Let down by 'stable' funds

Superannuation fund members who had hoped to make it through a big sharemarket downturn without loss by choosing a capital stable portfolio option have been disappointed by the results their funds achieved in the 2008-09 financial year.

The median return for capital stable funds for the year to June 30, according to the SuperRatings capital stable index, was a loss of 3.4 per cent  a significantly better result than balanced options (down an average of 12.7 per cent) and growth options (down an average of 15.7 per cent) but capital stable did not provide the protection many investors thought it would. These results have prompted a lot of soul-searching about the role of conservative investments  fixed interest funds and capital stable super options  in investors' portfolios but changes are under way.

The head of Australian fixed-interest manager research at the consulting group Watson Wyatt, Tony Arnold, says the stable conditions in credit markets in the years up to 2007 encouraged investment managers to add more high-yield fixed interest securities to their portfolios.

The composition of fixed interest funds changed from being made up largely of government and semi-government bonds and highly rated corporate debt to include more low-rated corporate debt and asset-backed securities such as mortgage bonds.

When the global financial crisis hit, the high-yield securities plunged in value. Just when investors were expecting that the defensive characteristics of their capital stable options would shield them from equity risk and general market volatility, they discovered their funds had become more risky.

Arnold says there is a return to fundamentals in fixed interest investment now. He says managers still see value in high-yield assets but they are moving them out of their fixed interest portfolios. "Fixed interest is returning to a more true-to-label style where the objective is to provide diversification from equity risk and to dampen portfolio volatility, he says.

The Watson Wyatt Global Pension Asset Study, published earlier this year, shows that Australian super funds are following a global trend to have higher levels of defensive assets in their portfolios. According to the study, Australian super funds have traditionally had a much higher allocation to equities than their pension-fund counterparts in other countries.

In 1998, the average allocation to equities was 53 per cent and in 2003 it was 59 per cent. Along with the US, Canada and Britain, Australia had the highest equity allocation in pension and super portfolios. The overall approach has been to take on higher risk in pursuit of higher returns.

The latest survey, taken at the end of last year, shows a global trend to a higher fixed-interest allocation. Australia is part of this trend, with the average fixed-interest allocation increasing from 25 per cent in 2003 to 29 per cent in 2008.

Fund managers are bullish about credit securities at the moment, believing that pricing is coming back to a more normal range. As spreads contract, investors stand to make capital gains on their positions, just as they make gains on government bonds as yields fall.

Fund managers were upbeat about the prospects of the credit market this time last year but were then run over by events when Lehman Brothers collapsed in September. Arnold says the risk of another event of that kind is low. The amount of government support for the financial system has had a positive effect.

What does worry Arnold is that the market is now in a default cycle  an increasing number of companies are in trouble and can't pay interest on their credit securities. The outlook for credit is positive, but investors need to make sure their managers invest in highly-rated corporate credit.

Gambled and lost

* Capital stable super options reported an average loss of 3.4 per cent for the year to June 30.

* The bond market was up more than 13 per cent for the year to June but investment managers were too exposed to corporate debt securities that lost money.

* Asset consultants say there is a return to basics in fixed interest management with the emphasis on diversification and risk minimisation.