Westscheme's Investment Strategy - September 2009
RECENT ENHANCEMENTS TO THE TRUSTEE’S SELECTION
10 September 2009
Westscheme aims to maximise the long-term returns of members by utilising an investment approach that seeks an appropriate balance between investment returns and risk. In this light, the objective of the Trustee’s Selection is to achieve a net investment performance that exceeds inflation (as measured by the Consumer Price Index (CPI) over rolling five year periods) by at least 3% per annum.
To achieve its objective, the Trustee’s Selection adopts an investment strategy that expands on the conventional approach by investing in a diverse range of listed and unlisted assets. This is achieved through the use of two distinct investment portfolios, as outlined below.
- The Market Portfolio (listed asset classes, such as cash, fixed interest and equities).
Listed assets generate returns that fluctuate over time with market movements. Westscheme aims for these assets to moderately outperform relevant market indices (benchmarks) with high conviction, minimal risk and low management fees; and - The Target Return Portfolio (alternative investments in sectors such as infrastructure, property, high yielding debt, private equity and natural resources).
While unlisted assets are relatively illiquid in nature, they are generally directly negotiated and confer significant contractual rights and benefits to the investor. In aggregate this portfolio is designed to deliver attractive risk adjusted returns that may help cushion members’ returns against short term fluctuations in listed markets, while providing returns that may be in line with or higher than listed equities over the long run.
The main benefits for members from the Two Portfolio Approach are a more diversified investment strategy than is typically adopted by most superannuation funds and higher expected long-term returns. The diversification of listed markets exposure through a relatively high allocation to unlisted assets is made possible by the adoption of a long-term view of investment, reflecting the long investment horizon of most Westscheme members.
This strategy has been tested during the Global Financial Crisis (GFC); however, Westscheme continues to consider it likely that the Two Portfolio Approach will provide favourable outcomes for members over the long term.
LESSONS LEARNT FROM THE GFC
While the performance of an investment strategy should generally be assessed over the long term, performance during certain periods can offer some insight about possible enhancements to the long-term strategy.
Implications for the portfolio structure of the Trustee’s Selection:
The extraordinary stress in credit markets during the GFC adversely affected all asset classes, with the main exceptions being cash and Government bonds. While the Target Return Portfolio has outperformed listed equity, it has provided poor returns during this period, mainly reflecting the impact of very onerous credit conditions and an associated collapse in global demand.
Although the Target Return Portfolio possesses some defensive characteristics, the GFC has demonstrated that under extreme credit conditions the performance of Westscheme’s Target Return Portfolio can be more correlated with listed equity than previously envisaged and targeted over the longer term. This primarily reflects the fact that the current crisis has been driven by a financial market shock via credit market dysfunction, whereas most previous equity market corrections have resulted from real economy shocks. This experience suggests that rather than relying solely on the Target Return Portfolio for its defensive characteristics, the Trustee’s Selection is likely to benefit from the inclusion of some additional sources of defensive exposures.
Another key point to arise from the GFC is the importance of liquidity risk. In particular, during stressful investment periods, correlated shocks have the potential to elevate the importance of liquidity, whereby liquidity concerns have the potential to materially impact a portfolio’s asset allocation. This suggests the need to allow for additional flexibility in the portfolio’s asset allocation to ensure Westscheme can appropriately respond to changing market conditions and capitalise on distressed selling. As a result, the Trustee’s Selection is likely to benefit from a moderate reduction in its allocation to the Target Return Portfolio.
While the GFC should be seen as an extraordinary event, the modifications to the investment strategy that it has motivated are expected to provide the Trustee’s Selection with greater protection from future adverse investment environments, while retaining its long term return objective. These adjustments are seen as enhancements to the current Two Portfolio Approach rather than wholesale changes, and include:
a moderate increase in the allocation to defensive asset classes such as fixed interest and cash (while remaining moderately lower than that of most superannuation funds); and
a slightly lower allocation to the Target Return Portfolio (that is, a strategic target of 42.5%, compared to 45.0% previously).
Implications for the Target Return Portfolio’s risk management framework:
The GFC has also provided a basis for assessing the performance of Westscheme’s Target Return Portfolio during an adverse investment environment. In light of this analysis, Westscheme has also reviewed and enhanced the risk management framework surrounding the Target Return Portfolio to promote better management of significant market shocks, should they occur in future.
Westscheme’s comprehensive TRP risk management framework includes:
- a factor risk framework;
- hurdle rates for TRP investments;
- asset cluster ranges; and
- drawdown limits for TRP investments.
At the highest level, these measures aim to ensure that the risks inherent to investing in unlisted assets are adequately compensated for and that the Target Return Portfolio encompasses an appropriate level of diversification, such that the portfolio’s exposure to the specific risks embedded in individual unlisted assets is limited.
Westscheme has recently reviewed the Target Return Portfolio risk management framework in light of its experiences during the GFC. As a result, a number of adjustments have been made to the measurement and/or application of the above measures. Collectively, these enhancements aim to reduce the Target Return Portfolio’s likely correlation with listed markets overtime, increase its underlying level of diversification and increase Westscheme’s focus on, and understanding of, the potential impacts of currency and liquidity risks on both its Target Return Portfolio and overall investment strategy.
STRATEGIC ASSET ALLOCATION RANGES
In light of its experience during the GFC, Westscheme has recently updated its optimisation analysis to determine the desired strategic asset allocation for the Trustee’s Selection. On the basis of this analysis, Westscheme adopted the strategic asset allocation and asset allocation ranges shown below in July 2009.
Although targeting the strategic asset allocations, over time the Trustee’s Selection’s actual allocation of funds is expected to fluctuate within the asset allocation ranges provided above, reflecting:
- the likely impact of movements in listed markets,
investments, divestments and/or re-valuations of unlisted assets, - the effects of rebalancing processes undertaken to manage Westscheme’s total assets across its various investment options; and
- slight modifications to Westscheme’s investment strategy that may be required from time to time reflecting changing market conditions or other investment concerns.
OUTLOOK
In positioning the Trustee’s Selection, Westscheme has incorporated an underlying expectation of a somewhat muted recovery in equity markets from here, characterised by below average earnings growth and above average volatility over the medium term. This view reflects the significant challenges that continue to face the global economy over this period, particularly with regards to the eventual need for policy makers to withdraw the current extreme level of stimulus.
Given the significant uncertainties regarding the medium term investment environment, it is important to keep in mind that it is impossible to construct a strategy that will outperform under all market conditions. While the Trustee’s Selection remains positioned to take advantage of growth opportunities, the recent enhancements made to its strategy are also expected to enhance the portfolio’s resilience to future market shocks, improving its likely relative performance should equity markets correct in a material fashion at some stage.
In essence, Westscheme considers that the recently adopted strategic asset allocation for the Trustee’s Selection strikes an appropriate balance between harnessing growth opportunities and providing suitable protection from adverse investment environments.
Further details of Westscheme’s investment strategy, including asset allocations and the management of risks within the Target Return Portfolio, are provided in the download file below.
If you would like to review your Westscheme investment option(s) and need assistance you can contact Industry Funds Financial Planning (IFFP) financial adviser, Albert Lim, on (08) 9218 4038 for limited financial advice at no additional cost.