Challenging The Attack on Growth Assets

It is perhaps advisable in life not to take on academics as the one thing that they do well is to argue. However the time has come for a stronger defence of the role of growth assets in investment portfolios.

My focus is a paper by professors Geoffrey Kingston and Lance Fisher from the Department of Economics at Macquarie University entitled “Down the retirement risk zone with gun and camera.” I have attached a link to the paper and recent trade press articles at the end of this blog.

Kingston and Fisher’s paper consider retirement risks and considers issues such as sequencing risk. Their core argument is that superannuation investors should reduce exposure to growth assets. They state:

We argue that sequencing risk has largely been a consequence of the dominant strategy for allocating assets in superannuation accounts. That strategy is aggressive constant-mix: allocate a high and stable share of the portfolio to growth assets. Almost all Australian providers have stubbornly adhered to aggressive constant-mix, despite the lingering fallout from 2008. That aggressive constant-mix is the industry standard is no coincidence. Superannuation balances typically peak in the neighbourhood of retirement, and the fees charged by fund managers are usually higher for growth assets than interest-bearing ones. So providers profit from aggressive constant-mix. Strong vertical integration of the Australian personal finance industry implies that financial planners typically benefit as well. And trustees enjoy a quiet life when people of different ages in the same workplace see the same superannuation returns when they compare annual statements.

If we didn’t get the message that the superannuation industry is not behaving responsibly then the authors drive the point home stating that “it is time that Australian practice shifted away from mindless constant-mix. Responsibility rests with the industry, ASIC, APRA and individual households.”

The first point is that by putting growth and defensive assets in a bucket is problematic. The superannuation industry has done a good job of educating consumers that fixed interest and bonds are defensive investments whilst shares are growth assets. However the superannuation industry itself has moved away from a simple classification of risk with the Standard Risk Measure providing guidance for how risk should be classified.

The point is that what are considered defensive investments such as bonds can be risky, whilst so called growth assets such as shares can have low volatility.

No one would think of Greek sovereign bonds as having low risk. Similarly there are companies such as Coca Cola that are less risky than other equity investments.

The other point is to understand growth and defensive investments in an Australian context.

One of the things that has always been said to me is that equity portfolios are managed differently to fixed interest portfolios. In order to achieve the desired risk and return objective from an equity portfolio a relatively small number of stocks are required. By contrast because fixed interest investments have a cap on their returns, but still have the capacity to lose capital, to deliver the desired risk and return objective it is necessary to invest in a breadth of investments. Fixed interest portfolios typically have a larger number of investments.

This represents the problem in the Australian context. The structure of the Australian capital market is that we have a small number of very large companies, and a large number of very small companies. The superannuation industry has already collectively reached the point where it will be necessary to invest more offshore as the local market is unable to absorb the flow of super contributions.

There has been a lot of discussion about the need to develop a corporate bond market in Australia. Whilst I would expect that the Australian market would evolve over time, if Australian superannuation funds shifted their investment strategies as Kingston and Fisher are advocating, the result would be that superannuation capital would flow offshore in order to find the diversity of fixed interest investments that would be required. That would require superannuation investors to increase the hedging of their portfolios in order to manage one of the major risks to capital; currency risk.

One of the questions for investors approaching retirement is volatility. Inflection Point Capital Management is looking at whether it is possible to achieve a lower volatility portfolio by investing in a portfolio of quality stocks. Inflection Point Capital’s methodology looks not only at environmental, social and governance factors as an indication of management quality, but factors such as innovation and agility. One of the things that we understand is that the world in the future will be volatile. A confluence of megatrends from climate change through to digital disruption and demographics will shape our society in coming decades. The companies that understand and adapt to their environment will also be those that are likely to provide investors with lower volatility.

Managing retirement risk is an issue that will impact on all western societies. Answers lie, not necessarily in investing in defensive investments, but considering new ways of investing.

Links

Recent Trade Press on the Kingston and Fisher paper:

http://finsia.com/news/news-article/2014/08/12/super-asset-allocations-leaving-investors-at-risk
http://www.superreview.com.au/news/superannuation/super-funds-urged-to-move-away-from-growth-assets

Geoffrey Kingston and Lance Fisher, Down the retirement risk zone with gun and camera, Department of Economics at Macquarie University, CIFR WORKING PAPER NO. 005/2014
MARCH 2014
See http://www.cifr.edu.au and http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2440977

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