In this interview, [i3] Insights speaks with Ian Patrick, Chief Investment Officer of the Australian Retirement Trust (ART), about the implications of the recent merger for the fund’s investments and the way it constructs portfolios going forward.
On 28 February, Sunsuper and QSuper merged to become the Australian Retirement Trust (ART). This date was not merely the end point of the amalgamation process, but in many ways just the beginning.
When two funds enter into merger discussions there are strict rules around the level of detail each party is privy to. After all, if the merger falls through, you end up being competitors again.
For Ian Patrick, Chief Investment Officer of ART and formerly of Sunsuper, this meant looking for efficiencies had to wait until after the set date.
“The sort of analogy I have used is of a gate, because in the run-up to the merger we were effectively preparing everything so that the gate could be opened, but then everybody rushes through the gate and wants to make progress across the field,” Patrick says in an interview with [i3] Insights.
“We didn’t have the ability to look into the field beforehand, because of competition protocols and so up to and including the point of merger you couldn’t really look at the most effective way of addressing things in the field. All of those kinds of things were unknown,” he says.
A key example of an unknown factor were the terms and conditions of the investment mandates with external managers of each fund. The fees and structure of the mandates were considered commercially sensitive information and have only become available to the combined investment team after the official merger date.
Of course, we've done our due diligence on everything we could, from the strategies each fund was pursuing in terms of the asset allocation to the core processes that each manager employed to derive their investment decisions from. But that due diligence then had to stop at certain points that are quite important to the ultimate rationalisation of the portfolios
“At no stage could we share details of the mandate structures and fees of the managers that we held in common or that were different between the two entities, or even details of those managers within either entity that the other might want to engage as part of their program going forward,” Patrick says.
“It could be seen as anti-competitive if you started to plan for consolidation and look at mandate negotiation strategies for fees.
“Of course, we’ve done our due diligence on everything we could, from the strategies each fund was pursuing in terms of the asset allocation to the core processes that each manager employed to derive their investment decisions from.
“But that due diligence then had to stop at certain points that are quite important to the ultimate rationalisation of the portfolios,” he says.
Early on in the due diligence process, the boards of Sunsuper and QSuper decided to retain the main options of both funds and continue to run them in parallel in the merged entity. But this didn’t mean all options would continue to exist in their pre-merger form.
“There are some obvious candidates [for rationalisation],” Patrick says. “For instance, continuing with two single Australian shares options is not in anybody’s interests. If you take a strict members’ best interest lens, then offering effectively the same option twice is inefficient.
“As part of the merger, it was always envisioned that a product review would follow not long after the merger and so in the coming months that product review will commence and it will look at the full suite of investment options,” he says.
Included in the product review will be the socially responsible balanced options of each fund. Patrick says these options have clear overlap and it would make sense to broaden the suite of what the merged entity offers in this space.
But he also points out that many of the possibilities for rationalisation will depend on whether ART is also able to rationalise the two custodians, since Sunsuper uses State Street Australia, while QSuper uses Northern Trust.
Patrick does expect to retain QSuper’s retirement product, Lifetime Pension.
“The experience of QSuper is of benefit to ART us and the work that they’ve done historically with Lifetime Pension plays very strongly into that consideration around the retirement income covenant,” he says.
“I would expect it to play quite a strong part in the response and, again, it doesn’t make any sense to duplicate that,” he says.
Risk Parity
A key challenge in rationalising the investment portfolio is the difference in investment philosophies between the two funds.
QSuper moved away from peer relative approaches and embarked on an approach that could be described as risk parity, also called risk-balanced approach.
“Risk-balanced means a number of things,” Patrick says. “Historically, one of which was using high duration bonds and then to get your bond risk return profile as close to equities as you can and allocate risk in equal measures between the two.
“Clearly, in a rising interest rate environment high duration bonds are not going to deliver your [targeted] return outcome, particularly when leveraged.
The use of high duration bonds can introduce a significant amount of tracking error relative to how the Your Future, Your Super performance test will see them. As a consequence, QSuper had prior to the merger already been rebalancing that risk
“Also, the use of high duration bonds can introduce a significant amount of tracking error relative to how the Your Future, Your Super performance test will see them. As a consequence, QSuper had prior to the merger already been rebalancing that risk. In other words, they had been bringing down the effective duration of the bond allocations in their portfolios, essentially reducing the leverage.
“So yes, that kind of approach has to be responsive to the environment, but it doesn’t mean risk-balanced portfolios have been abandoned.
“You need to diversify your sources of risk and return and so QSuper were happy to take higher levels of risk in a range of alternatives to reduce the dominance of equity risk, but to do so in a way that the whole portfolio looks well balanced,” he says.
Your Future, Your Super
Any rationalisation of the investment option and portfolio will be done in the light of the Your Future, Your Super regulations.
Some critics of the Your Future, Your Super regulations have argued that the performance test will increase the already high level of peer risk in the superannuation industry, as portfolios will start to look more alike in a benchmark sensitive world.
But Patrick does not see it this way.
“I actually think that the Your Future, Your Super performance test could diminishes peer risk, at least in theory, because the assessment is whether you have executed well against your SAA (strategic asset allocation),” he says.
“Yes, the SAA will determine how your returns stack up against your peers, because we all know that asset allocation is going to be the dominant driver of returns, but provided you have executed well relative to those benchmarks embodied in the performance test you will always pass the performance test regardless of how your peer performance ranks.”
The key risk with the performance test is not peer risk, but the decision where to take active risk against the benchmarks of the test, he says.
I actually think that the Your Future, Your Super performance test could diminishes peer risk, at least in theory, because the assessment is whether you have executed well against your SAA
For example, the performance test does not specify a benchmark for private credit and an allocation to this asset class will be treated as an ‘other’ investment, which means it will be tested against a benchmark that is 50 per cent equity and 50 fixed income.
An allocation to private credit could be seen as taking on an active risk versus the test.
Patrick says you could try to reduce these active risks by allocating more to passive strategies in other asset classes.
“A simplistic argument would run something like this: unlisted assets have tracking error by definition, because you can never build a portfolio that represents the APRA specified benchmark, simply by virtue of what you already hold and what you can acquire in the future ,” he says.
“However, in listed markets you can match the APRA (Australian Prudential Regulation Authority) benchmark, so if you’re going to take some kind of active risk, then you’ve already got it in unlisted. If you close it down in listed [assets], then you minimise your chances of failing the performance test.”
But in reality the decision of where to take active risk is more complex, because it can help with diversifying risk at a total portfolio level.
“The active risk that you run in equities can be diversifying to the active risk that you’re running in unlisted assets,” he says. “So we had to think quite carefully about our portfolio construction process and we weren’t just following that simple logic that I outlined above,” he says.
Net Zero
Another active risk many investors take against the Your Future, Your Super performance test is the decision to reduce the carbon footprint of their investment portfolios. ART has committed to achieving net zero emissions by 2050 and is therefore no exception to this development.
“The prospective board of ART was very firm at the outset that the sustainable investment policy and the climate change policy should be one ART policy. So when stepping over the threshold at the merger date, there shouldn’t be a Sunsuper policy and a QSuper policy and then some glue over the top of that.
“The board set out, very proactively, to create a single sustainable investment and climate change policy. So ART has a net zero commitment and a commitment to develop interim targets.
“The reason that the policy didn’t specify interim targets is that you need a baseline. Your target is relative to a baseline and I described earlier that the competition protocols were such that we couldn’t actually bring the two portfolios together and do a combined carbon intensity analysis.
The prospective board of ART was very firm at the outset that the sustainable investment policy and the climate change policy should be one ART policy. So when stepping over the threshold at the merger date, there shouldn't be a Sunsuper policy and a QSuper policy and then some glue over the top of that
“That had to wait until post the merger and is well advanced” he says.
Yet Sunsuper and QSuper had already embarked on a path to reduce the carbon emissions of their respective portfolios prior to the merger and in the case of Sunsuper this was reflected in the way they structured their mandate agreements with external managers. ART will continue this journey.
“[The implementation of] a pathway to decarbonisation for the equities portfolios was done in two slightly different ways, depending on the nature of the manager,” Patrick says. “So passive equities have low carbon target benchmarks, which are optimised, custom benchmarks with a low tracking error, whereas the enhanced passive and active managers have a carbon budget.
“We specify to those active managers what their weighted average carbon intensity target should be relative to their baseline. Now, the reason for doing it that way is that each of the different manager types have a different carbon profile, so you take a global growth manager with lots of exposure to US tech stocks and they will start from a lower baseline.
“To make sure the whole fund moves towards its target, you have to calibrate a target for them that is different from that for a value manager who has more utilities, say, in their portfolio. A value manager will have a different baseline and so we set a more aggressive budget.
“So we took a long, hard look at our portfolio construction approach, because [net zero] is one of the active risks that we are taking relative to the performance test, and we had to be comfortable with that,” he says.
__________
[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.