(Bloomberg) -- The smallest players in Australia’s A$3.3 trillion ($2.3 trillion) pensions industry face a double whammy this year: even more pressure to outperform rivals as they navigate markets still overwhelmed by rate hikes and stubborn inflation. 

As the regulator forces more mergers among small funds that are struggling to make decent returns, some are holding their ground better than others. They’re swooping on investments from private credit to property and infrastructure that aren’t large enough to lure the industry mega-funds. 

Many face an uphill battle in a sector where scale is king. Data from industry research house Rainmaker shows that funds with more than A$40 billion of assets are almost twice as likely to outperform their leaner rivals. Minister for Financial Services Stephen Jones said he expects more tie-ups, especially among small and inefficient funds that can’t provide good returns.

“I want to continue to see diversity and competition and innovation, and small, medium and big funds,” Jones said in an interview Thursday. “But I think mergers will continue.”

The industry suffered its worst performance since the global financial crisis last year, taking the average three-year return to 4.6% per annum for default products, according to SuperRatings. Bloomberg asked four of Australia’s smaller pension funds about their key investment strategies in 2023 as they look to recoup some of last year’s losses, and whether they’re open to mergers. 

Active Super

  • Assets Under Management: A$13.5 billion 
  • Three-year average annual return: 5.3%

Active Super Chief Investment Officer Craig Turnbull is looking to seize on opportunities this year, including moving money into public markets where valuations are getting cheaper. That’s where being a small player can be an advantage, he says. 

“There are some listed versions of alternative assets, like listed property, even things like listed credit funds,” said Turnbull. “You can give your money to a private credit manager and he’ll put you in a fund and charge you fees, but you can actually go onto the stock market and buy those things too if you’re not too big.” 

“We can move in to those areas without disturbing the price too much, whereas the mega funds can’t,” he said. 

Turnbull says he’s also looking to be nimble in fixed income. “Some of these areas are not that big, like your index-linked bonds for example, or there’s a trade credit fund that we’ve moved into. You can’t put a lot of money into those things quickly, but we are of a size where we can get a meaningful exposure to those areas.”

The fund is currently exploring a potential merger with Vision Super, which would about double its assets under management. “A merger is going to take a lot of effort if we go forward with it,” Turnbull said, adding that any further tie-ups weren’t likely in the short term.

Australian Ethical 

  • Assets Under Management: A$8.6 billion 
  • Three-year average annual return: 3.5%

Australian Ethical doesn’t invest in fossil fuel, nuclear or tobacco companies and prioritizes firms that have lower emissions, which can be a challenge during an energy crisis. Head of Asset Allocation John Woods said the fund has been looking to emerging markets.

“Investing in emerging markets through public assets as an ethical investor is difficult,” Woods said. “But when we’ve got the full array of private assets to choose from, we can find ways to target the impact we want in those markets and then we can add that exposure to our portfolio.” 

Recent investments have targeted the infrastructure, micro finance and venture capital sectors, including organizations that are developing new ways of recycling plastics. Woods said the fund had reduced its exposure to Australian fixed income, but had lifted its international exposure. 

“Our positioning for the next 12 months is to take advantage of those mid-risk asset classes,” Woods said. He added that the fund was open to potential merger opportunities but was also “very discerning due to its ethical credentials.” 

Meat Industry Employees’ Superannuation Fund 

  • Assets Under Management: A$1 billion 
  • Three-year average annual return: 6.3%

The fund that manages superannuation for just 16,000 meat industry employees is among the smallest in Australia. CIO Chris Artis said those workers are low paid with smaller than average retirement savings, making for a deliberately conservative investment strategy. 

MIESF pulled back on equities last year while building up its position in cash and adding to government bonds. It’s also been making investments of as little as A$10 million in unlisted property, which included shopping center funds. 

Starting 2023 with excess cash allows the fund to “reallocate back to equities if there’s a major drawdown,” said Artis. “If interest rates keep pushing up, then I’d be selling my long duration bonds to give you more cash. At some point, I’m happy to add to bonds if the Fed keeps signaling that they’re going to go harder and further and not cut rates until 2024.” 

CEO Katherine Kaspar said MIESF was not currently in merger discussions, but didn’t rule it out. “We have always been open to any and all discussions that provide opportunities for growth - organic and inorganic - provided these lead to better outcomes for our members,” she said.  

NGS Super

  • Assets Under Management: A$14 billion 
  • Three-year average annual return: 3.77%

Originally set up for education and community employees, NGS is now open to all workers. Private markets are particularly appealing this year for CIO Ben Squires, who agrees that smaller funds have an advantage. 

“We can be very selective on the deals that we go in, we can build our allocation very quickly,” he said, adding that being smaller was a significant advantage in private markets. “In the mid-market space, a lot of the deal sizes are relatively small so the bigger funds wouldn’t even look at them, they’re probably wanting to do check sizes of A$150 million per deal, we’re happy to do check sizes of A$5 million to A$10 million.”

He said the fund is finding fertile grounds in real estate debt. “I’m talking domestic, senior secured loans, 11 to 12%, LVRs of 60%, so really, really attractive terms for 12 months to 24 month loans.” 

“We’ve really got a sweet spot there.” The fund has no current merger plans, Squires said. 

NOTE: The annualized returns shown for the above funds are for the three years through December 2022 except MIESF which is to June 30. 

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