It has been a little over three years since the merger between SunSuper and QSuper created the Australian Retirement Trust and the world is now a very different place. We speak with CIO Ian Patrick about structural changes in global markets, the merits of strategic internalisation and touch upon learnings from the merger.
Concentration in equity markets is something Australian investors are used to, but which is a relatively new phenomenon in United States markets.
But the emergence of a handful of American technology stocks with near monopolistic characteristics in recent years has changed the dynamics of the markets significantly.
Last year, we saw the impact the performance of the Magnificent Seven had on the broader market and the issues it caused for active managers to outperform their benchmarks.
But does this mean institutional investors should change the way they invest?
Yes and no, says Ian Patrick, Chief Investment Officer at one of Australia’s largest funds, the Australian Retirement Trust (ART).
“You’ve had a valuation question and perhaps a concentration of valuation question – not just a concentration of representation, but also a dispersion of valuation between the Magnificent Seven and a couple of healthcare stocks,” Patrick says in an interview with [i3] Insights.
“Does that indicate one should do something a little bit differently? One response to that – which we hear anecdotally from the sell side and other researchers – is that you’re seeing people close out their active risk.”
As a result of this practice, institutional investors have been net buyers of the Magnificent Seven stocks to alleviate their underweight positions from employing active managers. The buying activity around these large-cap stocks has then caused further pressure on the valuation of these companies, aggravating the disconnect with the rest of the market.
Because everybody will be trying to manage that active risk at some level, does that actually increase the opportunity set for active management? Counterintuitively, it does because there's more opportunity to recognise market effects on pricing
But Patrick says this situation also creates opportunities for the fund.
“Because everybody will be trying to manage that active risk at some level, does that actually increase the opportunity set for active management? Counterintuitively, it does because there’s more opportunity to recognise market effects on pricing,” he says.
It doesn’t mean ART has fundamentally changed its approach to equity investing, but the current dynamics certainly have been a topic of discussion during investment committee meetings, he says. Ultimately, it is about understanding the drivers in the market so the fund can adjust the level of active risk it takes.
“We’re probably not fundamentally changing other than to recognise there’s a different set of dynamics in operation, which is a function of MySuper, a function of concentration and a function of increasingly sophisticated portfolio construction,” Patrick says.
“[But] one of the questions that the sell side posited to us was: ‘Should you maybe index stocks 50 to 100, or stocks 30 to 100, and employ a concentrated active [strategy] in the large-cap stocks, because the dynamics around flows, the dynamics around portfolio completion and the dynamics around let’s call it domestic and international macro factors might offer you the opportunity to be more active?
“Now it’s an open question, we haven’t concluded that research yet.”
Revisiting the Question of Internalisation
ART manages more than $330 billion in assets for 2.4 million members and it is continuing to grow every year. As it grows larger, the interaction of the fund with the broader market changes too, especially when considering the issue of capacity in equity markets and market impact.
One solution to capacity issues is internalisation. This could not only lead to lower investment costs, but also address problems around the deployment of large sums of capital.
When [i3] Insights spoke to Patrick three years ago, ART had only recently completed the merger with QSuper and he indicated internalisation wasn’t on the cards yet. But he also said at the time that the situation could easily change over the coming years.
Yet, when asked again, he remains firm in his conviction that the outsourced model has delivered strong performance for members.
“We will very deliberately, and I think proudly, say that to date the model of being largely outsourced for the majority of our invested capital has served us well in terms of the outcomes generated,” he says.
“We have deliberately evolved it through changing the nature of our partnerships, driving down the aggregate costs of that largely external model in a way that is commensurate with our size.
“We will still declare today that we believe this is the way to deliver the optimum outcome for our members and maintain access to the broadest skill sets and specialities relevant to the types of allocations we want to make.”
But he does acknowledge size is increasingly presenting a problem and it was a key driver in moving to a core of passive investments a few years ago.
For a couple of reasons, you invariably end up internalising components a little bit more, but the way we typically phrase it is we're pursuing internalisation where it's strategically important to us with the appropriate level of diversification
“It has always been the case that scale presents some disadvantages in relation to that model,” he says.
“You present business risk from being a single source of capital for an external partner or it may require too much change in terms of personnel and business complexity for a smaller manager. They might prefer not to work with us, so our scale presents some disadvantages.”
ART does manage certain functions in-house as there is a so-called ‘grey space’ in between insourcing and outsourcing that doesn’t fit neatly in either camp.
“There is a grey space where you just can’t find a market capability that has the [full] knowledge of your portfolio. In particular overlays, where we have a real-time view, or we can take a view and implement it in a dynamic asset allocation context with speed,” Patrick says.
“For a couple of reasons, you invariably end up internalising components a little bit more, but the way we typically phrase it is we’re pursuing internalisation where it’s strategically important to us with the appropriate level of diversification.”
He gives the example of trading sovereign bond derivatives to manage the fund’s targeted duration, also known as duration completion. A critical part of the execution of its investment strategy, ART manages duration completion at the core of several synthetic bond portfolios.
“You probably could get a manager to implement that for you, but it would be unlikely that you’d get a manager to design it for you in a way that acknowledges our investment process and the level of duration we want to target, given all the other exposures we have in our portfolio,” Patrick says.
“So extending the implementation of the target duration – given it’s a little bit more than a handful of sovereign bond future markets – is something that makes sense to us to internalise.
“But would we go and internalise investment-grade credit? No. When you think of investment-grade credit with the series of specialist sectors and analysts required for fundamental analysis spread across the globe, then we’re much better off using a suitably resourced specialist or shop with specialist capabilities.”
The Danger of Moving the Market
Although capacity issues are a real challenge in equity investing, ART is still some way away from breaching size thresholds.
The Corporations Act requires investors to declare a key shareholding when they breach the threshold of 5 per cent. ART has a number of significant positions as a result of its active strategies, but Patrick says the fund will not breach an average of 5 per cent across the ASX 300 until well into the 2030s.
But when those thresholds are reached, the fund will be forced to make a choice, he says.
“Both as a function of the concentration of institutional investors in the market and the ability to employ active management in a stealthy way so you don’t leave a market footprint will mean that you are doing things differently by the time you get to $500 billion to $800 billion,” he says.
“You’re either doing less active [management] or you’re taking a longer horizon and trading in and out of whatever active positions you have in a far more incremental way.
“The very fact that we went to a core of passive some time ago was in anticipation that it would become increasingly more difficult, but we’re not at the point where we’re saying the remaining active needs to be cut back drastically.”
Learnings From the Merger
It is a little over three years after the formal merger date between SunSuper and QSuper and Patrick has had time to reflect on the learnings from this milestone event.
Although the merger was a success on many fronts, there are always valuable takeaways to improve processes going forward. Asked if he would have done anything differently, he answers that there were some good lessons in how to assess all the different aspects that come into play when merging portfolios.
He illustrates his point by way of a hypothetical example.
Take two real estate portfolios that have a meaningfully different sector composition. How you merge these portfolios in a way that is fair to all members is not always straightforward.
“Let me use an example where one is overweight retail and the other one is overweight office [property],” Patrick says.
Because [in a merger] members effectively are trading parts of the underlying portfolio with each other, the risk-adjusted return on a go-forward basis should be similar. Are you going to be able to put your hand on your heart and say: ‘These members are getting a reasonable deal?’ That is quite a hard determination to make at the best of times
“With the one that is overweight office, you probably are more concerned about the veracity of current valuations because if you’re going back to March-June last year – well past COVID-19, but still not too long after Silicon Valley Bank had gone under – there was still quite a lot of concern about commercial mortgage-backed securities hanging around.
“And because [in a merger] members effectively are trading parts of the underlying portfolio with each other, the risk-adjusted return on a go-forward basis should be similar. Are you going to be able to put your hand on your heart and say: ‘These members are getting a reasonable deal?’ That is quite a hard determination to make at the best of times.
“Then you also need to think about how the investment committee would react, what body of evidence you need to build, what kind of tolerances you might accept in forward return impact to say: ‘On balance, we believe this is in the best interest of both sets of members to combine.’
“Progressively engaging that exercise taught us quite a lot and probably taught us things that we did differently in the end than where we might have started.”
__________
[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.