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.
Chant West’s fix for the ‘unintended, unacceptable’ consequences of YFYS
It will come as no surprise that the Your Future Your Super (YFYS) performance test is altering fund investment behaviour. But Chant West (headed up by Ian Fryer, photo at top) has now forecast that some funds’ “best ideas” might be compromised, and knows of several instances where funds have not taken up investment opportunities they would have before the test.
“Perhaps of more concern, we know of several funds that terminated diversifying strategies in 2021 because they had relatively high YFYS tracking error, when those strategies (e.g. alternatives, portfolio protection, lower volatility equities, shorter duration fixed interest) would have provided very effective protection in the FY22 investment environment when major asset sectors fell significantly,” the research house wrote in a report titled YFYS performance test: a better way.
“While the test has identified and eliminated some funds that were clearly sub-standard and destined to fail, it has caused collateral damage to others that were seeking to do the right thing by their members but were somewhat unlucky in the timing of the first test (i.e. over seven years of strong returns). More ominously, it has driven the behaviour of the surviving funds in ways that, in too many cases, have resulted in diminished returns for their members.”
The “dire consequences” of failing the test – what Chant West describes as public shaming, member anxiety, and existential threat to the fund – far outweigh the rewards for passing, meaning that funds are making passing the test their prime investment focus. Chant West’s proposed fix for the performance test would see funds compared to a simple reference portfolio (SRP) with the same volatility and include a metric incorporating risk-adjusted returns to indicate whether fund members are “receiving a reward commensurate with the risk being taken on their behalf”.
“Under our proposal, a fund’s performance would be compared with the performance of a SRP with the same volatility,” The report says. “Say, for example, that Fund A and Fund B both exhibited a volatility of returns of 6 per cent per annum over the past 8 years.”
“Their returns would be compared with those of a SRP that also had a volatility of 6 per cent per annum. If that SRP had returned 8 per cent per annum over the period, then that would be the pass mark. Fund A returned 9 per cent per annum and so passed, while Fund B’s 7 per cent per annum return would see it fail.”
The new measurement has a number of advantages over the incumbent, Chant West says, including that the simplicity of the new benchmark avoids the technical arguments still being debated over the current model; isn’t reliant on a particular methodology to classify growth assets; and incentivises funds to strive for strong risk-adjusted returns, meaning it is “absolutely aligned with desired member outcomes”.
When Chant West applied its proposed new test to those funds that have previously failed, it found that four funds that failed in 2021 but passed in 2022 (AvSuper, Christian Super, Commonwealth Bank Group Super and Maritime Super) would have passed in both years.
“We continue to see good funds curtail some elements of their investment strategy due to the very rational fear of failing the test at some point, not because they are poor funds but because of the methodology currently applied,” the report says.
“We need to address that unhelpful distraction, and the best way to do so is to replace the current test with one capable of gaining broad acceptance as a reasonable basis for taking significant remedial action against a fund. Our proposed test helps to rectify that asymmetry between efficacy and consequences. The test is simple, robust and aligned with member interests. A fund that fails our test really does identify itself as an underperforming fund, and probably needs to bear the consequences.”
