Recently one of the largest industry superannuation funds disclosed the pay and bonuses of its senior staff. The CIO of the fund achieved a maximum bonus of 60% of base salary in the 2013-2014 financial year by successfully delivering on the fund’s 3 performance objectives:
- A positive return.
- A return above inflation.
- A return above the SuperRatings SR50 Balanced Index median.
I am a believer in properly structured performance incentives.
For example, the legendary Walter Schloss* charged his clients a 25% performance fee with no base fee. Was this a fair deal? Absolutely. Schloss delivered a 21% gross return over 46 years. The net return was 16% per annum, compared to 10% for the S&P 500.
This may not sound like much of a difference but thanks to the magic of compounding, a $10,000 investment in the S&P 500 would have grown to over $900,000, while a similar investment with Schloss would have grown to approximately $11,000,000!
It’s true that Schloss earned a lot of money in fees over the years. But he only became wealthy because his clients became wealthy. And 100% of his fee was at risk every year. His fee, while generous, was not a “heads I win, tails you lose” proposition.
In this way, Schloss was incentivized to make money for his clients, while at the same time avoiding unnecessary risks. I have no problem with a performance fee arrangement such as this.
But I don’t believe in paying performance incentives for results that can be achieved easily and cheaply. **
With that in mind, I thought it might be interesting to analyze just how easy or difficult it is to exceed the performance hurdles listed above. Superannuation funds are required by law to publish the probability of a negative return (expressed as the number of years expected to have a negative return out of 20 years) for each of their investment options.
Most balanced funds have a probability of 4 or 5 negative years out of 20. In other words, over the long-term there’s roughly a 75-80% chance that investment returns will be positive in any given year.
Most asset classes provide a return above inflation over the long-term. Otherwise there would be little incentive to invest in these assets; in other words, there’s no point investing in an asset only to see your purchasing power get eroded over time.
So the first two hurdles are relatively easy to clear. What about beating the SuperRatings SR 50 Balanced Index median?
The SR50 Balanced Index is created using the monthly investment returns of 50 balanced investment options offered by a variety of superannuation funds. Each fund has an allocation to growth assets (equities, credit, property, hedge funds etc.) of between 60% and 70%. The index is based on the monthly unit prices or crediting rates paid by each fund to their members.
I decided to see how the performance of a simple, transparent, low-cost balanced portfolio compared to the performance of the SR50 Balanced Index. To do this, I selected the Vanguard Growth Index Fund, which has a 70% allocation to growth assets. The fund is 100% passively managed and the fund does not invest in illiquid assets.
|Asset Class||Vanguard Growth|
|Emerging market shares||3.5%|
|International small company shares||3.5%|
|International REITs (hedged)||4.0%|
|Australian fixed interest||12.0%|
|International government bonds (hedged)||12.0%|
|International credit (hedged)||6.0%|
I was able to get the financial year returns for the SR50 Index and the Vanguard Growth Index Fund from the SuperRatings and Vanguard (Australia) websites for the last 4 financial years.
|Financial Year||Super Ratings SR50 Balanced (60-76% growth) Index||Vanguard Growth Index Fund (net of fees)||Difference|
|2010 – 2011||7.7%||9.44%||1.7%|
|2013 – 2014||12.7%||14.88%||2.2%|
For the last 4 years, a simple, transparent, low cost balanced portfolio would have easily beaten the SR50 Index median.
This isn’t a surprising result. Australian or international equities have beaten cash or bonds approximately 60% of the time from 1970-2012 (Andex Charts). So if history is any guide, an equity-heavy balanced fund should, on average, out-perform peers 6 years out of every 10 – although it will also do a lot worse in a bear market.
Given the bonus structure described above, all a CIO has to do is hold a simple, transparent, low cost balanced portfolio with a decent allocation to equities. If you do, you have roughly an 80% probability of earning at least part of your bonus and a 60% probability of earning your full bonus in any given year.
This raises a few interesting questions:
- Why are bonuses based on annual performance when the investment performance objectives of most balanced funds are measured over 10-years?
- How might a high probability of earning a bonus, most of the time and without making any major or difficult investment decisions, affect behaviour?
* An interesting interview with Walter Schloss can be found in the excellent book: The Value Investors: Lessons from the World’s Top Fund Managers by Ronald Chan.
** Maybe I’m just jealous of those lucky enough to be earning them?