Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Super funds long-term investors no more as industry goes ‘limp mode’
Everybody knows that people will say what they really think as long as they don’t have to put their name to it. That’s what makes recent research conducted by David Bell, executive director of the Conexus Institute, so interesting. Unnamed CIOs of ten super funds have told Bell exactly how Your Future, Your Super (YFYS) is impacting their fund, and the unintended consequences of the reforms extend to every facet of the investment function.
The headline summary is that that a significant chunk of the industry is now in “limp mode” – that is, they have only a small performance buffer (the accrued performance gap against the test over the past eight years) and need to significantly reduce tracking error in order to survive. In a catch 22, rebuilding that buffer will require taking on more tracking error.
“That scenario of small buffer: it’s like turning up to a gladiator event with a butter knife!,” said one of the CIOs interviewed.
That is, in effect, creating two kinds of funds: those that integrate YFYS into their investment framework, “impacting activities from determining the strategic asset allocation through to implementation activities by asset class teams”; and those funds that take the view that existing investment process has produced their buffer, and feel there is a chance to further distance themselves from their peers by continuing to take risk. The second approach was less viable for funds with a small buffer, while others combined elements of both.
YFYS has also had the effect of reducing the investment horizon in order to avoid falling into limp mode, with one CIO saying: “Are we genuine long-term investors? No more.” Many of the CIOs also reported reduced portfolio management levers, with some investment opportunities now much more difficult to apply in size.
“These included opportunities in fixed income (low and high duration bonds, credit, inflation-linked bonds), public equities (low volatility strategies, small caps, and emerging market equities), alternatives (insurance-linked strategies, hedge funds, alternative risk premia), private assets (j-curve risk in new private equity exposure, characteristics of unlisted property and infrastructure).”
While fund CIOs were so far resisting “gaming” the performance test (For example, by taking positions in strategies which are benchmarked “generously”, like high yield and private debt, which are likely to outperform the composite bond index) they also expect that it’s only a matter of time before limp mode funds start trying to do exactly that: “perversities and gamification will undoubtedly become issues,” one CIO said.
But the biggest challenge is for sustainable and responsible investment (SRI) options. It’s bad when even the exclusion that nearly every fund runs for tobacco just “just chews up a chunk of (their) limited tracking error budget.” Some funds feel that running SRI options in their current format is unsustainable, and feel “trapped between meeting the stated demands of our members or risk being on the front page of the mainstream newspapers.”
“There was general agreement that the most focus would be on engagement, as this activity generated no performance test tracking error… Investments in dedicated impact investments will be limited. Here, some CIOs acknowledged that their firms would seek to maximise the full benefit of such investments through brand association,” the report says.
Still, the support for the performance test in default options was unanimous, though some funds believed that relying on members to essentially act as the “enforcement agent” by moving their money was flawed given low levels of engagement. But there was no clear-cut solution to the problems of YFYS.
“Many of the CIOs agreed that a framework combining multiple metrics and a qualitative assessment would be a significant improvement, if implemented well,” Bell wrote. “Here, CIOs broadly agreed that hindsight reflects well on the pre-YFYS APRA operating model (multiple metrics via the Heatmap and a qualitative assessment).”
“The question marks were whether the YFYS performance test had permanently raised APRA’s stance to its currently perceived strong level, and whether APRA’s frontline team would be able to assess a large throughput of complex qualitative assessments.”
