Capacity and Climate Affect Allocations

Capacity constraints and climate risks have started to impact how super funds allocate to Australian equities and small caps, JANA’s Jeremy Wilmot says.

As superannuation funds grow larger, either organically through member inflows or because of merger activity, scale is starting to affect how funds allocate their capital.

With some funds hitting the $250 billion mark and likely to grow to at least double that in the next few years, areas such as Australian equities and small caps are starting to creak under the weight of money.

Although traditionally super funds have had a home bias, with an Australian equity allocation of around 25 to 35 per cent, some funds have already started to allocate less to these securities.

“You’re just seeing more global equities relative to Australian equities in portfolios, which historically, because of the tax and franking credits, was the other way around,” Jeremy Wilmot, Principal Consultant and Chair of the JANA Investment Committee, said in an interview at last week’s JANA Annual Conference 2023 in Sydney.

“There was a yield and tax pick-up in Australia, but because of capacity constraints, you are seeing [more money] just go offshore.”

The balanced fund options of some of Australia’s largest super funds, including AustralianSuper, the Australian Retirement Trust and Aware Super, all have higher allocations to international equites than to Australian equities.

A number of these funds have started internalising Australian equity portfolios, which helps in managing capacity. But as they continue to grow, these portfolios will still face liquidity issues.

One way to get around such issues is to run multiple investment portfolios with different liquidity profiles, Wilmot said.

“You can run two sleeves. You can have an equity sleeve that is [invested] in the more liquid stocks and you can use that to rebalance the portfolio,” he said.

This more liquid portfolio can be held passively, or passive enhanced, and would focus on the 20 largest, most liquid large-cap stocks.

“And then you can have a more active sleeve, where you’re taking bigger positions in individual stocks and you may accept that you’re not going to get that liquidity,” Wilmot said.

Small Caps

Small caps is another area where scale causes problems. This becomes quickly clear where funds use external managers, which often prefer to have a broad client base, rather than have one fund take up all their capacity.

“Small caps, unless it’s run internally, probably does get exited because external managers don’t really want mandates of that size, just from a business risk perspective,” Wilmot said.

Internalisation does provide some relief here as capacity is less of an issue, while it also allows investors to hold on to those stocks for much longer than external managers can.

“If you have a long-term focus on those small caps and say that you’re going to hold this on a five-year horizon, then it probably works. But if you wanted to trade that portfolio, then you’re going to have a lot of constraints,” Wilmot said.

External managers also have to be mindful to stay true to the definition of small caps, which can become problematic when a company expands under its own success.

“A lot of the time, you’ll see that someone will buy a small-cap stock and hold it for 10 years because it eventually ends up in the top 50 and you can hold it the whole way through,” Wilmot said.

“If you’re a small-cap manager, you have to sell that when it hits a certain cap level because it’s outside your universe. So some of those big funds can actually find companies that have great growth profiles and just put them in the bottom drawer and let it grow through the portfolio.”

Climate Change

Scale is one issue that has started to impact Australian equities, but climate change and the commitment of many funds to move to net-zero investment portfolios also affects how eager funds are to keep investing large parts of their portfolios in Australian shares.

Earlier this year, JANA incorporated a climate-aware capital markets framework, which has changed its assumptions of future returns and volatility of various asset classes. Australian equities don’t look great from this perspective as the domestic economy has a skew towards mining stocks.

“Australian equities have more of that brown climate risk and so there was a penalty on the return,” Wilmot said.

“All things being equal, when you’re building a portfolio from scratch, it will direct more money away from Australian equities.”

But he also pointed out this is where the biggest gains can be made as institutional investors are already large shareholders of Australian companies and have, therefore, more influence on their business strategies.

“Australian equities we probably would say have got more brown risk, but it’s also the area where we’ve got the most chance of making a big change because of the collective voice of the large super funds,” he said.

“It is a lot easier to engage with an Australian company because you can get together with other like-minded investors that together represent 20 to 30 per cent of the stock and actually have some influence.

“Once you’re in the global sphere, it’s much more challenging to actually have that influence and so you see that most of the engagement programs focus on the Australian market.

“I think more collaboration and more understanding that collaboration, actual engagement, is more important than divestment.”