Ric Battellino: Challenges and opportunities for the funds management
industry in Australia
Opening remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to
the 20th Australasian Finance and Banking Conference, Sydney, 12 December 2007.
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Introduction
It is a pleasure to be here to open the 20th Australasian Finance and Banking Conference.
Over the past twenty years, the Conference has provided a stimulating forum for discussion
of a wide range of issues facing the banking and finance industry, and it has played an
important role in helping to promote Australia as a major financial centre. I'm sure this year
will be no exception.
This morning's Business Forum on the challenges and opportunities for the funds
management industry has already generated a number of interesting points for discussion.
The schedule for the next two and a half days will take the discussion into a broader range of
topics in the field of banking and finance but for the moment I will focus my remarks on the
funds management industry.
Industry size
Let me begin by recapping some facts on the size and growth of the industry.
As we have heard, the funds management industry in Australia has expanded at a
remarkable pace over the past couple of decades. Since 1990, the value of funds under
management has grown at an annualised rate of 121⁄2 per cent, and now stands at around
$1.7 trillion. This is equivalent to about 160 per cent of GDP, up from about 50 per cent in
1990.
By international standards, Australia's funds management industry is among the largest in
the world, not only as a ratio to GDP but also in absolute terms. Some reports rank Australia
as the fourth largest funds management industry in the world in terms of assets under
management. The data underlying this ranking are compiled by the Investment Company
Institute, an industry association for US mutual funds. This measure covers investments in
mutual funds and unit trusts, and therefore favours countries such as Australia where this
type of investment vehicle is quite common. On the other hand, it understates the size of the
funds management industry in countries that tend to use other investment structures.
An alternative approach for measuring the size of the funds management industry is to add
up all of the assets of pension funds, life insurance companies and other managed
investments, regardless of the precise legal structure in which they reside. This provides a
broader view of the funds management industry and one that is more comparable across
countries. This exercise is not straightforward, however, as consistent international data are
difficult to obtain.
After taking into account some of these measurement issues, my colleagues at the Bank
estimate that the Australian industry is among the world's ten largest, though more likely
towards the bottom of this group than in the top half. It is difficult to be more precise than this
but, nonetheless, it is clear that the Australian funds management industry is large by
international standards.
Reasons for growth
What has been behind this rapid expansion in the industry?
A large part of the growth over the past couple of decades has been due to superannuation.
Superannuation fund assets have grown by an average of 141⁄2 per cent per annum since
1990, and now comprise about half the funds under management in Australia. This rise in
superannuation assets reflects a number of government initiatives, such as the introduction
of compulsory superannuation contributions in the early 1990s and the concessional taxation
of superannuation.
Other parts of the funds management industry, however, have also grown quickly, reflecting
more general reasons such as the increased financial awareness of households and the
associated search for higher returns than those offered by traditional investments such as
bank deposits; the strength of world equity markets; and the demographic trend of "baby
boomers" entering the wealth-accumulation phase of their lives.
As well as investing in what might be considered to be fairly conventional financial products,
it is also notable that in Australia there has been significant direct participation by retail
investors in the markets for sophisticated financial products. For example, retail and high net
worth investors account for about two-thirds of the assets of Australian-based hedge funds,
compared with less than half globally. The available evidence for Australia also suggests a
larger retail presence in the market for collateralised debt obligations than is the case in other
markets. Over the past five years, retail investors are estimated to have purchased around
15 per cent of the CDOs issued in Australia.
One of the reasons for this higher participation by Australian retail investors in these markets
is that the regulatory regime in Australia does not restrict retail access to any financial
products as long as the provider meets certain disclosure requirements.
This approach has been beneficial in terms of providing investors with a greater range of
wealth-generating opportunities, but it does raise some important challenges.
I want to spend the rest of my time today outlining these and other challenges facing the
funds management industry.
Challenges
One of the most important challenges raised by a disclosure-based regime is that it places a
significant premium on financial literacy. This is because it relies heavily on the ability of
investors to understand the information that is presented to them and make appropriate
decisions based on that information. Some retail investors may not be in this position. A
particularly telling statistic comes from a recent survey conducted by the Financial Literacy
Foundation, in which only about a third of adult respondents indicated that they considered
both risk and return when choosing an investment. The fact that some retail investors had
apparently devoted the bulk of their savings to buying unsecured, high-yielding debt issued
by some recently collapsed property companies also suggests that some people have
difficulty understanding the financial risks of investment products.
The Australian Government, through the Financial Literacy Foundation, has a number of
initiatives underway to improve financial education and literacy standards. ASIC has also
been active in educating retail investors about financial products, and a range of
privatesector initiatives are underway to help improve financial literacy standards.
One way that the financial services industry can help retail investors make better investment
decisions is by providing clear and concise information about their financial products. For
some time now there have been concerns about the length and complexity of product
disclosure statements and prospectuses.
ASIC has been trying to address some of these concerns through various initiatives. It has
also recently introduced regulatory guidance to improve the quality of disclosure to retail
investors in unlisted debentures.
A related challenge facing the industry is financial advice, and how this is paid for.
There appears to be a general reluctance on the part of retail investors to pay for financial
advice on a fee-for-service basis. Instead, there has been a preference for
commissionbased advice, despite the conflicts of interest that can arise in this situation. This reluctance
to pay for advice upfront appears to be a form of money illusion, whereby investors may feel
that they are somehow paying less for financial advice if the cost is buried in reduced
earnings in the future.
The regulatory environment in Australia has tried to deal with potential conflicts in
commission-based advice by making it a requirement for advisors to provide their clients
with a written statement of advice that sets out, among other things, the basis on which the
advice is given, any potential conflicts of interest, and the dollar value of commissions they
stand to receive.
But the question remains as to whether full disclosure is enough to deal with the potential
conflicts of interest associated with commission-based fees, or whether there is merit in the
industry moving further in the direction of offering advice on a fee-for-service basis.
The cost of providing investment services to retail investors is also a challenge that needs to
be addressed. Recent research published by APRA compared the average net returns - that
is, returns after all fees, expenses and taxes - for different types of superannuation funds.
APRA found that over the decade to 2006, $1,000 invested in the average retail fund would
have risen to $1,650 after fees, expenses and taxes, compared with $1,888 for an industry
fund and about $2,100 for corporate and public sector funds. Of course, these figures are
averages and there would have been significant variation in the returns of individual funds.
While it is difficult to isolate the exact cause of the underperformance of retail funds, an
important contributing factor would have been that fees and expenses on retail funds are
typically higher than for industry and corporate funds. That said, I think it is encouraging that
competition has been putting downward pressure on expense ratios across most categories
of superannuation funds.
Another issue which has received attention is what level of superannuation contributions is
necessary to ensure an adequate retirement income.
Determining the adequacy of contribution rates is difficult because the modelling relies on
various assumptions about future investment returns, income growth, length of retirement
etc. There is also a need to specify what is meant by "adequate".
Most of the recent research, however, suggests that, to ensure an adequate replacement
income in retirement, the current level of superannuation guarantee contributions will need to
be supplemented by the old-age pension for lower-income households, or by voluntary
contributions for those households not eligible for the pension.
The issues I have raised today are, I am sure, well known to those of you in the industry.
There are many considerations to be taken into account in resolving them, and there will no
doubt need to be a large input from the industry in doing so.
Conclusion
For the moment, however, let me conclude by recording that the transformation of the
superannuation industry over the past couple of decades has been one of the great success
stories in the Australian financial sector. While further work needs to be done, conferences
such as this play an important role in raising and resolving issues.
I hope that your discussions over the next couple of days prove to be both thought-provoking
and rewarding.