Mark to market: Which super option should I choose?

Question:

Hi Mark

I have enjoyed your podcast. I hope you and your guests can spend time in one of the future episodes to go way deeper into the investment options inside super. Specifically I would love a comparison/discussion about indexed options.

ETFs have been all the rage for a while but over the long term inside super seemed to deliver lower returns than active high growth options. Let's take a look at Australian Super for example. The high growth pre-mix option produced 8.07 pa over 10 years, 7.90% pa over 5 years. Over the same periods the Indexed Diversified produced 7.23% pa and 6.98% pa. After fees and costs. Even the default balanced option would have been better over the last 10 years. Naturally past performance does not guarantee future performance and index options show better returns over 1 and (marginally) 3 years....

Looking across super funds, the index options have consistently lower investment objectives than actively managed high growth option, while judged at the same level of risk, e.g

• Australia Super: High Growth: CPI+4.5%, Indexed Diversified CPI+3%
• Aware Super: High Growth: CPI+4%, High Growth Indexed CPI+3%
• HostPlus: High Growth: CPI+4.5%, Indexed High Growth CPI+3%
• Vanguard Super: High Growth CPI+3.75 , Growth CPI+3.5

So while I do understand and agree with the advantages of investing in index funds/ETFs over actively managed funds in general, could it be that for super, actively managed high growth option might offer similar or better returns at comparable overall risk?

And if one wanted to go indexed, then what would be the most cost-effective structure: pre-mixed, DIY mix or member direct/ETFs?

Answer:

This is a great question with lots of components. The first step is diving into the first two super options mentioned – the actively managed pre-mixed options and the index diversified.

Below is the current asset class allocation of the pre-mixed high growth option.

Source AustralianSuper

Next is the asset allocation of indexed diversified option:

source AustralianSuper

These mixes are very different. The high-growth pre-mixed option has 10.25% allocated to defensive assets consisting of credit, fixed interest and cash. Conversely, the indexed diversified option has 30% allocated to the defensive assets consisting of fixed interest and cash.

Before looking at the historic performance we can form a hypothesis of how these difference mixes of assets would have performed over the last 10 years given strong equity markets and challenging conditions in fixed interest markets.

Asset allocation is the largest driver of returns. It is far more influential on the returns achieved in a portfolio than security selection. Given the significant differences in the defensive allocation between the high-growth pre-mixed option and the indexed diversified option I would expect the high-growth pre-mixed option to outperform over the long-term. Given conditions over the last 10 years I would expect the historical performance to be meaningfully better.

Given that the indexed diversified option is far more defensive than the high-growth pre-mixed option a better comparison may be the balanced pre-mixed option. The asset allocation of that option is below and we can see that 23.50% of the portfolio is allocated to the defensive assets of cash, fixed interest and credit.

Source AustralianSuper

This is still a meaningfully lower allocation to defensive assets than the index diversified option. Once again over the long-term I would expect the balanced option to outperform the index diversified option.

Performance

We now have some context to look at the actual performance of the different options over the last 10 years.

This aligns with my hypothesis. The options with a higher allocation to growth assets have outperformed during a period of strong performance for growth assets. I would expect that outperformance to continue in the future over the long-term given that growth assets have higher expected returns than defensive assets.

DIY options

AustralianSuper allows investors to create their own asset allocation mix using the DIY option. In this case returns will be driven by the choices made by individual investors. But we can look at the returns of each bucket that is available for investors to choose.

The 10-year AustralianSuper returns are below:

A couple things jump out at me here. We can see the relative outperformance of international and Australian shares over fixed-interest and cash. That is indicative of the market environment over the last 10 years that I alluded to before.

I’ve created 3 different DIY portfolios with allocations that mimic the growth / defensive asset mix of the high growth, balanced and index diversified options. Below is their performance over the last 10 years:

All three of the DIY mix options outperformed the pre-mixed and index diversified options. However, in a practical sense we can consider the returns as a wash based on three factors:

• I didn’t allocate anything to the lowest performing asset class which was cash.
• My allocation between Australian and International shares was just a high-level attempt to have around 10% more in Australian equities than international equities. I didn’t put much thought into it.
• I didn’t account for any rebalancing and just let the original allocation run. This would mean ending portfolios with a significantly different allocation to where it started.

What does this exercise tell us about active vs. passive?

I would argue it tell us nothing. And it tells us nothing because we have no idea what the actual investments are in any super fund. The description of the index diversified option on AustralianSuper’s website says it “Invests in a range of assets using indexing strategies with a focus on growth assets.”

We know they are using “indexing strategies” but we don’t know which ones. I can make some inferences from Morningstar data available on our website. It is clear there is some allocation to emerging markets and some to small and mid-caps. But ultimately, we have no idea what indexes are being used. It makes it very difficult to assess what led to the performance.

While “indexing strategies” are being used I don’t consider this a passive strategy. There are passive investments and there is passive investing. They are two very different things. We can see why I don’t consider this passive investing by looking again at the asset allocation of the index diversified option.

Source AustralianSuper

There is wide latitude within each asset class for AustralianSuper to change the allocation. This is represented by the range column. And this is at the asset class level. Within that asset class there may also be wide discretion to change the allocation.

We just don’t know because there is no transparency into what “indexing strategies” are being used. Could they tilt the international shares towards emerging market indexes? Can they take overweight positions in a certain country or region? I just don’t know. Inexplicably Australia is one of the only developed countries in the world where transparency into investments is not required.

There is nothing wrong with an investment team having wide discretion over how much to allocate to certain asset classes and the allocations within an asset class. But it means that future returns are reliant on the skills of the investment team even if “indexing strategies” are used.

The influence on returns from the decisions made by the investment team is why I don’t consider this a passively managed portfolio. The investment team has wide discretion and returns will be driven by their ability to make changes to asset allocation based on market conditions. That sounds a lot like active management to me.

What is passive management?

The only way to get pure passive management would be to select an asset allocation and just stick to it. Nobody is trying to find undervalued opportunities or predicting where the economy is going. All that happens is periodic rebalancing to maintain the desired long-term asset allocation. That is passive management.

The best approximation we have to that approach is the diversified options from Vanguard and BetaShares. The Vanguard Diversified High Growth ETF VDHG and BetaShares Ethical Divers High Gr ETF DZZF both have 90% allocated to growth assets and 10% to defensive. In this way they mirror the allocation of AustralianSuper’s high growth pre-mixed option. The BetaShares ETF adds an ESG lens but both ETFs follow passive indexes.

Neither ETF has been around for 10 years and only the Vanguard product has been around for 5 years. Over the past 5 years VDHG has an annual return of 8.89% compared to 7.90% for the AustralianSuper high growth option. Over the past 3 years VDHG has an annual return of 6.87% and DZZF has an annual return 6.26%. Both compare favourably 5.36% return for AustralianSuper’s high growth option.

Final thoughts

This was a long question and a long answer.

The premise of the question was is it better to choose a pre-mixed option, a DIY option or member direct option. I get a lot of questions asking which investment is “better”. And the answer is always ‘it depends’.

In this case it is based on how involved an investor wants to be in managing their portfolio, their comfort level with selecting individual investments and their view on outsourcing decision making to the investment team of a super fund when there is no transparency into any of the investments.

Those are all things to think through. But if there is one takeaway it is that the most important decision any investor can make is choosing the right asset allocation. No matter what option is selected the asset allocation will be the primary driver of long-term returns. Get that right and you are more than halfway home.

The other important thing to remember is that context matters. I could spend the rest of my life preaching that investors shouldn’t use performance as decision making criteria for selecting investments. It won’t matter. People will do it anyway. But it is important to remember that performance needs context. Make sure you know why an investment performed the way it did.  

Not knowing that is going to make it extremely hard to stay invested when the inevitable downturn occurs. If you only picked a certain super option because it went up there is nothing stopping you from selling when it goes down.

Have a question? Write me at [email protected] 

For more on selecting the right asset allocation see these resources:

• Foundations of financial independence: Asset allocation
• How to set an investment strategy

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Articles mentioned:

• When should you sell shares

Previous editions of Mark to market can be found here.