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.
Fewer YFYS failures with fees, data in focus
The results of this year’s YFYS performance test, released last Wednesday (August 31), proved a stark contrast to the first run. Only five products failed, and four of those products had failed in 2021 as well. Asset consultant JANA believes the lack of blood on the floor can be attributed to three things.
The first is that FY2022 was a strong year for performance against the composite benchmarks that comprise the test. Shorter-duration fixed interest “materially outperformed” full-duration exposures; alternative strategies delivered positive absolute returns, significantly outperforming the equity/bond composite index; and the valuation methodology of private equity means that many of those exposures haven’t experienced the same volatility as their listed peers.
“Clearly this worked in the favour of the industry in FY2022, but the reverse occurring (the listed market rallying into the end of a financial year) presents a material risk,” said JANA consultant Neil Maines (photo at top). “There is a regulatory focus on unlisted asset valuations at present, particularly from APRA’s review of SPS530, SPG530 and SPG531. This may extend to the performance test, for example through the addition of a more suitable benchmark for the private equity asset class, which we would welcome.”
The second reason there were fewer failures is that funds provided more accurate asset allocation information to APRA; inaccurate information had previously resulted in unrewarded tracking error risk against the performance test. The third reason is that many of last year’s underperformers have now merged.
JANA also estimates that median relevant administration fees and expenses (RAFE) have fallen from 0.33 per cent in 2021 to 0.27 per cent today – which APRA will see as a success. But the pace of those reductions will now also slow, and will be driven more by merger activity than the performance test.
But, as JANA notes, the time horizon of the performance test doesn’t correspond to the full market cycle and represents an “unfair assessment horizon for performance”; some products that failed last year passed in 2022, and there’s a risk that members will have switched out of them and not benefitted from the rebound.
“Just as an individual member may see worse investment outcomes by switching out of an underperforming product and thereby missing a recovery in performance, funds may close out active positions to reduce tracking error and thereby miss out on the market recovery in those active positions,” Maines said. “The decision to close out a short duration tilt in fixed interest or a value tilt in equities would have been very costly to returns over FY2022.”
But barring a “disastrous period for alpha”, JANA expects to see fewer test failures going forward.
“Our observation is many investment teams are considering the implementation of trigger mechanisms that if breached, would be the catalyst for some course of action,” Maines said. “For example, one such trigger might be the reduction in administration fee or tracking error by a specified amount should the cumulative probability of failing the performance test over the next (say) five years rise above a certain level.”
