Hindsight is a super thing

Ouch. Double ouch in fact. The official figures have confirmed what we all suspected. Last year was an absolute shocker for super funds with the average balanced fund reporting a record loss of 19.7 per cent.

After reporting a 6.4 per cent loss last financial year, the average fund is already down 12.5 per cent for the financial year to date. Unless something big happens in the next five months, investors will need to brace themselves for a second year of negative returns.

The size of the losses is also taking its toll. Unlike the single-digit losses posted in 2001-02, last year's losses were big enough to offset the normal boost to super accounts that comes from ongoing super contributions. And you can forget the comfort of those bumper double-digit returns we enjoyed during the final years of the boom. Thanks to last year's debacle, the average fund is now showing a loss of 0.4 per cent a year over the past three years. Those bumper profits have disappeared into the financial never-never.

Investors have good reason to be disappointed. Hindsight is a wonderful thing and regrets that we (or our fund trustees) didn't have the foresight to switch to cash when the sub-prime crisis emerged in mid-2007 are only natural.

But should we be disillusioned?

"Some people have said there's been a loss of faith in the industry," says Jeff Bresnahan, the managing director of research group SuperRatings. "But the reality is there shouldn't be. Super is just a tax structure . . . If you were to look at all your options for saving for retirement, super is the logical way to do it because it will deliver better returns for most people because of its tax concessions."

The problem, Bresnahan says, is many investors don't take responsibility for their super. The super system is a paternalistic structure where investors who don't know or care can simply opt for their fund's default option and assume the trustees will get it right.

"If a consumer takes out a home loan they'll spend a lot of time and effort researching the options and making sure they understand it," Bresnahan says. "But with super they don't care because it won't affect them for 20 years."

The performance tables produced for Money by SuperRatings show super is far from a homogenous product. Balanced fund returns - those with 60 per cent to 76 per cent in growth assets like shares and property - ranged from -7.2 per cent to -29.9 per cent. The worst-performing funds lost almost four times as much.

Not surprisingly, investors in cash did best, with the median cash fund returning 5.5 per cent, while more aggressive investors who had opted for an all-share fund were hammered. The median Australian shares super fund lost 35 per cent over the year while the median international share fund lost 29.5 per cent. The worst-performing share funds lost about 40 per cent and even capital-stable funds defied their name with the median fund down 7.8 per cent for the year. It's interesting to note that the worst capital-stable result of -14.8 per cent was worse than that posted by the better balanced funds.

The chief executive of the Association of Superannuation Funds of Australia, Pauline Vamos, says while no one likes to lose money, the average balanced fund has performed relatively well.

"Returns [from investment markets] like we had last year haven't happened for the past 40 years," she says. "When you look at how the overall market performed - with Australian shares losing about 40 per cent - they've handled it well."

Despite most funds now allowing investors to choose their investment option, balanced funds are still the fund of choice for most investors. But while all balanced funds hold a mix of investments, the strategies they employ can be wildly different.

Vamos says funds take into account the age and range of their members in formulating a strategy for the default fund. A fund with an older member base might adopt a more conservative balanced strategy than one that has mostly younger members, while a fund with a broad mix of members will have to tread a path somewhere in between.

Nevertheless, Bresnahan says there's been a trend for funds to pull their horns in through the crisis and shift to more defensive portfolios. In September 2007, he says, the average balanced fund had about 32 per cent of its portfolio in Australian shares and 25 per cent in international shares. By September 30 last year, these dropped to 29 per cent and 23 per cent.

Bresnahan says a lot of funds accumulated extra cash but a lot of it was diverted to alternative assets such as infrastructure and private equity.

"One of the things many investors don't understand - and why we get the questions about why the funds didn't see this coming and move to cash - is that they're legally constrained to stick within the investment ranges they say they will adopt," he says. "If they say they'll do one thing and do something different, they are misleading investors."

SuperRatings' figures show the top five balanced funds over the past five years had substantially different investment portfolios. MTAA Super's balanced fund, for example, returned 9.2 per cent and had 75 per cent of its assets in growth (see table left). By contrast, AustralianSuper's balanced option returned 7.07 per cent with 65 per cent in growth assets. AustralianSuper had a higher weighting to Australian shares (27.3 per cent versus 24.8 per cent) but MTAA had higher exposure to alternative assets.

"If you look at why certain funds have outperformed historically, it's mostly down to their asset allocation," Bresnahan says. "Fees play a role but funds like MTAA got into alternatives and infrastructure way back in the 1990s and it gave them a huge competitive advantage. But if they had got the decision wrong, it would have given them a huge disadvantage.

"Some of the commercial funds tended to hold higher levels of international equities, which has hurt them over the past five years. Similarly, a lot of the master funds held higher levels of fixed-interest and listed-property trusts. That helped them from 2003 to 2007 when they were doing well but hindered them last year when listed property was the hardest hit investment sector with 50 per cent losses."

Bresnahan says more defensive funds are doing better in the current climate but one of the big drivers of returns over the past year has been whether funds hold listed or unlisted assets.

While fear and panic on investment markets has sent the price of listed investments plummeting, the value of unlisted investments has so far held up reasonably well. Bresnahan says unlisted investments will inevitably be less volatile because they are valued according to a mathematical formula. By contrast, listed assets are valued every day on the market, where fear and greed play an inevitable role.

This trend has been most observable in the property market, where listed property trusts fell by about 50 per cent last year but direct property values held steady or enjoyed small increases.

Some in the industry, such as Dixon Advisory, have raised questions about the sustainability of these values. Dixon created a storm towards the end of last year when it advised clients in industry funds with high weightings to unlisted investments to switch to listed investment options within their funds. The managing director, Alan Dixon, says he stands by that advice - despite copping a caning from the industry fund movement. While he regards unlisted assets as a good long-term investment, Dixon says valuers tend to undervalue assets on the way up and overvalue them on the way down. That's not due to poor governance on the part of funds, he says, simply that valuations are backward- rather than forward-looking.

"I understand [the industry funds'] point of view that people should invest for the long term but what I'm suggesting wouldn't apply if the funds put in some provision for these assets until they know what the position is," he says.

Dixon is concerned some fund members may switch out of funds with listed assets to funds that look like better performers, only to find assets are written down in value later on.

He says it's not all funds with unlisted assets he's concerned about.

"If you only have 10 per cent in unlisted assets and they fall in value by 20 per cent, that's a 2 per cent reduction in your return," he says. "It's likely to all come out in the wash . . . It's the ones with 30 per cent or more that concern us. There is potentially a 6 per cent valuation error."

MTAA Super has one of the highest weightings to unlisted assets - about 50 per cent according to SuperRatings - and has topped the performance tables for the past 10 years. The principal executive officer, Michael Delaney, says it got into "alternatives" because they are "long generational investments". He says assets such as infrastructure are robust through the economic cycle, don't move in line with markets, are protected from inflation and "are not leveraged in any silly ways".

"If there is a deep worldwide recession, where does the spending stop?" he says. "It's discretionary spending that stops and we're in fundamentals like TV, radio, water, airports and toll roads. I'd never say an investment is recession-proof but I can say that people can't stop consuming these things."

MTAA is unusual in that its balanced fund invests in two sub-funds - one focusing on listed investments and the other a "targeted return" fund that holds unlisted assets. Delaney says the fund values all its unlisted assets three or four times a year and doesn't buy the argument that valuations are overstated. In December, he says, the fund arranged to have all its unlisted assets revalued in response to Dixon's claims. The results came in last month and showed only a marginal reduction in value "against modelling of a deep Australian and worldwide recession".

Bresnahan says while he doesn't believe there's anything "frightening around the corner", some unlisted assets may need to be written down further. He says unlisted investments can include everything from direct property to infrastructure to speculative private equity investments and all behave differently. Some assets will hold up better than others, just as in the listed market.

On a broader level, Bresnahan says falling returns have also resulted in many balanced funds failing to deliver on their long-term investment objectives. He says a common objective is to deliver the inflation rate plus 3.5 per cent over rolling five-year periods but with the five-year median balanced fund return falling to 5.7 per cent, this is looking iffy. He says the five-year returns will continue to decline as the strong returns reported in 2003 and 2004 slip out of the five-year numbers.

This is hardly surprising in the extreme market conditions we have experienced but it has raised questions about whether balanced funds are suitable for all investors.

"So-called balanced options are very suitable for someone under 40 but perhaps too aggressive for someone nearing retirement or getting a retirement income," Dixon says.

Vamos says more funds are looking at age-based default options where your asset allocation becomes less aggressive as you near retirement.

"For a long time, balances were low and the focus was on making sure what members put in was not substantially reduced by fees and that the risk-return profile was appropriate," she says. "But now account balances are increasing and default options have members who are ageing along with very young members who are just starting."

The chief executive of First State Super, Michael Dwyer, says the industry is also under pressure to cut fees. "Members will be looking for the best-value deal they can find," he says.

The Minister for Superannuation, Nick Sherry, recently called for average fees to be reduced from 1.25 per cent to less than 1 per cent. Vamos says funds now have the scale to address costs and explore ways to become more efficient. Measures already under way or being considered include a clearing house to process super contributions, regulatory changes to make it easier for fund managers to close or merge "legacy products" (those old products they no longer sell) and rethinking how investment managers are remunerated.

Dwyer says more funds will have to merge to become efficient and fees and commissions have also come under renewed fire. Addressing the National Press Club last week, Industry Funds Management chairman Garry Weaven called on the Government to outlaw commission-based selling of super products, which he claimed was directing investors into poorer-performing funds.

Bresnahan says one positive to come out of the recent losses is that fund members are taking more interest in their super.

"People are realising super isn't a magic pudding spitting out 15 per cent or 16 per cent returns year in, year out," he says.

Vamos says investors need to understand their super funds better and to choose an investment option appropriate to their needs. She says a recent decision to allow funds to give limited investment advice on questions like this is a positive step in helping members better understand their super (see page 10).

As for those returns, they're not going to get any better until investment markets pick up. As a rough guide, SuperRatings estimates balanced funds lose (or gain) about half a percentage point for each one percentage point move in the overall sharemarket.

The issue for investors is not whether they could have avoided the losses but whether their fund has a robust investment strategy and which option is most appropriate for their needs.