2.If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin. Explain why this is not the case?
1. The concept of superannuation fund has come in as a convenient mode to save for a comfortable retirement. Retirement needs a lot of funds and that is possible when an individual is able to plan it properly keeping into consideration the time frame and other factors that come into the picture. It encourages the savings habit especially among the tertiary sector employees and also increases the responsibility of the employer towards the employees in the form of systematic contributions to the fund. Hence a lot of factors need to be considered in deciding the type of fund, timing of the contributions, market forces and anticipation of returns from different types of investments, so on and so forth. A few of these factors with specific reference to the time value of money have been discussed. The Efficient Market Hypothesis has also been analyzed from a fund manager’s angle in selecting and deciding on the most appropriate type of portfolio.
Almost every active country encourages the habit of saving and investing in retirement benefits to ensure a balanced and good life for employees during the later years of life. With the increasing focus and regulations framed by the governments requiring mandated contributions by the employers, there are large amounts being deposited every year under the head of superannuation contributions. As per ASIC (2016) earning adequate returns from these investments becomes the responsibility of the financial institutions as the ultimate motive of superannuation contributions has to be achieved. Thus a lot of factors have to be considered by the fund managers with whom the superannuation contributions are placed to ensure that the required amount of money is made available to the employee on retirement.
In consideration of the economic sector, there are three major and relevant sectors namely primary, secondary and tertiary sectors. The major role of the tertiary sector is to share their experiences, wisdom, and productivity with those in the primary and secondary sectors as the root level problems and benefits are first identified by the tertiary sector employees (Libby et. al, 2011). To ensure the quality retirement life for employees, the government introduced the concept of mandated employer contributions which was at 3 percent and later enhanced to five percent from the year 2005. Due to this systematic allocation and savings, the burden of social security on the state gets reduced and the superannuation investment and pension payments system are seen upon as a beneficial mode in many other countries (ASIC, 2016). As the returns from such superannuation funds represent the savings over the entire term of employment, it is essential to ensure that the contribution amounts are invested in proper return bearing sectors (Davies & Crawford, 2012). When the lump sum amount is paid to the employee on retirement, it should be substantial and hence the factors that need to be considered are discussed hereunder.
Unisuper Limited is one of the biggest individual and industry based superannuation funds that manages and offers services to the employees of the tertiary sectors. The two main kinds of superannuation plans are Defined Benefit Plan and Investment Choice Plan (Goyal & Wahal, 2008). A new revolution in the superannuation funds industry is that now employees have the options of choosing among the superannuation fund products offering different types of retirement options and an enhanced flexibility in deciding the kinds of assets for the investment of the superannuation fund contributions.
A brief understanding of the types of the funds is highlighted. Under the Defined Benefits Plan, the final amount is paid upon the retirement of the employee. Such amount is determined after taking into account factors like the last drawn salary of the employee, the age of the employee, the number of years of service, etc (Parrino et. al, 2012). Under this plan, the employees are allowed to pool their contribution amounts and invest in the designated assets selected upon by the trustees and fund managers of the Unisuper Ltd. As the final payout amount is already decided, the returns from the portfolio investment become insignificant as it is not going to have an impact on the final payout which is decided by a formula. The returns from the portfolio of assets do not impact the individual employees but have to be considered by the fund managers. Thus, in a nutshell, it can be understood that it is the duty of the fund managers and trustees to ensure that there is sufficient amount available for payment upon the retirement of the employee (Shah, 2013).
The second type is Investment Choice Superannuation Fund. In this option, the annual amount of employer and employee contributions are retained in an accumulating account and managed by private institutions. The returns from portfolio assets are also added in these accounts and the administrative and management expenses are met from the same accounts. As the investment options are open, the employees can do a risk and return analysis and designate the investment amounts to certain types of assets like shares, fixed securities, or such other options upon discussion with the fund managers. The strategies have to be evolved and reviewed by the individual employees as the final payout depends upon the actual returns and the realistic amounts available in the accumulating accounts upon the retirement of the employee. Thus the employees encounter the risks related to the superannuation contributions.
Relevant Factors to be considered
As it is evident that under the Defined Benefits Plant, the payout amount is a fixed sum and will is not impacted by the volatility of returns. Thus it is a safer option for employees requiring steady returns.
Under the Investment Choice Plan, if the employees have a higher risk appetite and are confident that their own analysis and the analysis of the fund managers can provide higher returns, then they can go in for this option (Albrecht et. al, 2011).
Apart from this, the other factors include the ability to manage funds. If employees are knowledgeable about the markets and returns, then they can take up the responsibility of managing and invest in the portfolio based on their expertise and strategies and thus opt for the Investment Choice Plan.
On the other hand, if employees are incapable of managing their funds, then they can designate their funds to establish institutions like Unisuper Limited and save themselves from potential losses and wait for the safe and fixed return amounts. In such cases, the Defined Benefit Plan turns out to be beneficial.
Apart from this, the tertiary sector can opt for the Investment Choice Plan when they are having additional sources of income generating assets and hence the returns from superannuation funds can be variable.
On the other hand, if the employee is not having another additional source of income generation and has to depend upon the superannuation amounts, then the Defined Benefits Plan is a better option as it ensures a uniform return without being affected by the market movements.
Time Value of Money Consideration
There is always an opportunity cost involved in respect of investments. Time Value of Money takes into consideration the current value of future cash flows and the future value of the current investments. As money grows with time, it is essential to evaluate whether the designated investments are growing in line with the rate of returns from the markets. For instance, $100,000 today is not going to be the same $100,000 upon retirement, it would have got depreciated and hence these factors are essential in the decision-making process for selection of funds (Libby et. al, 2011). Hence, time value of money comes into action when deciding a future course of an action. The retirement funds need to be determined to keep into consideration the time value of money as the same amount will not be the same in the future course of time.
The superannuation contributions and retirement payouts are a life time’s earnings of the employees. Hence it is essential that the employees efficiently understand the concept of time value of money and make proper decisions with reference to the future value of presently invested amounts. The portfolio of investments should be studied on a historical basis to understand its past performance and also predict the future performance based upon the predictions from experts (Vaitilingam, 2010). The past performances provide a trend that can be evaluated to predict the future course of action and to know the pattern of behavior.
As time value of money aims for higher returns, there can be a few bad years as well due to the global economic conditions having an impact on the returns from investments. Thus the employee also has to determine the number of years they can wait to get the desired returns. This is more like a provisioning for bad market performance. The factors relevant in such cases would be the availability of alternative income generation options and the waiting period which includes preparing the employee for both the best and worst conditions and situations.
Thus time value of money concept is pretty significant and has to be considered to ensure safe returns.
2. Efficient Market Hypothesis
The efficient market hypothesis believes that share prices are a result of the market reactions and incorporates all the available market information to reflect the most efficient stock price. Hence it is assumed to be perfect. But this hypothesis does not hold true due to the following reasons:
Markets behave in an irrational manner and hence fair price is a myth. Investor psychologies are unpredictable and cannot always reflect the true price level. Hence theories based on this are undependable. If the stock markets are assumed to be performing properly, then it is in line with the random walk theory but in reality, investors are rational but the situations and events are uncertain.
Due to the above shortcomings, the fund manager cannot select a portfolio with a pin due to the following reasons:
The portfolio designed and selected might not be a very well diversified one leaving it open and susceptible to unique risks that do not usually reap rich rewards. Such a portfolio might also be open to too many systematic risks for the individual investors. In case the investors are having other primary investment options in riskless assets yielding higher rewards, then resorting to the efficient market hypothesis might not be a risky venture, else such a portfolio might have a pretty high beta in consideration of the individual’s risk preferences (Northington, 2011). A fund manager has to meet certain specific return goals and risk goals. Experience from the stock markets has time and again proved that there is no way to control the expected, anticipated and unanticipated risks of the portfolio.
Markets have no memory and there is no easy way to make money out of the stock markets. There are different types of risks involved in the case of short-term interest rates versus long-term interest rates (Porter & Norton, 2014). Hence portfolio selection needs to be done on a calculated and systematic basis. For stocks of smaller companies, the market size is relatively lower in comparison to those of higher companies (Deegan, 2011). Hence the price movements of such smaller stocks are a clear reflection of market inefficiency.
As per Fama (1998), every stock is fundamentally different in terms of market competition, capital structure, volatility, financial potential, etc. Hence the market can never adjust itself to suit the requirements of all the stocks. As the statistical analysis is bound to its inherent limitations, the exact market performance in line with the efficient market hypothesis can be termed as a mere ‘coincidence’. The taxation structure of different individuals is of critical nature as certain assets tend to earn surpluses due to the higher taxability. In such cases, the after-tax returns to individuals in low tax brackets on such assets turn out to be favorable. But this again does not hold good for all cases (Marsh, 2009).
Upon consideration of the above factors, it can be understood that portfolio selection cannot be done with a pin. The fund manager still has significant jobs to be done which are as follows:
The fund manager needs to ensure that the portfolio is well diversified. A large number of stocks in the portfolio do not essentially ensure a proper diversification. The risk of a diversified portfolio should be appropriate for the client. The expected money should be made available to the client on retirement for which the risk of the portfolio needs to be reviewed at regular intervals (Fama, 1998). Lastly, the portfolio has to be tailored to take advantage of the special tax laws and benefits for the pension funds. Such options make it possible to increase the expected returns of the portfolio without increasing the risk.
Thus the risk bearing ability aids in the decision-making process. The investment risks and return profiles have to be considered together in deciding upon the type of superannuation fund and investment according to the efficient market hypothesis.
ASIC 2016, Type of funds, viewed 16 May 2017 https://www.moneysmart.gov.au/superannuation-and-retirement/how-super-works/choosing-a-super-fund/types-of-super-funds
Albrecht, W, Stice, E & Stice, J 2011, Financial accounting, Mason, OH: Thomson/South-Western.
Davies, T & Crawford, I 2012, Financial accounting, Harlow, England: Pearson.
Deegan, C. M 2011, In Financial accounting theory, North Ryde, N.S.W: McGraw-Hill.
Fama, E.F 1998, ‘Market Efficiency, Long-term Returns, and Behavioral Finance’, Journal of Financial Economics, vol. 49, pp. 283-306
Goyal, A & Wahal, S 2008, ‘The Selection and Termination of Investment Management Firms by Plan Sponsors’, Journal of Finance , vol. 63, pp. 1802?1827.
Libby, R, Libby, P & Short, D 2011, Financial accounting, New York: McGraw-Hill/Irwin.
Marsh, C 2009, Mastering financial management, Harlow: Financial Times Prentice Hall
Northington, S 2011, Finance, New York, NY: Ferguson's.
Parrino, R, Kidwell, D & Bates, T 2012, Fundamentals of corporate finance, Hoboken,
Porter, G & Norton, C 2014, Financial Accounting: The Impact on Decision Maker, Texas: Cengage Learning
Shah, P 2013, Financial Accounting, London: Oxford University Press
Vaitilingam, R 2010, The Financial Times Guide to Using the Financial Pages, London: FT Prentice Hall.