Working Paper Risk and return of illiquid investments: A trade-off for superannuation funds offering transferable accounts

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1 Workng Paper Rsk and return of llqud nvestments: A trade-off for superannuaton funds offerng transferable accounts Dr James Rchard Cummngs and Dr Katrna Ells November Australan Prudental Regulaton Authorty

2 Dsclamer and copyrght Whle APRA endeavours to ensure the qualty of ths publcaton, t does not accept any responsblty for the accuracy, completeness or currency of the materal ncluded n ths publcaton and wll not be lable for any loss or damage arsng out of any use of, or relance on, ths publcaton. Australan Prudental Regulaton Authorty (APRA) Ths work s lcensed under the Creatve Commons Attrbuton 3.0 Australa Lcence (CCBY 3.0). Ths lcence allows you to copy, dstrbute and adapt ths work, provded you attrbute the work and do not suggest that APRA endorses you or your work. To vew a full copy of the terms of ths lcence, vst by/3.0/au/. Inqures For more nformaton on the contents of ths publcaton contact: James Cummngs, Polcy Research and Statstcs Australan Prudental Regulaton Authorty GPO Box 9836 Sydney NSW 2001 Tel: Emal: Acknowledgements Authors: James Rchard Cummngs and Katrna Ells, APRA

3 1 Rsk and return of llqud nvestments: A trade-off for superannuaton funds offerng transferable accounts by Dr James Rchard Cummngs Australan Prudental Regulaton Authorty Dr Katrna Ells Australan Prudental Regulaton Authorty November 2011 Abstract: Ths paper examnes the pattern of nvestment by Australan defned-contrbuton superannuaton funds n llqud assets. Not-for-proft funds allocate more of ther portfolos to llqud assets, on average, than retal funds. Ther allocatons reflect fund sze, net cash nflows and member age factors relevant to a fund s lqudty requrements. Furthermore, the allocatons reflect the extent of the fund s n-house nvestment management. In contrast, there s no sgnfcant relatonshp between these factors and allocatons by retal funds. Notfor-proft funds wth more llqud nvestments experence hgher rsk-adjusted returns, whch suggests they capture a return premum for nvestng n these assets. Acknowledgements: The authors thank APRA s Statstcs Unt for provdng the superannuaton data and Bruce Arnold, Catherne Bennett, Owen Bralsford, Roger Brown, Greg Brunner, Amee Burnage, Keth Chapman, Peter Chong, Kevn Dent, John Dow, Peter Edney, Doug Foster, Joel Grant, Ross Jones, Charles Lttrell, Kevn Lu, Bessy Ma, Crag Roodt and Irene Shu for ther comments and suggestons. Dsclamer: Ths paper reflects the authors vews and not necessarly the vews of APRA. APRA does not accept any responsblty for the accuracy, completeness or currency of the materal ncluded n ths publcaton, and wll not be lable for any loss or damage arsng out of any use of, or relance on, ths publcaton. Correspondng author:

4 2 Executve summary Most superannuaton fund assets are lqud, whch means they are able to be converted nto cash wthn a few days, and are able to be valued usng market prces. In recent years, however, many superannuaton funds have ncreased ther allocatons to llqud assets, n the expectaton that these assets would yeld suffcently large returns to compensate for ther llqudty. Ths paper examnes the nvestment by Australan defned-contrbuton superannuaton funds n llqud assets, n partcular, the amount nvested n these assets and the mpact on portfolo performance. These assets nclude drectly held property, unlsted property trusts, nfrastructure nvestments, prvate equty and hedge funds. Illqud assets may provde dversfcaton benefts and an opportunty for some funds to leverage off ther exstng nvestment expertse. At the same tme, superannuaton funds have lqudty demands ncludng those relatng to members rght to transfer ther balances to other funds whch cannot necessarly be met by regular cash nflows. Illqud assets are less functonal n meetng these demands, nsofar as the secondary markets for these assets are less actve than those for the tradtonal assets of stocks and bonds. In ths respect, the decson to nvest n llqud assets represents a trade-off between possble favourable return characterstcs and unfavourable lqudty characterstcs. Ths study fnds not-for-proft superannuaton funds allocate more of ther portfolos to llqud assets, although there s a consderable range n allocatons among both not-for-proft and retal funds. In the perod from September 2004 to June 2010, not-for-proft funds wth more llqud nvestments experenced hgher rsk-adjusted returns, whch suggests they captured a return premum for nvestng n these assets. However, ths result does not guarantee that funds wth llqud portfolos wll always outperform funds wth more lqud portfolos and nor does t obscure the rsks of nvestng n llqud assets. Gven the rsks, certan superannuaton fund characterstcs may lend themselves to larger allocatons to llqud assets. Ths paper fnds that not-for-proft funds whch are larger, have greater net cash nflows and have younger members all factors whch tend to reduce lqudty needs allocate a greater proporton of ther portfolos to llqud assets. The results are not the same for retal funds: there s no sgnfcant relatonshp between fund sze, fund flows or member age and nvestment n llqud assets.

5 3 Introducton The ablty of a superannuaton fund to meet payment oblgatons to members and benefcares n a tmely and effcent manner, wthout ncurrng sgnfcant unexpected costs, depends upon the marketablty of ts nvestments as well as the other cash flows nto and out of the fund. In ths paper we nvestgate the extent to whch defned contrbuton superannuaton funds n Australa nvest n llqud asset classes and look at the characterstcs that may nfluence these nvestment decsons, as well as the performance mpacts of these nvestments. The debate on an approprate allocaton to llqud nvestments for penson funds has been ongong for several decades, mostly wth a focus on defned beneft penson funds. On one hand there are those that support the Yale endowment nvestment strategy poneered by Davd Swensen whch advocates a very hgh allocaton to llqud nvestments. Ths s argued on the bass that endowment funds have very long nvestment horzons and reasonably predctable cash outflows, and thus are not as senstve to llqudty as other nvestors (see Swensen, 2000). On the other hand, researchers argue that despte llqud asset classes appearng attractve n a Markowtz mean-varance nvestment framework due to low correlaton wth standard assets such as equtes and bonds, llqud assets have other rsks, and are thus unattractve nvestments for penson funds. These addtonal rsks nclude transacton rsk (the rsk that t can take an uncertan tme to sell the asset, at an uncertan prce) and valuaton rsk (the rsk that the assets cannot be accurately valued). In the past two decades, there has been a steady shft away from defned beneft superannuaton funds to defned contrbuton superannuaton funds and coverage has extended to most of the Australan workforce (Broadbent, Palumbo and Woodman, 2006). More moble workers fnd defned contrbuton funds advantageous because benefts n these funds accrue more evenly through ther careers and are entrely portable when the worker leaves an employer or temporarly leaves the workforce. As a consequence, these funds place a greater emphass on lqudty than defned beneft funds. Hence, there s a need to examne how modern defned contrbuton funds manage the trade-off between short-term lqudty requrements and nvestment returns. Ths s why we consder characterstcs relevant to the lqudty requrements of defned contrbuton funds whch may nfluence ther decson to nvest n llqud assets.

6 4 Hstorcally, superannuaton funds n Australa have not reled on sellng ther nvestments n order to meet short-term lqudty requrements. Strong growth n assets and membershp, mandatory employer contrbutons (currently 9 per cent of wages) and postve nvestment returns have meant that beneft payments and outward rollovers to other funds have been met from regular net cash nflows rather than from asset realsaton. Based on current estmates, ndustry-wde outflows are projected to ncrease at a faster rate than nflows as the Australan superannuaton system matures over the next twenty years (see Rothman and Tells, 2008: 20-23). There s lkely to be an ncreasng need for lqudty rsk management to ensure that beneft payment oblgatons can contnue to be met as the postwar baby boomer generaton approaches retrement. Funds wth older members who are approachng retrement can be expected to have a greater relance on the realsaton of ther nvestments for meetng future payment oblgatons. Ths paper tests whether funds facng ths condton are more restraned n the extent to whch they hold llqud nvestments. Trade-off between portfolo lqudty and nvestment returns Portfolo selecton theory suggests that effcently dversfed balanced portfolos have allocatons to llqud assets whch are mperfectly correlated wth the tradtonal assets of stocks and bonds. Standard mean-varance portfolo optmsaton s used to justfy, for example, allocatons to real estate n the range of 10 to 15 per cent (Enns and Burk, 1991a) and prvate equty n the range of 2 to 9 per cent (Chen, Baerl and Kaplan, 2002). Studes generally conclude that holdngs of llqud assets beneft penson funds by mprovng dversfcaton and thereby ncreasng return per unt of rsk ncurred. Ths paper nvestgates how these results compare wth the actual practces of Australan superannuaton funds and whether nvestment n llqud assets has n fact delvered rsk/return benefts of the type reported n prevous studes. Counteractng any dversfcaton benefts, nvestors face lqudty drawbacks when they make a decson to nvest n llqud assets. Fndng a buyer or seller can be dffcult, tradng s nfrequent and transacton costs can be large relatve to those assocated wth marketable securtes. Portfolo lqudty s restrcted when nvestors agree to nvest for a mnmum perod of tme or the consent of other nvestors s requred to redeem unts n a trust. Development assets n property, nfrastructure and prvate equty may mpose addtonal cash flow oblgatons, where several captal contrbutons are requred to be made over a multyear perod.

7 5 For superannuaton funds n partcular, there may be nsuffcent tradng lqudty n llqud assets for the fund to meet any unantcpated cash flow oblgatons whch cannot be met by regular cash flows (that s, contrbuton nflows and nvestment ncome). These oblgatons nclude makng beneft payments to members, facltatng transfers to other funds wthn agreed tmeframes and facltatng swtches between nvestment optons wthn the same fund. Increased market volatlty and declnng nvestment returns from July 2007 to June 2009 may have nduced a reacton by members to reassess ther rsk exposures and swtch nvestment optons or superannuaton funds. 1 The nablty to dspose of llqud nvestments n a tmely manner may mean that t s mpractcal to rebalance the fund to ts target asset allocaton. Cash flow oblgatons and rebalancng requrements are lkely to mpose sgnfcant unexpected costs on the fund, f t has nsuffcent lqudty to cover these requrements. 2 Ths paper tests whether funds wth smaller and more unpredctable fund flows have smaller allocatons to llqud assets. Legslatve changes ntroduced to make the Australan superannuaton system more flexble place greater demands on the lqudty poston of superannuaton funds. Most superannuaton funds offer a choce of nvestments and allow members to choose the most approprate strategy to sut ther needs. The expanson of nvestment choce, together wth legslaton permttng nvestors to swtch ther retrement savngs between fund provders, has ncreased the lkelhood of member balances movng between optons wthn a fund and from one fund to another. 3 Ths creates a potental lqudty shortfall for superannuaton funds, when they experence perods of unexpectedly hgh redempton volume (see Taylor, 2009). In broad terms, a superannuaton fund under current swtchng legslaton may be subject to run rsks smlar to those that have long exsted n bankng Market volatlty can have a further mpact on the cash flow oblgatons of funds wth currency hedges n place. The Assocaton of Superannuaton Funds of Australa (2009: 6) reports that some funds had nsuffcent lqudty to cover hedgng collateral requrements n response to the dramatc decrease n the Australan dollar n late Secton 67 of the Superannuaton Industry (Supervson) Act 1993 (SIS Act) prohbts superannuaton funds from borrowng money, except n lmted crcumstances and for a short term to pay members benefts or settle a transacton. Wth the ntroducton of Choce of Fund legslaton from 1 July 2005, employees are enttled to choose whch superannuaton fund receves ther compulsory contrbutons. Trustees are oblged under Superannuaton Industry (Supervson) Regulatons 1994 to redeem a member s nvestment and transfer t to another fund when they receve a member s rollover request.

8 6 Methodology Data and sample Ths study focuses on 146 large superannuaton funds operatng n Australa wth at least twelve quarters of relevant data n the perod from September 2004 to June These funds represent about three-quarters of the assets n APRA-regulated superannuaton funds. Quarterly data are obtaned from APRA s statstcal data collectons on fund flows and ncome, total net assets, drectly held nvestments, expenses and taxes. 4 Annual collectons data are also obtaned on the age and gender of members, the average account balance, the number of nvestment optons offered, the value of member funds n the default nvestment opton, the asset allocaton of the default opton and other fund characterstcs. Informaton on the asset allocaton of the whole fund s obtaned from a compulsory nvestment performance survey admnstered by APRA n late Gven that the data perod ends n June 2006, recent changes n asset allocaton are not captured n ths survey. 6 A detaled descrpton of the superannuaton nvestment performance survey can be found n Ells, Tobn and Tracey (2008). The analyss s restrcted to accumulaton superannuaton funds and hybrd superannuaton funds. 7 Defned beneft funds wth all members havng defned benefts are excluded. 8 The data cover superannuaton funds wth total assets of at least $200 mllon at 30 June Funds are also requred to have at least twelve quarters of reported fund flows Gross returns are total ncome before expenses and tax dvded by cash flow adjusted net assets. Net returns are net earnngs after expenses and before tax dvded by cash flow adjusted net assets. Observatons for two funds wth greater than 80 per cent of assets reported as other nvestments (ncludng hedge funds, unlsted equtes) are excluded from the sample. A revew of product dsclosure statements for these funds makes t clear they are predomnantly nvested n shares and fxed ncome. The data for the default nvestment strategy suggest that the allocaton to llqud assets of the average not-for-proft fund ncreases steadly over the sample perod, whle the allocaton to these assets of the average retal fund decreases steadly. However, the emprcal analyss n ths paper focuses on the crosssectonal dfferences n allocatons between funds, rather than on the tme-seres trends. An accumulaton superannuaton fund s a superannuaton fund where the beneft a member receves s the total of specfcally defned contrbutons to the superannuaton fund plus earnngs on those contrbutons, mnus expenses and tax. A hybrd superannuaton fund represents a superannuaton fund whch conssts of a combnaton of both accumulaton and defned beneft members. A defned beneft superannuaton fund s a superannuaton fund where the formula for calculatng the retrement beneft s specfed, usually n terms of years of servce wth the employer and average salary level over the last few years pror to retrement. The employer sponsor/contrbutor to a defned beneft superannuaton fund carres the nvestment rsk. Approved depost funds (ADFs), elgble rollover funds (ERFs), pooled superannuaton trusts (PSTs), selfmanaged superannuaton funds (SMSFs) and small APRA funds (SAFs) are excluded from the sample.

9 7 and ncome. Ths addtonal restrcton s mposed to be able to relably estmate the strength and volatlty of fund flows for each fund. 10 All trustees of APRA-regulated superannuaton funds have, from 1 July 2006, been requred to hold a Regstrable Superannuaton Entty (RSE) lcence. The trustees of many funds exstng pror to that date decded not to apply for an RSE lcence and made arrangements for the transfer and wnd-up of the funds under ther trusteeshp. Industry consoldaton has contnued wth a seres of fund mergers ntated after the ntroducton of the new trustee lcensng system. For the dataset n ths study, transfers and wnd-ups are dentfed and the wound-up fund and the successor fund for the transfer are combned nto a sngle fund from the begnnng of the quarter n whch the transacton occurs. Specfcally, fund flows and ncome, total net assets, drectly held nvestments, expenses and taxes of the wound-up fund and successor fund are summed to obtan the data for the combned fund. Ths approach ensures the results pertanng to the mpact of portfolo lqudty on fund performance are not drven by large mergers between funds. In addton to the asset allocatons, ths study uses tradng volume and market captalsaton data for each asset class to measure the lqudty of each fund s asset portfolo. Dollar tradng volume and market captalsaton for each asset class were obtaned from a number of data sources. The market data are descrbed n table 1. Table 1 DATA SOURCES FOR TRADING VOLUME AND MARKET CAPITALISATION Asset class Representaton Source Cash Bank-accepted blls, certfcates of depost AFMA Fxed ncome Commonwealth government bonds AFMA Australan shares S&P ASX 200 Index consttuent stocks Bloomberg Internatonal shares Unted States S&P 500 Index consttuent stocks Bloomberg Unlsted property Unts n unlsted property trusts ABS Other nvestments Unts n unlsted equty trusts ABS Abbrevatons: AFMA Australan Fnancal Markets Assocaton, ABS Australan Bureau of Statstcs. 10 The analyss s replcated wthout ths restrcton. The results are unchanged.

10 8 Lqudty measures Ths study constructs two lqudty measures for each fund s portfolo. The frst measure focuses on llqud nvestments, whle the second measure s calbrated across all the asset classes held n a fund s portfolo. Lqudty measure 1 Illqud nvestments A potental consequence of the nablty to redeem llqud nvestments s that the fund may be unable to meet ts cash flow or rebalancng requrements n a tmely manner. The frst lqudty measure for a fund s portfolo s based on holdngs of llqud nvestments. More specfcally, LLI s defned as the percentage of unlsted property and other nvestments n a fund s portfolo: w + w LLI (1) 5 6 = 6 w = 1 where w 1 s the dollar value of cash, w 2 s the dollar value of fxed ncome, w 3 s the dollar value of Australan shares, w 4 s the dollar value of nternatonal shares, w 5 s the dollar value of unlsted property and w 6 s the dollar value of other nvestments. Lqudty measure 2 Average holdng perod The cost of contactng potental tradng partners and the rsk borne by the nvestor whle searchng and delayng the trade executon are expected to be hgher for any asset that s nfrequently traded. Amhud and Mendelson (1986a; b) show that nvestors such as penson funds wth long nvestment horzons wll tend to hold more llqud nvestments, because they can amortse ther transacton costs over longer holdng perods. The second lqudty measure, AHP, s defned as the weghted average holdng perod of all asset classes held n a fund s portfolo: 6 wholdngperod AHP = = 1 6 (2) w = 1

11 9 where w s the dollar value of asset class and HoldngPerod s the average market captalsaton dvded by the average daly dollar tradng volume of asset class over the entre sample perod. Role of trustees and members The above measures of portfolo lqudty are calculated for the default nvestment strategy and for the whole fund. 11 Portfolo lqudty of the default nvestment strategy can be attrbuted to decsons taken by the fund trustees. The default nvestment strategy s the nvestment opton where members superannuaton benefts are nvested when the members themselves provde no drecton regardng ther choce of strategy. In superannuaton and trust law, the trustee s solely responsble for settng the default nvestment strategy, ncludng the extent to whch the default strategy assets are held n llqud nvestments. 12 Portfolo lqudty of the whole fund can be attrbuted to decsons taken by both trustees and members. In the frst nstance, the fund trustee decdes what choce of nvestment strategy the fund wll offer. Ths offer of nvestment strategy choce s not mandatory; although nearly all publc offer superannuaton funds offer these choces as an ntegral sellng feature of ther products. The ndvdual nvestment optons may have varyng levels of exposure to llqud nvestments at the dscreton of the trustee. From that pont, members play a role n determnng the fund s effectve asset allocaton. In partcular, members are permtted to gve drectons to the trustee n relaton to ther choce of nvestment strategy. As a consequence, both trustees and members nfluence the extent to whch the whole-of-fund assets are held n llqud nvestments LLI and AHP for the whole fund are calculated based on the average asset allocaton from September 2004 to June Regulaton 4.09 of the Superannuaton Industry (Supervson) Regulatons 1994 requres the trustee of a superannuaton fund to formulate an nvestment strategy that has regard to all the crcumstances of the fund ncludng the lqudty of the fund s nvestments and ts expected cash flow requrements.

12 10 Results Descrptve statstcs Table 2 presents descrptve statstcs for not-for-proft funds (panel A), retal funds (panel B) and all sample funds as a group (panel C). 13 The entre group s dvded nto tertles based on ther holdngs of llqud nvestments (LLI). These portfolos are rebalanced as funds enter and ext the sample each quarter. In addton to summary statstcs for each fund type, summary statstcs for each tertle are also reported. For each data tem (for example, operatonal expense rato), frst the asset-weghted average across all funds for each quarter from September 2004 to June 2010 s calculated; and then a smple tme-seres average of the cross-sectonal averages s reported. Fgures n ths table are presented n annual terms. In each quarter, there are on average 139 funds comprsng 96 not-for-proft funds and 43 retal funds. Not-for-proft funds have substantally hgher holdngs of llqud nvestments than retal funds, wth 40 funds (42.0%) n the hghest tertle (table 2 panel A), whereas retal funds have only 6 funds (13.6%) n the hghest tertle and 30 funds (68.6%) n the lowest tertle (panel B). The average total net assets of all sample funds s $3.3 bllon. The average fund sze s larger for retal funds than for not-for-proft funds ($5.2 bllon compared wth $2.4 bllon). Among not-for-proft funds, those wth the hghest allocatons to llqud nvestments tend to be larger funds. Not-for-proft funds have a younger membershp than retal funds. The average proporton of members close to preservaton age (aged 50 years and over) s 22.6% for notfor-proft funds, compared wth 35.8% for retal funds. 14 Funds wth the hghest allocatons to llqud nvestments tend to have a smaller proporton of members aged 50 years and over Retal funds are establshed by banks, fund managers and other superannuaton provders and offer superannuaton products to the publc on a commercal bass. Not-for-proft funds nclude ndustry, corporate and publc sector funds and are typcally establshed by employer groups or trade unons to serve members n specfc workplaces or ndustres. Preservaton age s 55 years for people born before 1 July 1960 and ncreases ncrementally to 60 years for people born after 30 June 1964.

13 11 Table 2 Panel A: Not-for-proft funds DESCRIPTIVE STATISTICS Data tem Illqud nvestments tertle 1 (low) 2 3 (hgh) Total sample Number of funds Total net assets $ml 625 2,311 3,329 2,448 Preservaton age % Average balance $ Fund age years Investment choces Default strategy % Internally managed % Operatonal expense % Inflow % Outflow % Cash % Fxed ncome % Australan shares % Internatonal shares % Unlsted property % Other nvestments % Default strategy LLI % AHP days Whole-of-fund LLI % AHP days Ths table presents the summary statstcs for fund characterstcs. The sample perod s September 2004 to June The sample excludes defned beneft funds and funds wth total net assets less than $200 mllon. LLI and AHP are lqudty measures as defned n equatons (1) and (2) respectvely.

14 12 Table 2 contnued Panel B: Retal funds Data tem Illqud nvestments tertle 1 (low) 2 3 (hgh) Total sample Number of funds Total net assets $ml 5,922 3,485 4,130 5,239 Preservaton age % Average balance $ Fund age years Investment choces Default strategy % Internally managed % Operatonal expense % Inflow % Outflow % Cash % Fxed ncome % Australan shares % Internatonal shares % Unlsted property % Other nvestments % Default strategy LLI % AHP days Whole-of-fund LLI % AHP days Ths table presents the summary statstcs for fund characterstcs. The sample perod s September 2004 to June The sample excludes defned beneft funds and funds wth total net assets less than $200 mllon. LLI and AHP are lqudty measures as defned n equatons (1) and (2) respectvely.

15 13 Table 2 contnued Panel C: All funds Data tem Illqud nvestments tertle 1 (low) 2 3 (hgh) Total sample Number of funds Total net assets $ml 4,021 2,501 3,429 3,312 Preservaton age % Average balance $ Fund age years Investment choces Default strategy % Internally managed % Operatonal expense % Inflow % Outflow % Cash % Fxed ncome % Australan shares % Internatonal shares % Unlsted property % Other nvestments % Default strategy LLI % AHP days Whole-of-fund LLI % AHP days Ths table presents the summary statstcs for fund characterstcs. The sample perod s September 2004 to June The sample excludes defned beneft funds and funds wth total net assets less than $200 mllon. LLI and AHP are lqudty measures as defned n equatons (1) and (2) respectvely.

16 14 Retal funds offer the largest number of nvestment choces to members, wth an average of 212 optons per fund. In comparson, not-for-proft funds have an average of twelve nvestment optons per fund. Not-for-proft funds hold a greater proporton of assets (45.6%) n the default nvestment strategy than retal funds (10.1%). For not-for-proft funds, the percentage of fund assets that are managed nternally ncreases wth the percentage holdng of llqud nvestments. Retal and not-for-proft funds have exposure to dfferent types of llqud nvestments. Among superannuaton funds wth substantal allocatons to llqud nvestments (those n the second and thrd tertles), not-for-proft funds hold a hgher percentage of unlsted property and retal funds hold a hgher percentage of other nvestments ncludng prvate equty. For example, the average not-for-proft fund n the hghest llqud nvestments tertle holds 8.7% unlsted property and 13.2% other nvestments, whereas the average retal fund n the same tertle holds 0.3% unlsted property and 21.7% other nvestments. Turnng attenton to the lqudty measures, the LLI s 15.4% and the AHP s 402 days for the average default strategy. Default strateges of not-for-proft funds have hgher LLI and longer AHP, whch suggests they are more llqud than default strateges of retal funds. The LLI s 10.9% and the AHP s 378 days for the average fund as a whole. The weghted-average holdng perod ncreases wth the holdng of llqud nvestments. For example, the AHP s roughly sxteen months (488 days) for the hghest llqud nvestments tertle; however, t s less than ten months (286 days) for the lowest llqud nvestments tertle. Ths relatonshp reflects the longer average holdng perod for unlsted property and other nvestments than for other asset classes (see appendx 1). The dsparty n lqudty between the fund types at the whole-of-fund level s smlar to ther default strateges; not-for-proft funds have hgher LLI and longer AHP, whch suggests they are more llqud than retal funds. Table 3 presents the correlatons between lqudty measures and varous fund characterstcs. A smple tme-seres average for each data tem s calculated and then the cross-sectonal correlatons of the tme-seres averages are reported. Two lqudty measures for the default nvestment strategy and two lqudty measures for the whole fund are postvely correlated wth each other. Larger funds, funds that manage more of ther assets nternally and funds wth hgher net fund flows tend to nvest n less lqud assets. Funds wth older members, larger member balances and more unpredctable fund flows are nclned to hold more lqud assets.

17 15 Table 3 CROSS-SECTIONAL CORRELATIONS LOGSIZE PRSAGE LOGAAB FNDAGE INTMAN OPEXP FLOW VFLOW LLI ds AHP ds LLI wof AHP wof LOGSIZE 1.00 PRSAGE LOGAAB ** 1.00 FNDAGE -0.26** -0.21** INTMAN OPEXP ** -0.27** FLOW 0.21** -0.24** -0.31** -0.21** ** 1.00 VFLOW LLI ds 0.20** -0.25** -0.25** ** 0.34** AHP ds ** -0.26** ** 0.33** -0.23** 0.89** 1.00 LLI wof 0.17** -0.30** -0.24** ** ** -0.16** 0.62** 0.62** 1.00 AHP wof ** -0.20** ** -0.25** 0.62** 0.70** 0.93** 1.00 Ths table presents the correlatons between varous fund characterstcs ncludng lqudty. The sample perod s September 2004 to June The sample excludes defned beneft funds and funds wth total net assets less than $200 mllon. LOGSIZE s the dfference n logarthms between fund total net assets and mnmum total net assets for sample funds of $200 mllon. PRSAGE s the proporton of members aged 50 years and over. LOGAAB s the logarthm of the average account balance. FNDAGE s the logarthm of fund age. INTMAN s the percentage of fund assets that are managed nternally. OPEXP s the total operatng expenses dvded by cash flow adjusted net assets. FLOW s the percentage new fund flow nto the superannuaton fund over the quarter. VFLOW s the standard devaton of new fund flow nto the superannuaton fund over the quarter. LLI ds and AHP ds are lqudty measures for the default nvestment strategy. LLI wof and AHP wof are lqudty measures for the whole fund. The lqudty measures are defned n equatons (1) and (2) respectvely. ** ndcates sgnfcance at the 5% level.

18 16 Illqud nvestments and fund characterstcs In ths subsecton, the relaton between the lqudty of a fund's portfolo and varous fund characterstcs s examned. A cross-sectonal regresson approach s used. Specfcally, a smple tme-seres average for each data tem s calculated and then a cross-sectonal regresson of lqudty on the varous fund characterstcs s run. The specfcaton of the cross-sectonal regresson s as follows: LIQHOLDING = α + β LOGSIZE + β FLOW + β VFLOW + ε β PRSAGE 2 + β INTMAN 3 (3) where LIQHOLDING s the lqudty measure (LLI ds, AHP ds, LLI wof or AHP wof ), LOGSIZE s the dfference n logarthms between fund total net assets and mnmum total net assets for sample funds of $200 mllon, PRSAGE s the proporton of members aged 50 years and over, INTMAN s the percentage of fund assets that are managed nternally, FLOW s the percentage new fund flow over the quarter and VFLOW s the standard devaton of new fund flow over the quarter. Table 4 reports the coeffcent estmates from the cross-sectonal regressons for notfor-proft funds (panel A) and retal funds (panel B). The dependent varables of the regressons are the four lqudty measures, LLI ds, AHP ds, LLI wof and AHP wof, respectvely. For not-for-proft funds (panel A), larger funds and funds wth hgher net fund flows hold portfolos wth more llqud nvestments and longer average holdng perods. The coeffcents on net fund flow are larger and more statstcally sgnfcant for the default nvestment strategy (LLI ds and AHP ds ) than for the whole fund (LLI wof and AHP wof ). Funds wth stable fund flows hold fewer lqud assets. These results are consstent wth the dea that hgh contrbutons and low beneft payments reduce the need for funds to hold cash and other lqud nvestments for meetng payment oblgatons Addtonal analyss s undertaken based on an enlarged sample that ncludes both defned contrbuton and defned beneft funds. Defned contrbuton funds are found to hold more lqud portfolos than defned beneft funds. Ths result s consstent wth the portablty assocated wth the benefts of defned contrbuton funds and the fact that most defned contrbuton funds permt partcpants to swtch nvestment optons.

19 17 Table 4 Panel A: Not-for-proft funds FUND CHARACTERISTICS AND PORTFOLIO LIQUIDITY Dependent varable Default strategy Whole-of-fund Independent varables LLI ds AHP ds LLI wof AHP wof Intercept ** ** ** ** (4.75) (14.09) (3.87) (13.86) Log sze 2.609** ** 2.161** ** (3.40) (3.49) (3.06) (2.64) Preservaton age ** (-2.14) (-1.95) (-1.55) (-1.83) Internally managed 0.192** 1.746** 0.174** ** (3.02) (2.71) (2.97) (2.41) Fund flow 1.752** ** (2.73) (2.74) (1.61) (1.51) Volatlty of fund flow (-1.03) (-1.05) (-0.51) (-0.54) R F-statstc 10.35** 9.91** 6.50** 5.34 ** Observatons Ths table examnes the relaton between portfolo lqudty and varous fund characterstcs. The sample perod s September 2004 to June The sample excludes defned beneft funds and funds wth total net assets less than $200 mllon. LLI ds and AHP ds are lqudty measures for the default nvestment strategy. LLI wof and AHP wof are lqudty measures for the whole fund. The lqudty measures are defned n equatons (1) and (2) respectvely. Numbers n parentheses are t-statstcs. ** ndcates sgnfcance at the 5% level.

20 18 Table 4 contnued Panel B: Retal funds Dependent varable Default strategy Whole-of-fund Independent varables LLI ds AHP ds LLI wof AHP wof Intercept (1.12) ** 7.497** ** (5.64) (2.03) (9.45) Log sze (0.27) (0.16) (0.31) (0.38) Preservaton age (0.27) (-1.27) (-0.74) (-1.15) Internally managed ** (-0.61) (-1.71) (-0.31) (-2.19) Fund flow (0.99) (0.82) (0.37) (1.39) Volatlty of fund flow (-0.06) (-0.66) (-0.16) (-1.84) R F-statstc ** Observatons Ths table examnes the relaton between portfolo lqudty and varous fund characterstcs. The sample perod s September 2004 to June The sample excludes defned beneft funds and funds wth total net assets less than $200 mllon. LLI ds and AHP ds are lqudty measures for the default nvestment strategy. LLI wof and AHP wof are lqudty measures for the whole fund. The lqudty measures are defned n equatons (1) and (2) respectvely. Numbers n parentheses are t-statstcs. ** ndcates sgnfcance at the 5% level.

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