How Super Funds Can Make Scale Pay
The asset pool of Australia’s regulated superannuation funds hit $2 trillion at the end of 2019, having more than doubled in the past seven years. By contrast, the number of funds dropped by a third, as they seek better member outcomes and economies of scale to boost performance.
This has led to the emergence of so-called ‘mega funds’ and the phenomenon looks set to continue, with the Australian Prudential Regulation Authority (APRA) sustaining the pressure on poor-performing funds to “merge or exit the industry.”
Consolidation continued throughout 2020 despite the turbulent year. In August, IOOF announced its merger with MLC to create a $173 billion mega fund, surpassing the newly created Aware Super ($130 billion). The ongoing merger discussions of QSuper and Sunsuper, meanwhile, would create a $195 billion fund.
More deals are imminent and are estimated to involve $1.5 trillion of assets. To put that figure into perspective, the market capitalisation of companies listed on the Australian Securities Exchange (ASX) stands at $2.2 trillion.
Consolidation brings economies of scale — a central objective that has a number of benefits. Industry data provider Rainmaker says that member fees dropped by an average of 21% as a result of super fund mergers over the past three years.
On the income side of the balance sheet, a larger pool of money opens doors to other investment opportunities — particularly in alternative asset classes such as private equity, real estate and infrastructure.
However, these benefits do not happen automatically. The Productivity Commission’s 2018 assessment found evidence for benefits of scale related to administration expenses and investment returns, but this was not clear in all cases, and it indicated that “significant unrealised economies remain”.
The need for portfolio diversification means that mega funds have had to become global, multi-asset managers. As their portfolios have grown in size and complexity, a robust operating model is critical to providing effective and efficient support.
HOW TO BECOME AN EFFECTIVE MULTI-ASSET MANAGER
1) Internalisation of investment management: Look before you leap
As they grow their portfolio complexity and size, super funds have to consider which investment strategies to internalise as they think about cost controls and management fees.
AustralianSuper, for instance, has set a target of managing 50% of its assets in-house by 2021, and increased in-house management to 40% last year from 31%, driving $160 million in savings for members. UniSuper, which has led this insourcing trend, manages almost 70% of its investments internally.
But this trend will lead to investment teams demanding access to new markets, data and investment solutions at a faster pace than middle and back-office support staff can accommodate them. And building and managing the internal infrastructure to match the fund’s expansion might undo the economies of scale it was hoping to create.
2) Embedding flexibility: Get ready to scale up
Australia’s superannuation funds can learn something from some of the world’s largest public asset owners in the US, which have already been down this road. Many first attempted to install their own technology platforms, to build out back-office support and create their own data warehouses to maintain full control, only to realise it was sapping resources from higher-value activities and moving too slowly to properly enable investment teams.
Institutions are now focused on a model whereby more complex functions such as risk management, mark-to-market (MTM) valuations and data analysis and management are outsourced to a dedicated provider. This ensures continuity of access to the latest technology and frees up in-house talent to focus on core portfolio management responsibilities and more value-adding activities.
This model has been vindicated during the pandemic. The finance staff forced to work from home discovered that compliance and cybersecurity protocols have restricted access to their own proprietary information and disrupted business processes. Functions outsourced to a global provider, on the other hand, remained accessible.
Although keeping control of investment decisions is crucial, institutions can use the service providers’ expertise for more non-core, yet critical functions — including execution, analytics and reporting.
Super funds have longer-term demands to consider, too. As they expand their investment portfolios, they will need to convert the higher, fixed costs of internal trading platforms into scalable variable costs. And they need extensive access to liquidity pools and execution capabilities across markets and asset classes.
3) The technology arms race: How to keep pace
As super funds expand their investment portfolios, they need a flexible technology infrastructure to quickly and seamlessly onboard new asset classes and supporting operations.
But that is only part of the story. The investment industry is going through a technology revolution that is redefining how it consumes and applies data — and this is not a race that super funds can run on their own.
The data available to support investment decision-making is growing exponentially. Consultancy firm Opimas has estimated that the market for environmental, social and governance (ESG) data, for instance, could reach US$1 billion ($1.3 billion) globally in 2021, and analysis by industry trade groups suggests that there are now 445 — and rising — ‘alternative data’ firms providing institutional investors with insights from non-traditional information sources.
This tells us that super funds will need more advanced data management capabilities: increased migration to cloud and access to centralised data warehouses that can process proprietary and external information sources in near-real time.
BENEFITS BEYOND ECONOMIES OF SCALE
The power of size is about more than just economies of scale. In private markets, mega fund status offers a substantial competitive advantage. A mega fund with close to $200 billion has more freedom to co-invest with general partners in private assets, which helps to cut fees and improve returns, and they have more control over risk decisions. They can even bypass general partners altogether — buying a building, say, or even an airport outright — which gives them full control and a long-term income stream.
As super funds gain scale, they can also compete with private equity funds in the public markets, with the financial muscle to buy out a company and take it private, rather than just invest in it.
Mega funds can also capture opportunities that were previously hard to access, such as long-term lending. Banks have had to retreat as more onerous regulatory and capital requirements force their hand, allowing super funds to step in and lend directly to businesses. For a super fund, such opportunities bring the added advantage of supporting domestic businesses whose employees are the contributors of their funding.
HOW BIG IS BEST?
Debate rages about the exact endgame for the super fund industry. For instance, a Right Lane Consulting report concludes that the ideal structure for Australia’s superannuation system would be no more than five generalist mega-funds and 10 specialised funds. Others argue that we need a longer-term analysis of the impact on investment returns and insurance cover before this thesis is fully supported.
What is clear is that the debate is less about whether bigger is better, and more about how big is best?
The onus is now on super fund executives, regulators and outsourcing partners to make sure that ‘mega’ is used to its full potential — and that members reap the rewards.
Babloo Sarin is head of asset owners - Asia Pacific at State Street.
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