The correlation between asset classes has weakened in recent years, with the range of outcomes increasing and varying from conventional understanding. We talk to State Super’s Charles Wu about what this means for the risk management of the fund’s investment portfolio.
The year 2024 was a solid 12 months for many super funds, driven by strong performance in international equity markets, led by the Magnificent Seven in the United States.
State Super’s defined contribution growth fund held up with the best, producing a return of 12.3 per cent over the 12 months to 31 January 2025, while its 10-year performance puts it in the second quartile of top performing super funds in Australia. The fund is in the top quartile on a risk-adjusted basis.
But arguably the market environment going forward will be a lot more challenging.
The first few months of Donald Trump taking the helm as President of the US has seen a trade war being unleashed through haphazardly implemented tariffs. Geopolitical tensions have increased on the back of the ongoing war in Ukraine and shifting alliances, while more frequent devastating weather events disrupt lives and economic activity, and the impact of artificial intelligence is yet unclear.
Not only does this increase the risk of drawdowns in markets, it has also changed the relationship between asset classes in the market, which means super funds can’t necessarily rely on past risk management techniques.
For a fund such as State Super, which experiences negative cash flows due to its member demographic, managing the risks of significant drawdowns, even short-lived ones, is crucial, as it doesn’t have the same ability to simply sit out a crisis until a recovery sets in. State Super is constantly selling assets, so selling into down markets means members suffer permanent loss of capital.
To manage these risks, the fund has made a number of important changes to how it operates the portfolio, Charles Wu, Chief Investment Officer of State Super, says in an interview with [i3] Insights.
when I think about the last three years, we probably lean a lot more into contractual hedging, including put options, put spreads and other forms of contractual hedging. And the reason for that is because the reliance on correlation or relationship between asset classes has weakened
“We are in negative cash flow, so hedging is always a key component,” he says. “If I look at the first seven year period to 2022, then we relied a lot on statistical hedging. That means using currencies or the correlation between different asset classes to mitigate risk.
“But when I think about the last three years, we probably lean a lot more into contractual hedging, including put options, put spreads and other forms of contractual hedging. And the reason for that is because the reliance on correlation or relationship between asset classes has weakened.”
Wu gives the example of the Japanese yen, which was a great hedge in 2010, because it was the funding currency, while the Australian dollar was a high growth currency. The Australian dollar was more or less linked to iron ore demand, which in itself is correlated to industrialisation and economic growth.
But that relationship shifted as China transitioned their economic operating model to become more of a domestic services-orientated economy.
“The Australian dollar is still linked to commodities, and deemed as a high [equity] beta currency, but the response function is a lot weaker than what it was before. So, if you think about the GFC (Global Financial Crisis) as an example, the drawdown in the Australian dollar was almost equivalent to the drawdown of the equity market, or about 80 per cent of it,” Wu says.
“But nowadays you just don’t get that. So the reliance on statistical hedging has weakened and the reliance on contractual hedging increases.”
Managing Upside Surprises
Another risk Wu and his team have to manage is that of upside surprises. The Magnificent Seven is a good case in point. At the start of 2024, many investors thought these technology stocks were richly priced, but the year only saw an acceleration in share price appreciation.
State Super can’t simply increase its allocation to equities, as this would shift the portfolio to a risk profile that is not appropriate for its members, many of whom are approaching retirement.
“We are a negative cash-flow fund and there are liquidity events on a continuous basis. So that limits our ability to take risk meaningfully” he says.
Instead of increasing risk in the overall asset allocation of the fund, State Super uses call options to participate in upside surprises when they occur.
“We use put options on the left-hand side [to mitigate downside risk], while we use call options on the right-hand side. So rather than being risk on or risk-off, we are more or less risk neutral, and we play against the dispersion within the asset classes,” he says.
when I think about the last three years, we probably lean a lot more into contractual hedging, including put options, put spreads and other forms of contractual hedging. And the reason for that is because the reliance on correlation or relationship between asset classes has weakened
The dispersion in asset classes has increased a lot in recent years. Looking at the past 10 years, you can almost cut this period in half. The second half had about three times as many jumps of greater than 5 per cent, than the first five-year period. This has made it a lot harder to be risk-off in your asset allocation, Wu says.
“Especially in the last three years it was hard to hold risk. Basically, there was always a reason to de-risk,” he says. “But we have to be quite mindful that the right tail risk has increased substantially, so we now also hedge the upside.”
State Super has just appointed a manager, Long Tail Alpha, to implement this strategy. Long Tail Alpha was founded in 2015 by Vineer Bhansali, who is well-known for his former role as Head of the Quantitative Portfolios Team at PIMCO and who has authored several books on tail risk hedging.
“We put on a small sleeve of call options. So rather than blindly increasing risk, which has a linear pay-off, we hold the risk and then we use the option to take the upside. But we’re still hedging the downside more than the upside,” he says.
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[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.