producing high, one-year, time-weighted returns in order to compete for new members?
Beyond that foundational issue of super fund mission, better trust and a better value proposition can be built through understanding real member requirements for investing and divesting over the course of a lifetime, through the quality of member education and advice, and more individually-tailored offerings.
ISSUE 2: COSTS
To return to the issue of costs, raised by the thought experiment, are super fund members receiving sufficient value for the billions of dollars spent each year on active management? Assuming for the moment that the members are the only investors, and therefore own all the assets in the warehouse, how much active management should they employ?
Active management is currently defined as producing ‘alpha’, or the return relative to the market index that can be obtained passively and cheaply.
The problem is that by definition the relative returns from active management must sum to zero, and be negative after costs. Collectively the members own all the assets, and so the minimum cost solution would make more sense.
However, 100 per cent passive management isn’t the right answer, as market prices need to be set somehow.
It is tempting to conclude that super funds could hold a significantly higher proportion of their assets in low-cost passive, without any average reduction in their long-term returns. As the industry consolidates and the super funds grow very large, they will also morph into ‘universal owners’, which are essentially asset owners that are so large they cannot escape holding a slice of everything in the warehouse. The viable set of portfolios for such asset owners is different than that available to smaller funds.
Superannuation funds should also be thinking about a stronger value proposition for their members in terms of annual running costs. This can be partially achieved through harvesting economies of scale, and this has definitely been done in Australia. It can also be achieved through changing the mandates, or the terms of existing mandates, that super funds award.
Australia has had the time and scale to build high quality internal teams within the super funds, and these teams should be better at negotiating with external suppliers or even insource some asset management. In addition the time is now right to take further steps, as there is a new mood within society at large about what is fair and what isn’t.
SOLUTION: PUTTING THE SAVER BACK AT THE CENTRE
Superannuation funds and asset managers can create a sustainable future for both the investment industry and for fund members. Their role is long term, and collectively they are large enough to influence markets and companies. In aggregate, they own a large share of the whole economy and their actions play a key role in driving prosperity.
The industry will have succeeded when the end saver knows how best they can compound their wealth throughout their lifetime, and has the right products to be able to achieve that. It’s a lofty goal and whether or not it’s achievable, none of us should die wondering.
First published in ASFA’s Superfunds magazine, September 2015