Australian Super’s Elephant Gun Problem

Back in 1987, Warren Buffet made the following statement in a letter to Berkshire Hathaway shareholders: ‘Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun …’

Before you gasp in horror, the elephant he was referring to was a metaphor for the purchase of a large business, and the gun meant having the available cash to transact quickly when others cannot, or if there are concerns about the future due to economic uncertainty (such as a share market crash). Historically, Warren has been able to secure such purchases on very favourable terms and a large number of them have proven to be very profitable.

In his letter he went onto say: “If we find the right sort of business elephant within the next five years or so, the wait will have been worthwhile.”

More recently Warren has routinely explained to shareholders at Berkshire Hathaway’s annual general meetings and at media interviews that as a company gets larger, it becomes harder to outperform the market. The company’s 2018 annual report valued its portfolio at around US$172 billion. Yet one only has to look at Berkshire Hathaway’s share price to see it has underperformed on the S&P index by around 15.28% over the past five years. So it would be fair to wonder whether the company is starting to come under some pressure for its performance. It is unclear if this is a long-term trend, or simply that the market has not had a crash for a long time, to allow Warren to deploy his elephant gun.

In portfolio theory we talk about the law of large numbers, and the main reason fund managers that are providing “active management” understand their limitations with the size of assets they actively manage. In a lot of cases, the good ones simply close the fund to new investors at some point as the fund cannot handle unlimited amounts of capital.

There are a few reasons why this law persists in our industry. The first has to do with position size. Let’s take a portfolio worth around $1 million. If you purchase an investment option worth around $10,000 and it goes up by 30%, you might say ‘Hey, what a great return!’ Well, not really. You just gave yourself an administrative stomach-ache. The return, although good, only moved up the value of your fund by 0.3%. As the size of the portfolio gets larger – say $150 billion plus – your ability to buy a large enough stake to make a worthwhile return gets harder and harder.

Another aspect of this law has to do with being able to move capital around in the portfolio. With such massive position sizes it can sometimes take six to twelve months just to sell out, which creates some questions about being nimble in a quickly changing market.

The third reason has to do with inflows. Each year a huge amount flows into Berkshire Hathaway from dividends of listed companies that Berkshire Hathaway owns and all the profits from the private companies they own too. Warren’s company needs to allocate this into existing or new investment options. This growing cash pile can make the situation worse: when there is too much cash not being deployed effectively we call this ‘cash drag’ because it can create a drag on performance returns.

So, what does all this have to do with Australian Super? Well, as at 30 June 2018 this super fund provider reported that they had about A$140 billion or so in funds, which they manage on behalf of members. They also have a huge amount in super contributions coming in, which they need to allocate each year to investment options.

The larger the super funds become should mean some increase in economics with hopefully cheaper fees in the long term based on economics of scale. This would normally be one of the selling points of increasing its size. However, it appears Australia Super did not get this memo, as they had close to doubled their administration fees by 30 June 2019.

The reality is that as these super funds get larger, they start to push the limits of what they can do as an outperformance fund and may simply just track or underperform the respective indexes. It will be just a case of time to see if this plays out.

As you can see, if your money is being lumped into a large pool and yet you are looking for an active management approach, you start to see a clash with these two strategies in the longer term.

So the next time you are thinking about selecting your investment options or a superannuation fund, it is important that you seek quality advice from a practising financial planner and of course, I recommend AJ Financial Planning.