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Failure and frustration for ESG post-YFYS

Your Future, Your Super (YFYS) is the ultimate blunt instrument, and super will be glad to see it tweaked. But perhaps the bigger debate is around the future use of another blunt instrument: exclusion.

If recent market moves are any determinant, it’s the exclusionary funds that will suffer most under the YFYS performance test, by virtue of the tracking error they take on by applying negative screens to carbon-intense indices like the ASX 200. And if something isn’t done to fix it, the industry will become even less differentiated – and accommodating to different member segments – than it is now.

“They’re doing the right thing, but they’re being penalized for different reasons,” says Dr David Walsh, head of investments at systematic equity manager Realindex, which was established in 2008 by First Sentier and now manages just under A$28 billion for domestic institutional clients.

“YFYS needs to be more flexible in a way that carries important issues that investors are thinking of. Having strict single benchmarks for particular funds is good in principal but doesn’t allow for subtleties around things like exclusion.”

Like most in the industry, Walsh believes benchmarking makes sense for competitive reasons and to help prospective members compare funds that might be highly differentiated. But YFYS has been  
prescriptive rather than collaborative; even the then-Opposition was unaware that the reforms would appear on that fateful Budget Night in October 2020, and the concerns of neither asset managers nor asset owners found their way into the regulations despite a long draft exposure period.

If they had, certain provisions might have been put in place for the faith-based and exclusionary funds that invest according to the ethical beliefs of their member base, or those with more conservative asset allocations intended to reduce sequencing risk.

But exclusion increasingly seems to be offering only return-free risk. Gone are the halcyon days of March 2020, when ESG mainstays in the health sector were rewarded while fossil fuels were punished to the extreme. In the last six to nine months, exclusion has been a significant performance drag – a dynamic only heightened by the economic impacts of Russia’s invasion of Ukraine. The cumulative impact of another resources super-cycle or even a few more years of the current conditions could see the exclusionary funds fail the YFYS test.

That wouldn’t be ideal for their members –  but the current tepid investment outcomes of exclusion might not be either. Exclusion is falling by the wayside in favour of engagement with pollutive companies, which asset owners and managers believe will deliver them not only returns but the sustainability outcomes they desire. But members also want exclusion. The issue goes to the heart of an industry that is becoming less differentiated and the effect that YFYS is having on the market principals that formerly governed it. Members would ordinarily determine the best product for them based on their own values. That’s no longer possible.

“It’s too tight at the moment in the way it’s constructed; it doesn’t allow a values-based opinion to be put in place,” Walsh says. “And you can end up in the situation we’re seeing at the moment where for the right reasons, the performance of these funds is looking poor and it might actually affect their long-term viability by doing the right thing. That’s clearly a perverse outcome that wasn’t designed in YFYS.”

While Walsh is uncertain on how to engineer a fix that would allow exclusion to work, part of the solution might lie in the substance of the penalty for a failure; an amnesty like those proposed by incoming finance minister Stephen Jones; or by allowing members to apply for an exception. What’s for certain is that the previous way of judging funds was too diffuse, and the current way is too prescriptive. The answer, like most things, will lie somewhere in the middle.  

Time for a change
Asset managers are now taking the initiative in developing low tracking error products that deliver on ESG and sustainability goals while accounting for the performance test. Other managers are creating funds tailored to beat YFYS benchmarks that do not include certain assets and so offer opportunities for outperformance.

“That’s a natural industry reaction to the changes,” Walsh says. “Should those funds be more sensitive to the issues that clients think are important as well? The answer to that is yes. But some of these structures that have been put in place by managers are not flexible enough either. They’re trying to answer one question rather than many, and I think you can wind up answering none.”

“But if you’re concerned about maximizing unitholder wealth while dealing with the issues associated with ESG, then your structure and your investment management process needs to have that flexibility embedded in it.”

That obviously becomes easier if the YFYS regulations aren’t so tight. But asset managers, regardless of what happens with YFYS, will need to change their value proposition as the consolidation and insourcing trends gather speed. It’s going to be a tougher environment for boutiques; external managers will need to have significant scale themselves to keep up.

“Once an investment team has been in-sourced and part of the furniture, it tends to offer less opportunity and less flexibility than you might have with an external manager who is having to compete in that space,” Walsh says. “While in-sourcing is a strong trend, and there’s good cases for it, it doesn’t provide the flexibility that experts like us should be able to provide.”

“One of my big mantras for a few years has been – and this will sound like a cliché – is that investment managers have been product providers rather than solutions providers. As clients get bigger, we need to engage and give them customized solutions. We can’t do that very easily if the benchmarks are so tight.”

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