Australian Prudential Regulation Authority (ARPA) research has found not-for-profit superannuation funds with a higher allocation to illiquid investments, such as directly held property, infrastructure and alternative investments, have higher risk-adjusted returns.
APRA considered the investment patterns of 146 super funds with total assets each of at least $200 million between September 2004 and June 2010.
It found not-for-profit funds, such as industry funds, allocated more of their portfolios to illiquid assets, compared to retail super funds. Not-for-profit funds that held more illiquid assets had higher risk-adjusted returns over the sample period, and APRA suggests they "captured a return premium for investing in [illiquid] assets".
APRA's paper has implications for the debate about whether super funds should invest much more in unlisted infrastructure projects and help reduce a nationwide infrastructure backlog estimated at more than $700 billion.
The research shows illiquid assets can play a useful role for not-for-profit super funds that are larger, have greater net cash inflows and younger members.
APRA notes: "This result does not guarantee that funds with illiquid portfolios will always outperform funds with more liquid portfolios, and nor does it obscure the risks of investing in illiquid assets."
A higher allocation to less liquid assets, such as private equity and hedge funds, can be a problem for funds that need more regular cash inflows to meet the demands of departing members.
The paper says there is likely to be an increasing need for liquidity-risk management, to ensure benefit-payment obligations can be met as the baby-boomer generation approaches retirement.
Other researchers have predicted industry-wide super outflows will increase at a faster rate than inflows over the next 20 years.
Funds with older members who are approaching retirement will rely more on realising fund investments to meet future payment obligations.
Holding too many illiquid investments could be a problem for such funds, especially during times of intense market volatility if there are withdrawal 'runs' on super funds as some members panic and cash out.
Other risks are an illiquid asset taking too long to sell, high price uncertainty and the difficulty in valuing some unlisted assets. There is also a view that listed assets on global exchanges are better regulated and have more safeguards for investors than unlisted markets.
Against that, the paper says illiquid assets can benefit super funds by improving diversification and increasing their return per unit of risk incurred.
Such investments can also have lower transaction costs and leverage the super fund's in-house expertise, such as the largest industry super funds taking big stakes in Australian and offshore unlisted infrastructure projects.
The largest funds may be able to leverage their scale to achieve more favourable positions in key projects.
APRA says: "The decision to invest in illiquid assets represents a trade-off between possible favourable return characteristics and unfavourable liquidity characteristics."
The research arguably strengthens the case for large industry super funds with strong fund inflows and younger average membership bases to lift their positions in illiquid assets such as infrastructure or property investments that may last decades.
Such funds could use these investments to improve risk-adjusted returns and outsource less investment management in illiquid assets to fund managers, thus lowering average portfolio transaction costs for members.
