Daniel Liptak explains why low fees are not necessarily a guarantee of higher investment returns.
While it appears the rest of the world is recovering from the shock of the global financial crisis (GFC), Australia should not rest on its laurels. Many domestic commentators will collectively pat each other on the back and make comments to the effect that we are smarter than the rest of the world – but this hubris is misplaced.
This hubris is evident even in our approach to regulating the financial system post the GFC. While there is still confusion about the cause of the GFC, the readiness to point the finger towards bankers and their bonuses is essentially political in nature. While it is true some of the blame for the credit excesses in the lead-up to the GFC can be directed at banks, demand from the market also kindled the fires during the boom time. Some of this demand can be related directly back to governments and regulators.
In the 1990s, many governments – including Australia – reduced debt levels. But these same governments forgot to change policies and regulations that force many institutional investors to hold highly rated paper. Simultaneously, a wave of baby boomers nearing retirement age in western economies caused a spike in demand for pension planning.
This changing demographic increased demand for quality paper at the same time supply was falling. Thus we finished the millennium with a demographic, regulatory and government distortion to the supply/demand curve which moved interest rates to low levels, aided and encouraged by obliging monetary policy. Luckily for investors who wanted extra return without the extra risk, investment banks stepped into the void; and as they say, the rest is history.
‘High cost investment opportunities tend to protect the downside’
The regulatory and trustee requirements that compel institutional investors to hold some of their portfolios in high-grade paper should be abolished. It was this policy and an outdated asset-consulting model that created the negative yield curve, forcing investors to look for alternatives, such as structured credit. Secondly, policymakers created the rating agencies that in turn rated Collateralised Debt Obligations (CDOs).
In short then, the rush to regulate all parts of the finance industry needs to be considered in the context that regulators significantly contributed to the GFC. That being said, there is room for regulatory reform.
Superannuation in particular needs serious attention. Current debate centres on fees, not on the liability matching. In other words, we all contribute to super, but there is no requirement for the boards and portfolio managers to provide a return that will enable us to live out our old age without calling on the Government (that is, the aged pension).
The system that we have in place does rest on its laurels. Super funds look over their shoulders at peers to ensure they don’t stray too far out of the mainstream. In addition, there is a prevailing thought that low fees are drivers of investment outcome – but this is not true. In a recent study of Australian equity market-neutral funds, we found that low fees have cost investors more in long-term compounding than higher-cost alternatives. The result of this is that over the long run, say 10 years, low-cost investments tend to significantly provide for poorer returns.
Table 1 demonstrates this point. The striking and frightening long-term under-performance that accumulates to low-cost investing (ETFs or index tracking vehicles) means that there is less chance of positively compounding returns. On the other hand, high-cost investment opportunities tend to protect the downside. While it is true they do suffer losses, this table shows that, by comparison, these falls are not as deep, and consequently investors receive the benefits of positive compounding.
An accrued benefit scheme that is weighted to keeping down costs ensures at best mediocre returns and, importantly, returns that are of no value to superannuants. While defined benefit schemes are quite rightly ridiculed, they do provide retirement certainty. Our current system does not.
One answer is for superannuation contributions to be raised from 9 per cent to upwards of 15 per cent. This is akin to throwing good money after bad. A better solution would be one which marries the best of the actuarial based model (that is, lifetime pension based on a percentage of average salary) and our compulsory pension savings plan.
With the aging demographics, our current superannuation model will limit the future monetary policy options. It will likely see a continual accumulated asset sell-off (in particular, housing). This extra supply should be expected to depress asset prices in Australia for the next 20 years as baby boomers retire. The current focus on limiting immigration will further reduce demand for housing assets.
While many individuals in the past have tended to prefer to be cash poor, relying on the old age pension to buy Home Brand canned food, I am not sure that baby boomers are that way inclined.
Consequently, without further refinement and improvement in superannuation, Australian wealth will fall. The large superannuation pool in Australia provided a buffer during the GFC. It also created an important illusion for millions of Australians that their retirement was being taken care of; and thus many individuals did not rush to the door in panic.
