The problem with Grattan’s default fund tender

The Grattan Institute this week released a report into Australia’s superannuation system proposing that the Government should introduce a tender for default funds.

The aim of the default tender would be to reduce costs in the system – something that would have long term benefits for future retirees through increased account balances.

Grattan argue that a core criteria of the default fund tender would be fees. There are a number of ways that a superannuation fund reduce fees. One way, as identified by Grattan, is through scale. Another way is to invest passively, something that Grattan supports on the basis of the track record that active managers have beating their indexes.

Leaving aside the debate about passive and active management, there is a need to consider the impact that index investment has on capital markets and capital formation.

According to Jeffrey Wurgler, Nomura Professor of Finance at the NYU Stern School of Business, the dominance of indexed linked investing is having economic consequences.

According to Professor Wurgler “There is no doubt that indices and associated investment products are innovations that on the whole have benefited many individuals and institutions. On the other hand, their popularity has created underappreciated side effects.. (which) stem from the finite ability of stock markets to absorb index-shaped demands for stocks. Not unlike the life cycles of some other major financial innovations, the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs.

Wurgler documents a number of impacts of index investing including Index Inclusion Effects. On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event.

Once a stock becomes part of an index it starts to move with the index, something Wurgler describes as comovement. Over time index members slowly detach from the rest of the market. Evidence is also suggesting that increased index investing is associated with increased volatility in the market. Other impacts include on debt finance, with research demonstrating that new S&P 500 inclusions increase their rate of equity issuance and reduce their leverage.

As an investment strategy, indexing can make sense. However, the danger with the Grattan proposal is that we create policy settings that encourage indexing without any consideration whatsoever as to whether there is even the possibility that there could be an impact on the market and the Australian economy.

A default fund tender is not a bad idea. But before we proceed we need to consider all the impacts. The size of the superannuation pool means that superannuation is now interconnected with the Australian economy. And it also why it is time that the Grattan Institute established a permanent work stream on superannuation.

LINKS
On the Economic Consequences of Index-Linked Investing
Jeffrey Wurgler
Nomura Professor of Finance, NYU Stern School of Business
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1667188

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One thought on “The problem with Grattan’s default fund tender

  1. Gordon, thanks for engaging on the issue. These are good points.

    The report is not highly prescriptive on whether to ‘go more passive’ though it canvasses some evidence that suggests you may be able to cut costs that way. It does note that in unlisted assets (p.47) ” … government could give weight in its selection criteria to past performance net of fees, and to modelling of prospective future net returns. It could also restrict participation to funds that have substantial continuing businesses in those asset classes.” http://grattan.edu.au/report/super-savings/

    If, as you say, super is too big in say Aust Equities to rely on other market participants to provide the ‘public goods’ of price discovery etc, then super will need to play a role in providing those public goods. It may be able to do so without some of the current inefficiencies such as paying active managers who may be on opposing sides of the same trades – even at times for a single fund.

    Jim

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