‘Equity Bias’ and the Prudent Trustee
September 25, 2012
Over the past few years a falling stock market together with increased volatility in financial assets generally have brought the investment strategies of Australian superannuation fund trustees into particular focus. This is not just because a portion of employees’ wage and salary incomes must by law be diverted away from present day consumption into long term savings. Rather, it occurs because of the manner in which those moneys are deployed: mainly by defined contribution schemes, where returns are directly linked to financial market fluctuations.
Recent public commentary has raised the question of whether, despite this obligatory assumption of long term financial risk by ordinary workers there has been added a further risk, being a bias among superannuation fund trustees for investing in Australian equities, to the exclusion of alternative and potentially less risky asset classes. If such an ‘equity bias’ exists, the question arises as to whether this is a prudent investment strategy for the trustees.
The principle of a trustee being expected to make prudent investments is founded upon the seemingly quaint notion of the ‘prudent man’ of 18th and 19th century English and US trusts law. Trustees managing large funds or estates in those times were expected to exercise the level of skill and caution that a prudent man of business would put into effect in managing his own money.
This fundamental principle is reflected not just in Australian common law but, latterly, in statute law by virtue of late 20th century amendments to the various State Trustee Acts , and, in the federal sphere, through section 52(2) of the Superannuation Industry (Supervision) Act 1993 (C’th) (the “SIS Act”).
This provision basically says the powers and duties of superannuation trustees must not only be exercised with the same degree and skill of an ordinary prudent person, but, by the implementation of an (appropriate) investment strategy which should be in the best interests of the beneficiaries.
Prudence then is an amalgam of two things: the kind of cautious behaviour expected of someone managing another’s money, and secondly the choices made in its use, which should imply diligent investment selection and as a corollary, appropriate risk aversion.
In financial markets, the conventional wisdom is that, in Australia at least, listed shares have historically exhibited an excess return over risk-free and similar fixed interest investments. From 1980 up to recent years this excess has been regarded as being in the range of 5 – 6 per cent per annum. Australia’s near one trillion dollar corporate, industry and public super fund sector has, the argument goes, implicitly used the excess return presumption to justify majority portfolio weightings in Australian (and global) shares. In so doing, they are paying insufficient attention to the merits of other asset classes such as cash, commercial real property and private (non-listed) equity opportunities.
According to the Organisation for Economic Co-operation & Development (“OECD”) these weightings are overly large relative to portfolio weightings in other advanced investment markets. Concerns about prudence may arise when it is considered that the average annual return of all ASX listed shares has fallen by nearly 10% per annum over the past 5 years. Over that same time period the average balanced superannuation fund has lost 0.2% per annum on a rolling basis, returning just 0.7% in the past year.
Without getting into the realms of finance theory, the implication is that if such a skewing of investment choices is left uncorrected, it could amount to less than prudent investment behaviour.
Many trustees customarily appoint investment professionals with a brief to manage their assets in an active manner so as to exceed the average market return, measured by an index or other performance indicator. Active investment management is widespread market practice. Given the increasing correlation between world stock markets, market participants’ knowledge and expertise are most likely geared to local and, to a lesser extent, international equities.
So if trustees are to be seen to be acting prudently, they must be able to demonstrate a basis for their belief that their manager can “beat the market”. The courts will not uncritically accept what is put forward as contemporary investment practice. The rationale for a superfund’s investment strategy must be validated by the party relying on it.
An unintended consequence of the proliferation of laws and regulations (with more to come) in the superannuation area is that trustees of one fund become inclined (if not encouraged) to mimic the investment choices of their peers. Quite often this will be the product of the group-think of the same set of asset allocation experts whom all of the funds consult from time to time. For trustees, the rationale is that it is harder to characterise a decision as imprudent if it resembles the decisions everyone else is making.
However, trustees may take comfort from the fact that the courts, whilst not uncritical of finance theory are still prepared to accept credible and defensible contemporary best practice when judging prudence.
Further, in construing the SIS Act, courts should be prepared to take account of the unique background of public superannuation trusts – for example the absence of the need for the not uncommon private trust distinction between income and capital. They recognise that the SIS Act’s tests are directed to inputs, not outcomes. Provided the trustee has acted diligently, considering all aspects of what is the appropriate exercise of skill and care, it will not follow that, just because a trend develops such as portfolios being found to be skewed to equities the trustee is presumed to be less than prudent.
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This article is intended to provide general information in summary form on a legal topic, current at the time of publication. The contents do not constitute legal advice and should not be relied on as such. Formal legal advice should be sought in specific circumstances.