Tim Farrelly | Portfolio Construction Forum | 14 December 2018
Australia’s largest super fund, Australian Super, would have us believe a balanced fund has 80% in growth assets, the industry euphemism for risky assets. The Vanguard Balanced Fund has a more cautious 50% in growth assets. At an extreme, the Host Plus Balanced fund has 90% in growth assets but claims 75% by classifying infrastructure as 50% growth and property as 25% growth. Many investment advisory firms have their balanced portfolios at closer to 50% growth assets, while others have it at 70%.
Clearly, we have a problem! How are investors meant to deal with this? They are entitled to think that the industry has some standards so that they may compare like with like, but obviously that’s not the case.
The Financial Services Council and Association of Super Funds Australia have had a crack at this with their Standard Risk Measure. For each fund, a manager is meant to estimate how often the fund will experience negative returns in any 20-year period, using some reasonably similar assumptions. This should enable investors to compare like with like.
Unfortunately, the results produced by the Standard Risk Measure are nonsensical.
Firstly, the results are unstable. In 2010, when the SRM was released, a government bond fund with expected returns of 5% and a volatility of 3.5% would have been deemed to be Low to Medium risk with between one and two negative returns expected every 20 years. Today, with bond rates at 2.7%, the same fund should produce four to five negative returns every 20 years, putting it in the the second riskiest category, the High Risk basket.
Secondly, the measure estimates how often a fund may produce negative returns but says nothing about how large that fall might be. Today, a balanced fund may be assumed to produce 7.5% per annum returns with 10% volatility. That implies five negative returns every 20 years – the same as for a government bond fund! The only difference between the two is that, in a bad year, the bond fund might produce a –8% return as opposed to a –30% return from a balanced fund. farrelly’s thinks investors would like to know this up front.
farrelly’s would like to see a standard risk measure that estimates how a fund may perform in a serious bear market for that fund. We could use 1975, 1987 and 2008 as benchmarks. This would deliver both meaningful and stable outcomes. In this world, the Australian Super Fund would be rated at approximately a –35% risk, and the Vanguard Balanced fund would come in at around a -22% risk. Now we would have a risk measure that provides genuinely valuable information to investors and would enable sensible comparisons of performance between funds of similar risk levels.
But we shouldn’t hold our breath. The industry seems to have little interest in genuinely informing investors about risk.
Instead, farrelly’s suggests dropping confusing and unhelpful portfolio labels in favour of numbers (e.g. portfolios 1 to 5). Using numbers shifts the focus to communicating the true level of risk in a portfolio to investors, rather than trying to match an investor with a nebulous label.
Meaningless fund names? A standard risk measure that tells us very little about risk?
It’s nuts and you can clearly see it’s nuts.
ABOUT THE AUTHOR
Tim Farrelly is principal of specialist asset allocation research house, farrelly’s Investment Strategy
Is your balanced superannuation fund risky and unbalanced?
After nine years of strong performance, balanced super funds are underwater five months into the new financial year, prompting some to question that they are carrying too much risk.
VOLATILE financial markets are set to pressure Aussie savers to question just how risky their superannuation fund’s balanced investment option is.
Big variations in asset mixes within funds’ will cause some members to worry about what’s in their nest egg.
A majority of workers’ super is in default balanced funds, which government figures show comprise an average 70 per cent growth assets such as shares and property, and 30 per cent defensive assets such as cash and bonds.
However, Marinis Financial Group managing director Theo Marinis said some balanced funds were a “wolf in sheep’s clothing” because they comprised up to 90 per cent growth assets.
“Any link with a balanced fund profile is tenuous,” he said.
A large market correction would result in “massive underperformance” by so-called balanced funds that were really growth funds, Mr Marinis said, so members needed to know just how their money was invested.
We’re five months into the 2018-19 financial year and the nation’s biggest balanced super funds have a negative year-to-date investment return after sharp falls in shares. Their high-growth options have fallen further, and even their conservative investment options are negative, hit by low interest rates.
Rainmaker Information, the research group behind the SelectingSuper fund comparison service, defines a balanced portfolio as having between 55 and 75 per cent in growth assets.
Its executive director of research, Alex Dunnin, said there were several definitions of balanced but none were universally accepted.
“Yes the term is very confusing. But before we get too excited the issue only matters if you’re trying to compare funds or decompose why they did well or didn’t,” he said.
Many people did not care too much about the term “balanced”, Mr Dunnin said, and simply wanted their fund to invest for good long-term returns without taking on excessive risks.
“Recently some people in superannuation have been saying balanced funds should be a 50:50 mix between growth and defensive assets, but that would make for very conservative portfolios.”
Mr Marinis said the Productivity Commission should set rules to define investment profiles such as “balanced”, “conservative” and “high growth”.
“The potential for people to rely on terms which are fundamentally misleading should be removed,” he said.
However, Mr Dunnin said national rules were unlikely. “Let’s recall that if we can’t agree on the formal definition of what a free range egg is how on earth will we be able to define what a ‘balanced’ portfolio is?”
HOW DEFAULT SUPER FUNDS INVEST
Aussie shares 21%
International shares 29%
Fixed interest 20%
(Source: APRA MySuper data)
Original article here