Bigger isn’t (always) better: The final words on fund size
In an expansive new research paper, ANU associate professor director Geoff Warren (pictured) and investment consultant Scott Lawrence attempt to answer a question that has for years bedevilled the superannuation industry and its regulators: do members actually benefit from fund size? The answer: “it depends”.
“Small funds and large funds can both do well – they just have to do it in a way that befits their size,” Warren says. “They have to identify what they’re good at and execute or implement accordingly. It is possible to be too small – likely because you can’t deliver on the governance or infrastructure requirements to do the basic stuff too well… Can you be too big? There has to be some level at which you’re too big, but I don’t think Australian funds are at that size.”
Still, there are obvious benefits to scale. Large ticket size helps in private markets, investment management costs can be cut in public markets, and there’s resources funds can utilise they might not have otherwise had – for example, portfolio completion or overview teams that a small fund would lack. Then there’s s also the ability to mass customise for the retirement phase.
“The big problem with all of that is that none of it is easy to do well,” Warren says. “Public markets, particularly equities become harder to generate alpha in, and there’ll be a pressure to go more passive, and that’s a loss to the extent you could have made some returns there… private assets aren’t always that easy to do if you’re going to have a big program, and systems projects are well known to run over budget and fail.”
“And when you start to become really big you inevitably have to build overseas offices and you’re entering into a whole new game, and you have all these staffing and coordination problems… Some organisations will do it well and some might stuff up.”
The fact that superannuation is a defined contribution system with member choice and the presence of the Your Future Your Super performance test also constrains their ability to move towards the Canadian model of large internal teams managing large allocations to unlisted assets.
“These factors lower tolerance for illiquidity and tracking error to the YFYS benchmarks, respectively. Australian superannuation funds do not appear to be embracing the Norway model (ed: of harvesting market beta due to the belief that alpha is hard to generate at size) as they are showing few signs of eschewing the search for alpha in listed markets; although some passive exposures are being added as core exposure.”
At the other end of the scale, small funds are likely to be less cost-efficient (they’re unable to access internal management on any meaningful level) but can generate “outstanding performance” regardless; they can also add value by catering for members with unique characteristics in specialised industries.
“Superannuation funds must be operated efficiently regardless of size to deliver competitive returns and excellent services to their members,” the paper says. “Members might be better served if industry participants such as policy makers, regulators and the funds themselves start to ask whether operating models are being configured to succeed at scale, rather than pushing for size for its own sake.”
“Concentrating assets in the hands of investors who behave in a similar manner can impact on market resilience. Markets are more resilient when populated by a diverse range of investors.
But there’s also an argument (and counter-argument) for keeping small funds around because they’re small.
“Having a superannuation fund industry populated by a diverse range of participants of differing sizes may bring benefits in terms of market liquidity and resilience, competition and financing of smaller firms,” the paper says. “On the other hand, small funds might generate more variable outcomes because of less well-defined governance, processes and systems, as well as being more reliant on a few key staff.”
While big funds have their benefits, Warren believes that the challenge and risk of having a lot of large funds operating in the same space has been “underplayed” and that there’s a gap in the thinking around the potential systemic risks posed by having a small number of megafunds controlling the vast majority of the retirement savings pool. Investment decisions that could affect the overall Australian economy are being “progressively concentrated” in the hands of a smaller numbers of super funds.
“Concentrating assets in the hands of investors who behave in a similar manner can impact on market resilience,” the paper says. “Markets are more resilient when populated by a diverse range of investors. This requires investors with different investment objectives and processes, risk aversions, cash flow profiles, tax status, time horizons and liquidity needs. Diversity helps avoid one-sided markets where investors tend to herd into and out of the same opportunities, which can result in lower market depth, higher volatility and potentially bubbles and crashes.”
The presence of mostly large funds and not many small ones could also mean the withdrawal of institutional capital from smaller firms – though any adverse effect would be “at the margin” as super funds aren’t their sole source of financing – while also removing the benefits of an institutional investor presence, like pricing discipline, research and deeper liquidity. A large fund encountering difficulties through YFYS underperformance could also be subject to a “run” from members, disrupting markets as assets are offloaded.
“While the Australian superannuation industry is a long way from being oligopolistic, any trend towards consolidation could diminish the variety of offerings and reduce competition to some degree,” the paper says.
“A hollowing out of smaller funds may be detrimental to the extent that they offer an alternative to large funds. For example, small and medium sized funds may act as innovators and occasionally market disruptors. This risk is compounded by barriers to entry such as difficulties in building a member base from scratch, licensing requirements, and a concern that funds with less $50 billion in assets may be considered unviable.”