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.
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 via www.bdw.com.au.