Cerulli Asia Pacific Edge: Innovation in Australia

Cerulli Asia Pacific Edge, May 2013

When you are home to a A$1.5 trillion pension fund industry, on top of a healthy managed funds sector, you have room for a little innovation. And so it is in Australia, where steadily growing asset volumes are being accompanied by progressive new ideas.

Admittedly, a lot of what’s new in Australia has already been tried and tested in the US or Europe, but when it finally reaches Sydney and Melbourne, it tends to grow very quickly. A clear illustration of this can be found in exchange-traded funds. As fig A4 shows, assets under management in Australian ETFs have grown from A$1.1 billion in 2008 to $6.4 billion in 2012, an almost sixfold increase through the middle of a global financial crisis, and new products are appearing at a rapid pace, with 25 in 2012 alone.

But what’s particularly interesting about ETF growth in Australia is the way that it has moved quickly from vanilla product to new ideas. For many years there was only one ETF of any note in Australia, State Street Global Advisors’ product over the S&P/ASX 200, later followed by a version focusing on property trusts. While cheap and successful, it did not attract copycats for many years because financial planners tended not to recommend ETFs as they paid no commission. Only when fee reform began to take hold towards the end of the last decade, and the fee for service model became more common, did financial planners more frequently recommend them to clients, which in turn led to the blooming of new product that is evident in chart A4.

Since then, ETFs have swiftly appeared for foreign markets, for individual sectors of the equity markets, and for commodities. Next, rule-based ETFs began to appear in 2010, with Russell Investments launching a high dividend Australian shares ETF, based on a customised Russell index of blue chip companies expected to pay above average dividends. State Street followed with its SPDR MSCI Australia Select High Dividend Yield Fund. For the first time, an element of subjective judgement was entering these passive products.

The next step for Australian ETFs came with the appearance of fixed income products, which for many years were not possible until the Australian regulator and stock market came to agreement about what form they should take. That agreement finally came in March 2012, and then six funds were launched within two days, three apiece from Russell and iShares, swiftly followed by others including Vanguard. Almost instantly, investors found themselves with multitudinous choice: government bond funds, semi-governments, corporate bonds, inflation index-linked ETFs, treasuries, composite index products, and all of them at very low fees from 0.24 to 0.28% apiece.

Now, 2013 has brought the next incarnation of Australian ETFs, with the UBS IQ Research Preferred Australian Share Fund, based on a portfolio of companies that UBS equity research analysts have buy recommendations on. While retaining something of a passive approach, this is clearly building in subjective judgements.

These are not necessarily the sort of products attracting all the new inflows, though. According to Morningstar Direct, more than half of all net new flows into ETFs in 2012 were in to equity products, followed by fixed income and money market. But a closer look at the data shows that all the money market inflows – A$125 million – went into a single fund, whereas the equity flows were split between 50, and fixed income between 10. The success of the one available money market product in Australia, BetaShares’ Australian High Interest Cash ETF, suggests that managers might be better looking at the simple solutions rather than the complex and clever.

Nevertheless, the product evolution in ETFs is interesting because it mirrors something that is also happening in the institutional sphere: the idea of alternative beta.

Ibbotson, for example, part of the Morningstar group, builds what it calls Fundamental Quality portfolios for investors, which take a new approach to passive investment styles. The principle here is that existing market cap-weighted benchmarks are flawed, because they guarantee investors will be overweight stocks that are overvalued, and underweight stocks that are cheap.  Ibbotson offers about 30 different strategies for clients in Australia, but what’s common to all of them is that market cap weightings have been stripped out of all passive products. Instead, the selections are based on perceived quality of stocks, and their value.

Increasingly, this stance is going to be relevant to all Australian investors, with the arrival of MySuper, a new type of superannuation fund that will form the default option for Australians, and will have a heavy emphasis on simplicity and low fees. Necessarily, to keep the costs low, these will involve large passive elements, and so these alternative methods of providing the low-turnover passive component will become increasingly important.

Another area of innovation in Australia is the life cycle fund – again, something very familiar to Americans.

In their simplest form, a life cycle fund changes a person’s allocations between growth and defensive assets at various points in their life. An investor in Telstra Super Personal Plus, for example, will be in a balanced option for most of their working life (74% growth, 26% defensive) but shift to a more conservative level at the age of 60, moving to a 40/60 growth/income split in order to preserve assets. In HealthSuper, investors are automatically switched from a long-term growth portfolio to a medium-term growth allocation at 50, then again to a balanced portfolio at 60.

However, many are cynical about these approaches, saying they take no account of market behaviour or individual circumstances, so already a second generation of products is underway. QSuper, for example, is attempting to build in an algorithm that understands an individual’s life circumstances and moves allocations around accordingly.

One of the most successful examples of a life cycle fund is BT’s Super for Life, which allocates investors into particular asset allocations according to their date of birth. It doesn’t pretend to be trying to time the market, but then again it’s very cheap, just 0.99%, exactly the sort of level the government wants MySuper products to be around; it is designed to fit Australians who don’t have the time or the money to get independent financial advice, and so keeps those investors out of what would otherwise be one default level of allocation for their whole lives.

Chart A1 shows how this fund has gained traction since its launch, with a clear sense of reaching critical mass during 2012, when assets almost doubled and net new flows topped A$500 million. Chart A2 demonstrates exactly how allocations change according to the age of the investor, and A3 shows the same thing for a similar Suncorp product.

Funds like these are likely to receive very healthy inflows in the year ahead, for one reason: MySuper will allow life cycle funds as default options. This matters more than might at first be apparent. MySuper has a heavy emphasis on simplicity and low fees, meaning most funds will prioritise passive allocations, as outlined above; that means they are all likely to look the same. If offering a life cycle variation helps to differentiate a fund from the herd, it’s likely to be popular.

Elsewhere, innovation involves exposing investors to new asset classes. In March Goldman Sachs Asset management launched its Growth and Emerging Markets Debt Local Fund in Australia, the first fund to put Australian investors into high yielding emerging market debt. And there are signs of other innovations from elsewhere in the world capturing attention in Australia too: as chart x shows, funeral bond funds are gaining traction.

But new product launches mainly stick with what Australians already know. According to Morningstar, in 2012 there were 29 new Australian equity ‘large cap blend’ funds, 22 Australian cash products, 17 world equity large blend, 11 multisector balanced, and 10 diversified credit.

And in the main, the single biggest driver of product development in Australia is to deliver results with simplicity and a low fee, by combining an element of passive selection with new ideas about the underlying benchmarks. As MySuper comes into force, this theme is going to become steadily more pronounced.