First Super: Merger pressure fizzles out

The blind rush to consolidate that gripped the $3.4 trillion superannuation sector for the past eight months may be finally over, according to First Super chief executive Bill Watson.

Instead of seeing big funds gobbling up smaller rivals, Watson expects more considered mergers that make a difference for members rather than rushed mergers that suit the regulator.

Watson believes that with a change of government, there is a change in focus.

Further, he notes that financial services minister Stephen Jones has publicly said there is a place for diversity within the superannuation sector.

Jones does not want the superannuation sector to mirror the banking sector by consisting of four dominant players.

"This is a reversal of the previous government policy for fewer funds that were carried out by the prudential regulator," says Watson.

"Accordingly, there was unrelenting pressure on funds to merge and achieve scale, creating a super system that looked like the banking system."

The First Super chief executive says the message is now more nuanced, and APRA chair Wayne Byres is leading the charge.

Still, while the regulator says it no longer has a merger agenda, Watson goes on to say, dealing with sustainability and investment returns will continue to be hugely important.

"Using a metaphor from the maritime industry, Byres says you plot your course. You know where your destination is. You've got to ensure your vessel is seaworthy and your crew capable."

"But if the ship is unseaworthy and your crew is incompetent, Byres is saying you will still encounter the maritime patrol".

So it all seems a little less crude now, according to Watson, who has demonstrated that being below APRA's $30 billion benchmark does not necessarily mean funds will achieve lower returns than larger funds.

"We've seen with fund mergers there's been a focus on getting larger to achieve better investment returns. Well, we don't think that's the case."

"The regulator telling us that if you're small, you can't you don't have the scale for investment opportunities is just not true."

The numbers back him up.

According to Rainmaker, over the last 12 months, six of the top ten funds were below $30 billion, underlining that scale does not automatically deliver out-performance.

Moreover, First Super was among the few to end the year in the black. Its default balanced option returned 1.0 per cent for the current financial year compared to the median industry return of -3.7 per cent.

The fund ranks in the top five for MySuper/default options over one year.

This is confirmed by new data from Frontier Advisors which concludes that asset allocation was more influential for the investment performance of super funds than size and scale.

The figures prove that a small fund can trump behemoths.

Watson concedes though that small funds had a good year.

And, that 12 months is just one data point and with current market volatility, it is too early to say whether this will continue.

The trouble with bears

Watson believes that the long-running bull market has meant that size has potentially created greater returns.

But as he sees it, that return differential will shrink in a bear market. "And, potentially, the larger you are, the greater the risk and volatility that you'll encounter," he warns.

"In some areas, the bigger you get, the less opportunity there is in Australia. So, you then have to be more agile, which is why we see the large funds opening up offices in London, New York, and Hong Kong. And that's great for their members as it opens up global opportunities that smaller funds can't directly access

The chief executive says it isn't just size that needs addressing - it is returns and service.

Unfortunately, he adds, poor performance doesn't belong to small funds only. What needs to be called out is poor performance irrespective of fund size.

Watson says big funds cannot always deliver scale or investment return benefits to their members as they can create diseconomies that retard some types of investment.

"For instance, they can't invest in Australian small-cap stocks because they would distort the market. And given their forecast growth, they won't be able to actively invest in large caps either."

But can't they take an Australian public company private and achieve higher risk premia and a better return?

Watson agrees but points to the downside, which is a loss of liquidity which has its own problems.

"Our system is constructed so members can switch in and out of options daily or even hourly. So there's a tension between being a long-term investor, but having short-term pressures, which limits the ability to take these longer-term bets in illiquid markets."

"As a small fund, we can fish in Australian small caps pond and private equity mid-market sector," he says.

Unlisted markets

What's working for First Super is its $200 million private equity mandate. "We're putting money into mature cash-producing businesses worth around $50 million."

"There are no J curve issues, they're mature businesses, but they need institutional money. While their performance has had ups and downs in the short term, they've been the gift that keeps on giving over the longer term."

Last year, First Super's private equity program returned almost 30 per cent before tax and after fees.

"So that's meaningful returns for our members with 3.8 billion of funds under management."

The chief executive watches three key indicators - net investment returns, the cost of running the fund, and, most importantly, the level of service for members.

"Therefore, in terms of any merger opportunity, we want someone capable of delivering better investment returns, lower costs and maintaining the quality of service,' he says.

Watson says the legislative "guardrails" include the performance test and the heat maps. To those, he wants to add a third guardrail which is service quality.

"Being kept on hold by a contact centre for hours isn't an acceptable service," he says.

Watson feels that First Super is doing a pretty good job for members with returns, service relative to other funds and administration fees.

Coming from other heavily regulated industries - maritime transport and rail - he's not bothered by the increasing intensity of regulatory scrutiny.

Those who look after other people's retirement savings should be scrutinized

Despite the performance test and heat maps, First Super has remained true to its conviction with its active management, strategic asset allocation and asset class selection.

"So we have not changed anything because of these tests. We are underweight emerging markets which have been net positive for members and not detracted from performance test outcomes," says Watson.

Bargain basement

As for service, First Super has a high-touch model that does come with a cost.

"You can go to a bargain-basement Jetstar kind of operation and look good in the APRA heat maps without any measure of the quality of the service."

Aside from wrestling with service quality, sustainability, costs and stapling, the rollout of ESG remains a challenge.

"We find that not all managers have embraced the integration of ESG into investment processes. However, our private equity program is applying a bespoke ESG evaluation process that our private equity managers have embraced."

So how do you then grow your membership base without a merger?

First Super is one of the few funds to launch a KiwiSaver initiative a couple of years ago to allow Kiwis to transfer their money to Australia.

While the number of New Zealanders who roll their money into Australia is not huge, for a fund comprising 46,000, it's a big deal.

And First Super is close to its industry groups which have held up its membership. Timber, manufacturing beds, hard and soft furnishing and kitchen cabinets have all been in high demand.

"This means members have worked continuously through the pandemic."

"So we've had year-on-year membership growth. Our membership growth initiatives may be sub-scale stuff or a rounding error for large funds, but growth from these initiatives is material for us."

From where Watson sits, smaller funds, close to their members, investing in their industries, low fees, outperforming, and providing more nuanced and bespoke services to their membership, continue to prove that size isn't everything.