Do industry funds really outperform?

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With the change of government, industry funds face the prospect of a more challenging external environment. It is Coalition policy to sever the connection between industrial awards and super, with the potential for any MySuper product to become eligible to receive mandated contributions, thus breaking the semi-monopolies that many industry funds enjoy.

While a serious challenge to industry fund incumbency is still several years off at a minimum, assuming that the government can actually implement its policy, the protagonists are already starting to mount their arguments.

One of the regular, and more interesting, arguments is that industry funds outperform their retail competitors; that over the past 10 years they have outperformed by >1% pa.

There are some quibbles about whether this is an apples with apples comparison, but it’s generally accepted that industry funds have outperformed, and that this is substantially because of lower costs and much higher allocations to unlisted assets. It has been common for large industry funds to have illiquid exposures (mainly infrastructure, real estate, and private equity) of ~25%, much higher than would be observed in retail funds.

While historical outperformance of retail competitors is a great competitive position to be starting from, is it a useful indicator for the future?

Not necessarily.

For a start, the retail competitor of the future will be different, in an environment where retailers have unbundled advice costs post-FoFA, and cut portfolio and other costs post-MySuper. The cost differential has largely disappeared; indeed retail may prove lower cost in some cases going forward.

It’s also possible that the performance kicker was a one-off from unlisted assets being mispriced in the past. But let’s assume that outperformance came from capturing the illiquidity premium of unlisted assets, and that this will persist into the future. It could well be argued that industry funds were only able to take such large illiquid positions due to their semi-monopolies on mandated contributions, which have guaranteed large net inflow positions. Retail competitors do not enjoy such advantages, and tend to be in more marginal net inflow positions, which greatly limits the degree of illiquidity which can be prudently taken on.

As every fund manager knows, it’s generally a huge advantage to have strong net inflow. It’s like having a gale blowing at your back. It provides greatly enhanced flexibility in managing a portfolio, making it easier to fund new positions, and dilutes mistakes away.

On this analysis, it’s not a surprise that industry funds have outperformed. The really interesting question is, having enjoyed such large cashflow advantages, have industry funds outperformed as much as they should have? Or asked differently, have industry funds outperformed on a cashflow adjusted basis? That is a question for the asset consultants (if they dare).

The other question which falls out is this – has the super system as a whole has benefited from limitations on competition for mandated contributions?

Clearly members of the industry fund segment have done so in the past decade. But has that simply been at the cost of members elsewhere in the system? Ie if retail funds had been able to compete for those contributions, they would have enjoyed more secure net inflow positions, and may have taken on higher illiquid exposures, increasing returns to their members.

But it’s also possible that open competition for contributions may have resulted in less secure net inflow positions for everyone, leading to lower illiquid exposures, and lower returns across the board.

It’s impossible to say either way. But it does serve as a reminder that cashflow can be an important contributor to performance, and that industry funds have enjoyed tremendous cashflow advantages over the past decade of outperformance.

Those net cashflows are now eroding as fund memberships mature and age, and higher balance members look to SMSFs; some smaller industry funds are already finding themselves constrained in their illiquid exposures.

So yes, industry funds really have outperformed, but on both cost and investment return drivers, may find it harder to maintain this into the future.

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