The head of one of Australia's biggest investors has some advice for super fund managers who struggle to balance the books. Richard Newell listens to his words of wisdom
Leo de Bever, chief investment officer of Victorian Funds Management Corporation (VFMC) is highly regarded by his peers for his vision and good sense in the management of institutional portfolios. Prior to joining VFMC, he spent 10 years at the now $96bn Ontario Teachers Provident Plan Board with responsibility for long-term investment strategy, risk management and real assets including infrastructure, timberland and commodities. VFMC currently manages over A$40bn on behalf of the Victorian Government, including superannuation funds, insurance funds and endowments for universities and hospitals within the State.
While the growth of super fund assets has been one of the great success stories of recent years, the performance of many super fund managers has been less exceptional. De Bever is not alone in finding it hard to believe that 75% of Australian super funds cannot beat a passive stock-bond benchmark after expenses: "Which is interesting because it means you have to be top quartile just to break even." A lack of scale for many super funds, high cost of investment policy implementation and the low net return of many active fund managers are the key reasons for this failure.
De Bever advocates a simple concept of doing the basics better. For example, cash management; de Bever says, "you can make 30-40 basis points just by doing that better." Liability-driven investment has only come about as a justification for an asset mix that everyone forgot, he says. "Filling asset allocation buckets is not consistent with efficient risk allocation. Managers of long duration assets should shift from asset allocation to asset/liability risk allocation. And make sure your passive benchmarks are consistent with your liability funding objectives."
Hedge funds, says de Bever will change the way super funds invest. "There is a lot more optionality in these alternative assets. We will also see a re-evaluation of returns, with investors growing to understand that excess returns have in many cases disappeared." The shift to unlisted assets and alternatives will drive investors to embrace global markets more fully, at a time when illiquid assets are becoming more mainstream.
De Bever estimates that the IRR on real estate has fallen to 4% plus CPI, as its popularity has risen. While excess return has all but disappeared from real estate, markets such as timber and commodities are at a less mature stage of the cycle. For timberland, it is more like 6% above CPI in the US and higher in Brazil, New Zealand and Australia. For infrastructure, you are looking at unleveraged returns of 6-7% above CPI. It is an area with "lots of future opportunity", says de Bever. Private infrastructure is likely to increase dramatically, "since the public sector does not have the means or the motivation to do it efficiently. There is $500bn needed in energy infrastructure alone."
US investment bank Morgan Stanley has entered a strategic alliance with VFMC in a bid to take advantage of global infrastructure opportunities. Under the alliance, VFMC has made an initial commitment of US$400m to Morgan Stanley. VFMC has also announced that a substantially larger amount will be invested through preferential co-investment rights. It is building an internal team in Melbourne to originate assets to maximise net investment returns drawn from the alliance.
De Bever says: "The combined financial strength of our two organisations should over time make this partnership a significant player in global infrastructure investment. Infrastructure has highly desirable risk and return characteristics for VFMC clients.'
Private equity is an area where investors may be under the impression they will be getting significant added value to their portfolios. De Bever suggests this may not be so. "Statistics show that in 75% of projects, net returns are not much more than you would get in listed equity markets. Investors need to understand the risks they are taking on, especially operational risk in private equity. In reality, though, few investors calculate risk-adjusted returns".
De Bever suggests a greater use of derivatives is another trend, with investors growing to realise that using synthetic instruments can be far more cost-effective than buying and selling physical securities. However, any use of new or alternative investment approaches should only be undertaken "with the full support of the board and senior management, and should be in keeping with the corporate culture. Above all, they must be supported by strong accounting and risk control systems."
In summary then, while de Bever believes the sources of return and opportunity will increase for super funds, "alternatives will never be big enough to compensate on a risk-adjusted basis for lower returns from traditional assets. If 20% of assets add 2%, that is only 40bps." Active strategies will remain a source of consistent but only modest incremental return. Good work done in-house is the best course of action. Says de Bever: "Higher operational efficiency will be the most consistent near term source of return improvement."