The Australian market is being hit by a new, compounding wall of superannuation money, which we think will significantly alter the outlook and composition of returns for the next decade. This has serious implications for policy makers and investors in Australia.
Increasingly, big super funds will struggle to find local investments. They will be forced to head offshore and into synthetic investments, such as derivatives. That will increase market volatility and dilute the impact of franking credits on their returns.
We think that scenario will significantly increase the appeal of SMSF and self-directed investors, who will be able to maintain control of their investments and asset allocations.
Another trillion of super
You may have seen that Australian super assets recently hit $2 trillion. According to the ATO, those total super assets are now forecast to surge to $3 trillion by 2020.
Figure 1. SMSF and Industry Growth
Source: ATO and Cadence Capital Estimates
To put that into context, by 2020 Australia’s GDP will be approximately $2 trillion – and the value of super assets will be 33 per cent more. Super assets will also swamp the Australian stock market, which by 2020 will have a total market capitalisation equivalent to GDP of around $2 trillion.
As an aside, over five years, the addition of another $1 trillion of super suggests a compound growth rate of 8 per cent. Half that growth will come from contributions; that indicates the trend for the return on investment assets is falling, with a lower return outlook of around 5 to 6 per cent over the next decade. We believe that is likely.
The two implications of the wall of money
We think the wall of super money will have serious implications for the market because large super funds will have to change their investment strategies. The largest super funds will struggle to have a proper allocation to the Australian equity market. Our market won’t be big enough.
They will do two things: the big funds will increasingly look offshore for investments; secondly, because they won’t be able to get physical exposure to local investments, they will shift into index or over-the-counter (OTC) trading.
There are two implications from these shifts:
- The growth of derivatives trading will increase market volatility. Derivatives, which will surge to allow asset managers to get exposure to the local market, will magnify the effect of market gyrations. Was the market move on the last day of May an indication of what lies ahead?
- Exposure to Australian equities will decline as a percentage of super assets over time, which will dilute the impact of franking credits. Franking credits will therefore decline as a proportion of total pre-tax returns. That, in time, will erode support for franking, particularly from big super and institutional investors as they see lower benefits to their total returns.
Figure 2. Global Pension Assets: Growth from 2004 to 2014
Source: Towers Watson Global Pension Assets Study 2015
We think the compounding super wall of money raises policy issues for Government. Are we creating an excessive land bank of money which can’t possibly be properly invested?
It’s something that needs to be thought about. It’s alright putting money away, but how do we invest it? Australia is creating a massive capital pool that will struggle to be invested to generate a proper return.
SMSF and self-directed investing becomes more appealing
We think this also has implications for investors. If the wall of super money will dilute returns and franking credits, we would argue that SMSF and self-directed investing becomes more attractive.
As mentioned, the big funds will be the most impacted because they can’t invest in the Australian market. They will also increasingly offer synthetic or ‘pretend’ investments through derivatives; so their investors won’t actually own BHP, bank shares or Telstra; they will own an option on an index.
SMSF and self-directed investors will avoid these pitfalls. And they won’t get caught by the asset allocation decisions of big funds, which might be driven more by the fact they ‘can’t invest because they’re too large’, rather than because it’s the right investment. SMSFs will benefit from franking credits and can manage their exposures unaffected by excessive size.
So if there are diseconomies in investment funds then Australia may in coming years provide the factual evidence of this suspected phenomena.
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