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APRA seeks to prove its theory of scale

Analysis

APRA’s orthodoxy on scale and its importance to funds has been disputed by all comers, with “massive and passive” a common refrain. But the regulator is hoping to prove that bigger really is better.

One of the more controversial moments of Helen Rowell’s career as APRA’s superannuation executive was the claim that any fund below the $30 billion FUM mark was subscale. Many in the super industry were startled by the arbitrary nature of the claim – small funds most of all, who believed that their size allowed them to compete in areas of the domestic public market that were now inaccessible to their gargantuan brethren due to the capacity constraints of small- and mid-cap strategies and their ilk.

But Margaret Cole, APRA’s new superannuation czar, has revealed research that the regulator hopes will prove once and for all that scale will leave members better off in the long-term.

“What we have found is that the trustees of the largest superannuation funds are leveraging their scale and structure to lower expenses and improve operating efficiency,” Cole said on Monday (March 28). “Specifically, across funds assessed in the heatmaps, we found that the administration fees and operating expenses of the large funds with net assets greater than $50 billion are significantly less than that of the small funds with net assets under $10 billion – 0.33 per cent of net assets compared to 0.57 per cent.”

The fee argument is undoubtedly compelling. Few members want to see their retirement balance eroded by fees, especially when performance is underwhelming. But beyond fees – and absent research from APRA demonstrating a similarly positive effect of scale on investment performance – the same arguments against “bigger is better” remain.

The issue of size as it pertains to performance in areas like equities is well-researched, with plenty of anecdotal and analytic evidence to suggest that it is not always a boon (likewise, there’s research that says otherwise – do yours). The main concern is that the opportunity set dries up; the portfolio becomes generic, a closet index fund. Tack on the YFYS performance test, which Cole is at pains to say that nobody is safe from, and you have a recipe for big funds becoming their benchmarks.

The investment staff of many large funds are taking measures to avoid this undesirable scenario by expanding into areas of the private markets and exploring more innovative public market strategies; those areas have their own pitfalls, and it remains to be seen whether they’ll be successful. These areas will also likely become very crowded in the years ahead, and the top-quality managers required for successful private equity and other alternative investments harder to access.

On the one hand, we shouldn’t venerate the cult of benchmark beating returns too much; what will likely matter to members in the long-term is that their retirement savings are well-managed through events that could otherwise catastrophically reduce them. On the other, they’re entitled to – and paying for – performance beyond what they would get in an index fund.

These are ultimately philosophical criticisms of the scale argument; there’s nothing inherently wrong with “massive and passive”, but it would be helpful if APRA described its vision for how the industry should operate in greater detail. As Mine Super CEO Vasyl Nair said earlier this month: “All we know right now is that we’re being told to just drive in this particular direction at a certain speed in a certain way, but we haven’t been told where we’re going.”. Other executives have lamented what they believe will be a loss of focus on individual members they’re able to provide by virtue of being a smaller fund.

Ironically, one of the driving forces behind APRA’s push for consolidation is to reduce duplication of product design and strategy, a dynamic that is “inefficient and contrary to the functioning of a vibrant competitive market and contrary to the best financial interests of members.” If that is the case now, it will still be the case when there is only a handful of large funds. The duplication will instead be a feature of the ten or so that remain rather than the hundred-odd operating today.

Or, as ASFA chief Martin Fahy put (more succinctly) to this publication in May 2021: “Ultimately, we’re facing a choice: do we want a situation where the population ecology of super funds is characterised by diversity, where there’s innovation and competition within the market and there’s players that are niche and differentiated? Or do we want competition for the market where incumbency becomes the dominant feature? While it may be stable, it isn’t efficient and innovative.”

APRA’s research also found that around half of smaller and medium sized funds face “sustainability challenges” relating to declining member accounts and cashflows. That’s not necessarily a function of their size, or something that can’t be turned around, though the marketing budgets of the mega-funds will give them the upper hand here. Cole does not seem wedded to the $30 billion FUM level that Rowell espoused, and notes that many smaller funds are still attracting new members by differentiating themselves on key issues like ESG and sustainable investing

But scale will not be achieved through these avenues alone, and a merger is the fastest route to the big end of town. APRA will still be doing everything it can to encourage them, short of actually forcing one – a power that’s on Cole’s regulatory wish list.

It seems that APRA believes that size is a virtue, and for many good reasons – fees among them. But we should be careful lest we start to believe that size is a virtue unto itself, and APRA’s efforts to create a “vibrant, competitive market” accomplish just the opposite.




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