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.
How Willis Towers Watson would fix alts for the test
The infamous “other” bucket of the Your Future Your Super (YFYS) performance test has been the bane of many an allocator, with everything from hedge funds, commodities, and momentum and carry strategies compared to a benchmark of 50/50 global equities and global bonds. It’s a tough benchmark to beat for alternative strategies with an equity beta of less than 0.5 (most of them), and “acts as a disincentive for investors to pursue strategies that provide strong diversification benefits”.
Willis Towers Watson (WTW) is now seeing a reduced appetite for alternatives, particularly those “that are genuinely diversifying to equities”. But while WTW thinks that a mix of equities and bonds is a good starting point for alternatives benchmarking, the mix needs to be adjusted.
“As an alternative, a broader range of indices for the “Other” category could be introduced, ranging from 100 per cent equities/zero per cent cash through to zero per cent equities/100 per cent cash, in increments of 25 per cent,” WTW said in its submission to the YFYS consultation process. “This would result in five benchmarks for the “Other” category and would allow a fund to select the most appropriate benchmark for each investment in this category.”
“While the approach outlined above may lead to concerns that super funds will ‘game’ the system, in reality this potential already exists – funds wishing to outperform the existing benchmark for the “Other” category are incentivised to invest in strategies that have an equity beta of more than 0.5 (i.e., by investing in strategies with a higher correlation to global equities); or, if their existing strategies have a beta to equities of less than 0.5, to avoid investing in these altogether (to avoid the risk of benchmark underperformance).”
The submission, prepared by WTW superannuation sector lead Jonathan Grigg (photo at top), warns that while the current set of indices is “reasonably comprehensive” in most asset classes, fixed income receives the same inadequate coverage as alternatives. And WTW is now seeing the construction of fixed income portfolios “cognisant of the long-duration, nominal, government-dominated benchmarks used in the performance test” – resulting in options that could leave members with an outsized exposure to duration, inflation, or cash.
WTW recommends the introduction of three additional fixed income benchmarks that cover inflation-linked bonds (the Bloomberg AusBond Inflation Government Index); short-duration bonds (the Bloomberg AusBond Composite 0-3 Year Index); and long-duration bonds (the Bloomberg AusBond Composite 10+ Year Index).
Credit is also problematic – it doesn’t have a dedicated benchmark, and is included in fixed income -and WTW warns that the efficacy of the performance test is reduced by the opportunity set not being accurately matched, while there are incentives for funds to over-allocate to riskier credit in a bid to increase their return relative to the performance benchmark “without being penalised for the additional risk being taken”.
While the breadth of the fixed interest and credit universe makes benchmarking it more challenging, WTW believes that “modest changes” to the proposed benchmarks would have a meaningful impact on the efficacy of the test.
“Specifically, we propose: continuing to benchmark investment grade government and corporate fixed interest using the existing approach, but with the inclusion of the three additional benchmarks proposed in the Fixed Interest section above,” the submission says.
“Adding one additional benchmark – the Bloomberg Barclays Global High Yield Index – that better matches the characteristics of the riskier types of credit described and which could be used for all credit investments that fall into the “Fixed Income Non-Investment Grade” category.”
WTW also notes that while the consolidation already seen among the 140 funds in Australia has likely improved member outcomes, it’s unclear that consolidation among “(say) 20 funds – once that point is reached – would continue to do so”.
‘In addition, we expect less variation between MySuper options and less innovation, due to the constraints placed on funds by the performance test and the limitations of the test itself,” the submission says. “The likely reduction in alternative asset classes may lead to increased volatility in MySuper portfolios, though the impact on long-term member outcomes may be more muted.”
