State Super was one of the top-performing funds in Australia during the March quarter, largely due to its decision to have tail-risk strategies in place. We talk to CEO John Livanas about the fund’s approach and the changed world post-pandemic.
While markets today seem to be buoyed by confidence in central banks and the rapid measures they put in place to support their economies, as well as perhaps by optimism around the ability to find a coronavirus vaccine, John Livanas, Chief Executive Officer of State Super, remains cautious and says that, as is often the case when there is a significant global disruption such as the COVID-19 pandemic, the world is likely to have changed permanently.
It will accelerate some trends and create disruption in others over the long term.
One clear example is property. The case of challenges in commercial property is clear – and in particular retail property. But increasingly, there are likely to be changes in office and also residential property as people reassess their living and working conditions. Of course, this will have an effect on transport, distribution and delivery of services.
“Just one example might be a possible reversal of the trend to ever-smaller apartments in the inner-city,” Livanas says in an interview with [i3] Insights.
“Remote working is not conducive to small apartments where they really have only been designed as a place to go and sleep.
“There is some evidence from the USA that people are looking to move to the suburbs as a result of the capability to work remotely and the benefit of now having far less frequent commuting.”
And yet, even such a change might have flow-on effects for how services are delivered, how companies organise themselves to deliver their services, how they motivate their staff and manage their capital.
It’s a bigger shock than I’ve ever seen in my career and you’re going to have winners and losers. So if that’s the case, then you’re going to be really careful not to just invest passively into the market
It is just one example of the many changes Livanas expects to see from such a dramatic shock. “When these shocks happen, there are always beneficiaries and there are those that miss the boat,” he says.
“It’s a bigger shock than I’ve ever seen in my career and you’re going to have winners and losers. So if that’s the case, then you’re going to be really careful not to just invest passively into the market.
“Maybe you’ll be okay in the short term as the massive policy interventions buoy the economy, but certainly in the medium to long term, you’re going to have a massive dispersion of outcomes. You need to have much more active management.”
But even among active managers there will be many who will be unable to identify the companies that will benefit in this environment. “We’re about to see, I think, one of the widest dispersions in outcomes in active management that we’ve ever seen before. Some will get it right and some very, very wrong,” he says.
“Right now the market is going up because the cost of risk has dropped all the way down as a result of policy support. But at some stage earnings will matter because ultimately companies operate in the real economy and earnings are what really keeps businesses solvent over the long term.
“We spend quite a lot of time thinking about what our portfolio is going to look like under different scenarios.
“We have successfully navigated the first part of this disruption so far. Part of that has been the fact that, unlike most funds, we are a closed fund and we’ve always had to face the potential of significant liquidity requests. And that’s forced us to actually create a portfolio that is different to many of the others.”
State Super is a closed fund and has been closed to new members since 1992. Its existing member base is getting older, with many retiring and redeeming their money. As a result, the fund sees about $5 billion in outflows a year.
This characteristic meant the fund required a portfolio that was biased towards managing the downside risks of significant outflows, with liquidity at the centre of its design.
“More and more of our members are retiring each year, and when they do, many are required to take their money out of the portfolio as a lump sum. This is true for both our defined benefit (DB) and defined contribution (DC) portfolios. So whichever way you look at it, we are required to maintain the appropriate amount of liquidity in the portfolios to ensure we are always able to meet our obligations,” Livanas says.
“This philosophy is in the DNA of State Super. And these challenges dictate a number of our policies.
“The first was that we expected retirements to increase and we had to make sure we had the capacity to support these retirements without impacting the portfolio. This led to a comprehensive liquidity policy.
Given the much shorter horizon of our members, we needed to limit the downside risks so that it was less likely that members’ retirement funds would be overtly affected by the date on which they retired. This led to a defensive requirement in the portfolio as a policy.
“Secondly, given the much shorter horizon of our members, we needed to limit the downside risks so that it was less likely that members’ retirement funds would be overtly affected by the date on which they retired. This led to a defensive requirement in the portfolio as a policy.
“But thirdly, with shorter duration and the need for defensiveness and liquidity, it became harder to achieve our objectives. This meant investing in ways that would pay for our downside protection framework and also reduce volatility through understanding how all of our assets interact with each other.
“We still have to take a lot of equity-like risk, but then we have a derivatives and diversification program to protect the downside.”
Portfolio protection comes in many forms, from defensive and unlisted assets to option overlays. A key part of State Super’s approach is a downside risk hedging strategy that is managed on behalf of State Super by TCorp for the DB funds and internally and externally for the DC funds.
“In the DC portfolio, because we offer accumulation-style options and members can switch, we are focused on a shoulder event of up to 20 per cent. Protection costs the portfolio money, but we have demonstrated our strong performance in up markets and great performance in down markets,” Livanas says.
Much has been made about the federal government’s decision to allow people who are experiencing financial hardship as a result of the pandemic to access part of their super early, withdrawing $10,000 in 2019/20 and another $10,000 in 2020/21. This puts additional strain on a fund’s liquidity position, but Livanas says this doesn’t affect State Super much.
“By and large our members have got much higher balances [than the average super fund] so taking $10,000 out is not going to impact our liquidity significantly. The bigger difference for us is when members retire and take all of their money out; that’s what we work hard to model,” he says.
State Super’s capital-preserving approach to investing has worked for it during the recent turmoil, but it is not simply a matter of keeping these positions on. Put options are now prohibitively expensive, while the cash generated from their previous tail-risk hedges also needs to find a home.
“If you think about it, our equity positions dropped significantly in value in the middle of March, for which our options strategies paid out in cash. Our team didn’t rebalance straight away because once we had monetised our options, our portfolio risk profile changed,” Livanas says.
“However, over April and May we were able to use this added capital to rebuild our defensive positions and then to gradually increase our risk exposure.
“There is a school of thought that talks about disciplined rebalancing. As is the case with most disruptive events in financial markets, the prices of some assets are more volatile than others.
Comparing the value of equity holdings to that of property on a particular rebalance date can result in spurious rebalancing. That’s when judgment should be used.
“For example, illiquid versus liquid assets are often priced in different ways. Securities are priced on the basis of their last trades. Property is revalued less frequently and is based on a mix of assumptions. Comparing the value of equity holdings to that of property on a particular rebalance date can result in spurious rebalancing. That’s when judgment should be used.”
The issue is less precarious for State Super’s DB portfolio, since the pooled nature of the fund means it can withstand larger shocks.
“The DB portfolio’s downside is more about tail risk so it’s there to protect it when it drops below 20 to 25 per cent and it has worked really well. A significant residual tail-risk hedge was retained after March,” Livanas says.
Livanas says his team is constructive but cautious. Yes, equity markets have recovered most of their March losses, but the outlook is uncertain and the chance of further pain to come is high.
“We took risk off the table quickly in early March and since then we have maintained a somewhat defensive posture until we have some greater clarity and have appropriate defensiveness in our portfolio. We think our primary role is to protect the relative gains we made in the downturn, even as we increase our risk exposure,” Livanas says.
“We still have quite a lot of exposure to foreign currency, which provides some downside protection, and then we also have quite a lot of cash. At one stage we were up to 12 to 15 per cent cash in our Growth fund.
“Are we comfortable that we may underperform a little bit on the upside? Given that it’s coming to the end of the financial year, we know some members retire in July. We think it better to hold onto the relative gains we made in March and be more cautious in taking risk.”
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.