The A$370 billion ($258 billion) Australian Retirement Trust has been homing in on efficient usage of derivatives for exposure and liquidity management and alpha generation, as chief investment officer Ian Patrick says integrated balance sheet management will “beyond a shadow of a doubt” become a more prominent feature in the Australian superannuation industry.
The function’s build-out has accelerated with ART’s adoption of the total portfolio approach, as the fund looks to be more nimble in the face of higher payouts to a growing cohort of retirees, and currency risks from investing in more assets offshore.
“[Derivatives] as an alpha source is less critical of an objective, and it is more one where you have different costs of capital between different types of balance sheets – bank balance sheets versus super[annuation] balance sheets,” he told Top1000funds.com’s sister publication Investment Magazine, on the sideline of an American Chamber of Commerce event in Sydney last week.
“Banks, particularly investment banks, they’ve taken on risk in the form of total return swaps and the like and they want to offload that risk. They may pay you for you to hold, let’s say, the reference index plus a margin, they may pay you to hold the other side of the trade, and that’s generating alpha.”
One example of such alpha-producing activity is getting exposure to onshore Chinese equities using total return swaps referencing the local index. The A-share market is restricted, and foreign investors need to obtain a QFII licence for direct share purchases, but by partnering with, for example, an investment bank which has that status, a fund can gain access to opportunities it might otherwise have to forgo.
ART has also been utilising cross currency basis swaps, “whereby there’s mispricing between those who desire to hedge a currency and the bank providing the currency hedge, and you can pick up a margin with no directional risk on the currency”, Patrick says.
But liquidity management is the primary objective. Being an Australian dollar investor, the fund is also wary of liquidity drain that may come from significant depreciation of the currency.
As the fund grew in size, its rebalancing activity was also becoming increasingly complex which led to its decision to begin building balance sheet management as an integrated function in 2019.
Derivatives are used for exposure management when members switch between different investment options. For example, when a significant shift from the less growth-oriented balanced option to the high growth option briefly leaves the fund short equities, the use of derivatives closes that gap without having to trade the underlying portfolio.
“As that rebalancing process in the fund became more, let’s call it, dynamic we had to ensure that we had all the liquidity processes to accommodate that, because you have to post margin against those derivatives on a daily basis with your clearing broker. So that was the origins of it,” Patrick says.
Elsewhere in the world, integrated balance sheet management has been a notable practice among Canadian pension funds which manage large defined benefits books. CPP Investments, for example, runs a dedicated total fund management group that dynamically manages the fund’s balancing portfolios and balance sheet, optimising trade-offs between exposures, leverage and liquidity. Its leverage is managed at the total fund level and assessed alongside funding capacity and collateral demands, not for the objective to scale risk but to support diversification.
When asked if balance sheet management will also soon become a prominent feature among Australian super funds, Patrick says “in a one-word answer, yes”.
“If you take everything from the size of the funds to their systemic importance, to the fact that we’re heading… to an environment where liquidity becomes more prominent in how you have to manage the fund because of the number of retirees, yes, beyond a shadow of a doubt,” he says.
‘Net risk’ for AI
Apart from balance sheet management, artificial intelligence is another issue top of mind for Patrick. Despite the sector propelling equities markets to historical heights, in Patrick’s mind AI’s impacts will present “net risk” for the portfolio.
“I’m positioning my answer in the context of what I see is probably extended optimism [around AI], which is very early in a long story,” he says.
“Is AI transformative? There’s no doubt. But from an investment point of view, where value will be created, how to price the prospect of that value, when it will emerge, what the sovereign challenge between particularly US dominance versus China dominance in AI really may mean down the track, I think it’s net risky to a portfolio from a current position of quite strong optimism.”
Data centres and chipmakers are currently generating stratospheric returns for investors, while software companies are most prone to disruption, but that dynamic could change fast, Patrick says.
“You could see economic value change hands quite quickly there, and that all happened several times because we’ve seen the iteration of these models at quite a significant pace. How long [before that happens]? Three to five years, probably.”
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