‘Is that the best outcome?’: Member inequality lurks in illiquids
Despite their surging popularity, risks lurk within illiquid assets that put member outcomes and portfolio quality at risk – and there’s little regulation for handling them.
Illiquid assets – anything from infrastructure and commercial property to venture capital and private equity – are experiencing a surge in popularity as institutional investors face down a future of muted equity market returns. But outside of their investment applications, illiquid assets, and the way that super funds handle them, can create inequality for members.
“The most obvious example is stale pricing in the fund – one member will be transacting at a premium and the other member is on the other side of that,” says David Bell, executive director of the Conexus Institute and former CIO of Mine Super. “But imagine you step through a market crisis, like the GFC. You’ve got members switching out of your main options, you’ve got FX settlements – a whole bunch of claims you have to fund.”
“And you do that with your liquid assets, and your illiquid assets become a larger part of your portfolio, which gets out of shape and that becomes a problem that the remaining members are exposed to as opposed to ones who are redeeming and so contributing to that problem.”
The next problem follows from the portfolio quality piece; getting it back into shape will involve selling some of the illiquid assets, and doing that during a crisis means incurring large transaction costs and likely taking a hit on the value.
“That cost is purely being borne by the remaining members in the fund,” Bell says. “Is that the best outcome?”
In the world of managed investment schemes, a fund with a greater than 20 per cent allocation to illiquid assets would be deemed an illiquid fund by ASIC. While APRA has provided updated guidance on liquidity and cash flow that requires trustees to have a liquidity management plan in place for each investment option, the “simple, rigid policy” applied to managed funds doesn’t apply to super funds.
The other, well-understood problem with illiquid assets, is right there in the name – and other commentators have warned that the system faces the prospect of an “old-fashioned bank run”
“If you have 50 per cent of your members redeem in some terrible public relations scenario, it doesn’t matter if you’re big or small,” Bell says. “If you’re really big it might be worthwhile for the investment banks to get in and work out ways to facilitate liquidity for you, because there’s bigger tickets at play, but you’re still just as exposed.”
It’s hardly a new problem – during the GFC, MTAA Super, then one of the best performing funds in the market, faced fierce criticism from regulators and the press for the consequences of its high allocation to illiquid assets– but it is one that begs for closer examination in the aftermath of the Your Future Your Super reforms, which are almost guaranteed to create a liquidity event for any fund that fails the performance test.
“Your Future Your Super does introduce another possible reason for switching rates that weren’t planned for… Hopefully as Your Future Your Super came in every single fund updated their frameworks and thought about that a bit more,” Bell says.
Conexus conducted open-source research alongside CFA Societies and found that super funds need to consider the limit of inequality for members that they’re prepared to accept as a trustee and created models to do so – including ones dealing with the potential impact of Your Future Your Super.
“What we’re just calling out here is, do the benefits exceed the challenges that come with allocating to this, and can we manage these challenges in a good framework?” Bell says. “And then building some policy around how you manage these issues that would then feed into your portfolio construction decisions and your product design decisions.”