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The Australian hedge fund market has undergone significant
expansion in recent years and is now receiving fund allocations
by the trustees of superannuation funds, the Australian equivalent
of a retirement or pension fund. These superannuation funds
are established as trusts. There are therefore a range of
legal issues that superannuation trustees need to address
in order to fulfil their obligations to fund members when
investing in less traditional assets such as hedge funds.
The Australian Superannuation System
The superannuation system in Australia establishes a form
of pension fund scheme under which an employer is given an
incentive to contribute to a long-term retirement income plan
which complies with certain specified statutory requirements,
to assist in providing its employees with an income after
those employees retire. This system operates on the basis
of a mandated employer contribution expressed as a percentage
of an employee's salary and was made compulsory in Australia
in the mid-1990s in order to ease the burden on the social
welfare system of funding pensions for retirees, particularly
in light of an aging Australian population.
In Australia the Federal government has constitutional responsibility
for legislating on superannuation matters. The law governing
superannuation is comprised of Federal statute and common
law (case law) with an overlay of taxation legislation enacted
by the Federal government.
The Federal Superannuation Guarantee Scheme requires all
employers in Australia to make a prescribed level of contributions
(currently, 9%) to a complying superannuation fund on behalf
of their employees. The superannuation fund then makes investments
on behalf of the employees to build up the retirement savings
of those employees. Therefore, the scale of this scheme ensures
that superannuation funds have sizeable capital to invest
in both Australian and international markets.
The principal Federal enactment governing superannuation
funds is the Superannuation Industry (Supervision) Act 1993
("SIS Act"). This legislation regulates the entities
that operate superannuation funds and lays down certain requirements
in relation to the manner in which superannuation funds invest
the monies under their control. By way of example, the Commonwealth
Superannuation Scheme/Public Sector Superannuation Scheme
which is Australia's second largest superannuation fund had,
as at 30 June 2002, approximately A$5.3 billion in net assets.
The SIS Act effectively requires that all superannuation
entities conduct their operations using a trust structure.
Trusts are widely used in Australia as a method for protecting
a person's assets and also for their tax transparency in certain
circumstances. Trust law (both general case law and legislation)
applies to all trusts including superannuation funds.
Under a trust structure the trustee has legal ownership of
the funds contributed. However, the trustee only manages the
funds it holds, the economic or beneficial interest is held
by a beneficiary, which in the case of a superannuation fund
is the employee. Subject to the terms of the trust deed, the
trustee has the right to use its discretion to invest those
funds for the ultimate benefit of the beneficiary. The trustee
is under strict duties to deal prudently with the funds on
behalf of the beneficiary and in the best interests of such
beneficiary. It is personally liable for losses incurred in
relation to unauthorised or "imprudent" investments.
Duties of Superannuation Trustees
Superannuation trustees (or "responsible entities")
operate under various duties which include: preserving the
trust property, acting carefully and prudently, acting loyally
for the benefit of the trust beneficiaries and not for the
benefit of anyone else, acting personally and accepting responsibility
for actions it takes, keeping members informed of their rights,
and formulating investment and reserve strategies.
A trustee is only able to make "authorised investments".
Investments are authorised by a combination of the particular
trust deed for the superannuation trust as supplemented by
the State or Territory trustee legislation. While the various
pieces of trustee legislation authorise certain lower risk
investments only, such as bank deposits, government securities,
and loans on first mortgages of real estate, any higher risk
investments must be authorised by the trust deed.
The SIS Act also imposes some very strict parameters on the
types of investments that superannuation trustees or "responsible
entities" can make. For example, the investments must
be at arm's length and must not be in-house asset investments
(that is, investments in an employer sponsor of the fund,
or an associate of certain other related parties). There are
also restrictions on borrowing and lending to superannuation
fund members or acquiring assets from members.
The trustee is required by the SIS Act to articulate an investment
plan and strategy that in all the circumstances of the plan
takes into account and includes risk against return, investment
objectives, cash flow needs and diversification of investments.
If the trustee properly formulates and implements such strategy,
then the SIS Act confers protection on trustees from civil
action for loss or damage.
The general case law on trusts makes it very clear that where
a trust is established to generate financial benefit for its
beneficiaries, the trustee must carefully balance the risk
of such investments with the need to provide its beneficiaries
with a diversified fund which gives the best return on their
investment. The trustee therefore has an implicit duty to
manage portfolio concentration risk. The risk-return profile
is assessed by looking at the whole portfolio, not each individual
investment. Each investment, however, should be within the
investment strategy.
Because of the duties a trustee has to the trust beneficiaries,
the trustee must balance its investments so as to provide
a return on the retirement savings of the beneficiary but
preserve those investment assets. As indicated, this requires
diversification and an investment strategy that is neither
too conservative nor too speculative. Because of this concern,
trustees are traditionally wary about investments that are
perceived to be highly speculative like futures, derivatives
or gold.
Investments in Hedge Funds
The hedge fund market is relatively new in Australia. Although
some hedge funds have been operating for some years, it is
mainly in the last three years that the Australian hedge fund
market has undergone significant expansion. Based on AIMA
and ASSIRT's recent survey (September, 2002), that industry
is estimated currently to be worth about A$5.4 billion.
Superannuation fund trustees have traditionally not invested
in hedge funds both because of the infancy of the hedge fund
market in Australia and because of the legal obligations described
above. Rather, superannuation trustees have tended to prefer
to invest in fixed interest investments, cash, government
bonds, and property investment trusts.
Hedge funds have not been favoured areas of investment principally
because of perceptions concerning:
- the volatility of returns;
- level of regulation;
- the perceived lack of transparency of hedge funds ;
- levels of management fees; and
- additional risks associated with the use of derivatives by
hedge fund managers.
In order to make such investments, superannuation trustees
need to give careful consideration to the legal restrictions
imposed in the form of general trustee duties and the investment
parameters imposed by their trust deed, investment plan and
the SIS Act.
However, despite this traditional reluctance to invest in
hedge funds, superannuation trustees in Australia are now
starting to use hedge funds to diversify their investments.
Hedge fund investment is providing superannuation trustees
with a way of counter-balancing the decline in returns on
investments in traditional products. Those trustees are also
attracted by the relative low correlation between the performance
of some hedge funds and that of the equity markets more generally.
There is also a considerable degree of liquidity with hedge
funds, something that real estate or other structured assets
may not offer. Finally, the introduction of hedge funds for
retail investors has made the product apparently more mainstream
and therefore, for trustees, possibly less likely to result
in fund member concern.
Future Growth
Notwithstanding the actual or perceived risks of investing
in hedge funds, it is notable that a number of large superannuation
trustees in Australia have started allocating capital to hedge
funds. For particular superannuation funds, those investments
have been considered to be prudent and this development promises
well for the growth of the Australian hedge fund market and
for overseas participants wishing to attract Australian superannuation
trustee investors.
This article is intended to highlight some
general issues and does not constitute legal advice
by Blake Dawson Waldron. Any inquiries should
be directed to the authors or Michael Vrisakis
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