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.
Narrow strategies and nation-building kneecapped: Where YFYS goes wrong
The consequences of failing the performance test make passing it the main goal of super funds, according to former Sunsuper CIO David Hartley, while investment objectives more important to actual member outcomes – total return, returns relative to inflation, and the magnitude of negative investment returns – have “become subsidiary to passing the test.”
“Performance relative to a benchmark constructed by Treasury officials would not normally be regarded as a high priority in the context of member outcomes, even if it was in existence at the start of the YFYS performance measurement period,” Hartley writes in his submission to Treasury on its review of the YFYS reforms.
“However, the consequences of failing the YFYS test can be very negative for fund members simply because of the potential impact to cash flows. This has an inevitable impact on fiduciary responsibilities. It elevates the objective of passing the test to become paramount, instead of being of relatively minor importance.”
But fixing the test itself is a tall order. Instead, its consequences could be tweaked.
“Despite these shortcomings, the benchmark indices currently prescribed might not be able to be improved,” Hartley writes. “The consequences of failing the test upon which they are based present the main practical problem.”
“The real efficacy of the test lies in the questions that it raises for further inquiry as opposed to the narrow aspect of performance that it measures. If the consequences of the test were not so dire and, more simply, led to dialogue and further analysis by APRA across a broader range of factors than simple past performance, this would give better recognition that the benchmarks and the test are not perfect and should be viewed in a broader context.”
The YFYS test as it stands will likely introduce systemic risk into a space that has previously been mostly inured against it. With investment programs becoming more and more concentrated in a “narrow range of strategies”, dispersion in returns will decrease, and all funds will wind up constructing their investment strategies “in a way that virtually guarantees that the test will be passed.”
“Money will flow naïvely into strategies represented by the benchmarks as selected by Treasury and the short to medium term performance of such naïve strategies will be very strong,” Hartley writes. “Funds that choose not to invest in this way will suffer in terms of performance. As a bubble inflates trustees will be discouraged from looking for other assets.”
“In time, assets represented by the Treasury benchmarks will become highly priced relative to other assets but there will be no incentive to seek the better-value assets. The overall effect that will emerge will represent a serious institutionalised systemic risk for the superannuation system as well as the whole economy.”
Private capital – including private equity, venture capital and social housing projects – are not explicitly benchmarked in the reforms (they’re instead measured against a 50/50 benchmark of bonds and equities) and “by implication” are not considered sensible long-term investments under the test.
“No one can deny the worthy intentions of a performance test that is used in the correct way,” Hartley writes. “However, one of the negative outcomes of this particular test will be to discourage superannuation funds from pursuing the innovative investments that may be necessary to help Australian superannuation fund members and the Australian economy to navigate the difficult times ahead.”
At the same time, the benchmarks encourage investment outside of Australia, particularly investment in Chinese companies, and a decision not to invest there will have “significant impacts on tracking error relative to the prescribed benchmarks.”
“Analysis from a Hong Kong based manager indicates that the simple decision to exclude China from an international equities portfolio will introduce tracking error of around 100 basis points, which could lead to performance that is more than one per cent different to that of the benchmark in around one year in every three.
“As a result, the YFYS performance test and its prescribed letter reflect a policy that, when the implications are understood fully, discourages investments into areas such as Australian private capital and will lead to more investments into Chinese companies. This may result in a higher investment return over some periods of time, or it might not. This is an inherent feature of investing.”
Treasury is yet to release the full set of submissions, with many industry experts working around the clock to meet the deadline last week.
