Home / Analysis / Net Zero and other damage in YFYS test

With complaints about its efficacy still reverberating through the super industry, the YFYS performance test is to be extended next year to cover certain member investment options. Sustainability will be a big loser. Having delivered its first-year test results last month (August 31), the Treasury-instigated APRA-implemented test for big super funds found that the MySuper default options of 13 funds failed the performance test. One of the many points of contention is that the funds have not been told by how much they failed, even though they are required this month to write to members to inform them of APRA’s ruling. If they fail a second time – next year, which will include the performance of the recently past seven years – they cannot take on new members. The failed funds don’t know how much ground they need to make up next year in order to get eight years performance deemed to be a pass. Neither have the funds which did not fail been told how much they were ahead of the nominated index. They have an idea, of course, but for an organisation which lauds transparency among super funds and other institutions over which it presides, APRA’s own lack of it, in this instance at least, is difficult to understand. This month (September 10), Margaret Cole, APRA executive director, was asked at the House of Representatives Standing Committee on Economics hearing why funds hadn’t been told their scores. She said: “Because it provides a very clear message to the consumers of the products.” In answer to a further question she said she understood it was the regulator’s intention to make the scores public later this year. For funds which have been taking tilts away from the indices in major asset classes, such as local and international equities and fixed income, the flaws in the testing regime are about to become more apparent with their application on what APRA refers to as ‘trustee directed options’. These are multi-asset packaged investment options, including the increasingly popular ‘sustainable’ investments choices, which fall into the testing range in the current financial year. ESG-focused options and funds have been the major driver of inflows across the investment world in the past two years, both in Australia and globally, thanks to increasing awareness of the importance of net-zero targets to fight climate change. Impacts from the pandemic have also spurred these investment tilts. The $64 billion HESTA provides an interesting example. The health and community services sector fund has one of the oldest ESG-orientated investment options in the industry, launched as ‘Eco Pool’ in 2000. Now known as ‘Sustainable Growth’ the option is among the top investment performers of any fund, with an average annual return of 11.28 per cent over the 10 years to June. Members are told the option’s objective is “long term (10 years) CPI plus 3.5 per cent. The suggested minimum investment timeframe is “7-10 years”. It invests in “shares, debt and private equity of companies with above average environmental, social and governance performance, along with some exposure to environmental property investments”. The fund advises: “This option aims to achieve medium to long-term growth with some possible ups and downs in the short term… Probable number of negative annual returns over 20 years is four to less than six.” Stephanie Weston, HESTA’s head of portfolio design (photo at top), said the fund supported the broad objective of tackling underperformance. However, performance tests needed to look at what mattered for working Australians, which was what they ended up with in their super accounts after fees and charges. One of the real challenges of YFYS was it did not measure member outcomes, she said. “Performance test considerations are secondary to our primary objective of achieving the best possible long-term returns for members,” Weston said. “Where we consider tilts it’s because we have conviction that this will support us to achieve stronger long-term investment returns for members.” HESTA has previously made it clear that historical administration fees should be included in the calculation of the net performance of options. The fund has also raised concerns that, for several asset classes, proxy benchmarks are used that may increase tracking error, such as with private equity where a listed benchmark is used. APRA has, however, changed its benchmarks being applied to real infrastructure and property from those representing only listed companies to MSCI unlisted indices. These MSCI indices are not particularly well regarded as being representative, either, but are at least better than the listed alternatives.

David Carruthers, principal consultant and head of member solutions at Frontier, said last week (September 15) that the advisory firm’s recent comments on the test, published on September 1, should not have been a surprise. “We have made them all before,” he said. “They (APRA) are not testing the right thing. They need a different test or series of tests which reflect what members actually earned.” In respect of super fund tilts away from the nominated indices, such as for climate-related or ESG reasons, he said: “On the one hand, APRA says that climate risk is a financial risk that funds cannot ignore. They have been saying that for a number of years. But it creates a new risk under this test. “A 2050 [net zero] target, even an interim 2030, is not a short-term investment horizon. The funds are trying to do the right thing in the long-term interests of members, and they are being marked down by the regulator,” Carruthers said.

David Hartley, a trustee and investment committee chair at Australian Catholic Superannuation Retirement Fund (ACSRF), one of the 13 funds to fail in the recent APRA-regulated performance test, has studied the potential tracking error problems that funds face in deviating away from the standard cap-weighted indices. He likes to use a geographical tilt as an example to emphasise his point. If a fund decided, for geopolitical reasons, to tilt its global equities portfolio away from China, for instance, it would experience a tracking error of about 1 per cent just from that one decision. This means that in about one year in every three, they would see their return be more than 1 per cent from the APRA benchmark. And it could easily be worse than this. Following a string of a few years in which the Chinese market did well, the fund would be labelled as ‘underperforming’ irrespective of whether the fund trustee believed it was acting in members’ best interest. “This is about all the tracking error a fund can afford to take,” Hartley says. That calculation, verified by a Hong Kong-based investment manager, means that funds subject to the APRA test will need to make sure they know how to invest in China. China currently makes up 5.3 per cent of the MSCI ACWI index, which is the index Treasury nominated in its position paper. But the MSCI Group’s index producers have already announced a program to gradually increase China’s weighting, so it is better representative of the Chinese market versus the rest of the world – long a criticism of most index providers. “So, implicit in the Government’s performance test is an incentive for super funds to invest in China, even if they didn’t want to for whatever reason,” Hartley says. “And it will become a bigger issue under the MSCI timetable to increase the weighting.” In the fixed income market, if a fund excluded China from the standard Bloomberg Barclays fixed income aggregate index, the tracking error would be 28bps. This may also grow over time. Australian investors in growth markets such as China and India cannot enter and exit the markets as quickly and easily as in Australia, say. “If I decided today I wanted to invest in Chinese bonds, there are a lot of things I have to do,” Hartley says. “I have to get a manager who can do it, I have to set up a custodian arrangement or invest in a suitable pooled fund. Deciding to invest passively may not make much sense because this means I would automatically be lending the most money to those who borrow the most. So, I would really need to consider active management by someone who really knows China.” It is not only growth-orientated members that would be impacted. “In helping its members transition to retirement, it might make sense for funds to offer portfolios that focus more on dividend-paying shares. Despite the clear focus on member outcomes, this would also result in tracking error and risk an ‘underperforming’ label.” Unlike for the first test this year, when APRA does its test on trustee-directed options for the eight years to next June 30, it does not have the data to assess the funds’ products. It will be using data supplied by one of the commercial ratings firms, SuperRatings (part of the listed Lonsec Group), and will be providing a ‘heatmap’ as it did in the development phase of the current performance test for MySuper products. As one of SuperRatings’ clients said of the data move by APRA: “At least the asset allocation numbers should add up to 100 this time.” Frontier’s Carruthers says that a lot of what is being implemented by APRA under YFYS goes back to the report of the Productivity Commission of the efficiency and competitiveness of the superannuation system, handed down in January 2019 after a 12-month inquiry. The Commission said that the worst-performing sector in superannuation was the SMSF sector. The second-worst were the providers of investment choice options among super funds and the best performers were the providers of MySuper products. Post the Productivity Commission report, Carruthers says, the Government has started with MySuper and is now moving onto ‘choice’. So far, no-one has touched SMSFs.” ACSRF’s Hartley says that there are various ways to measure and manage risk in an investment portfolio. “It’s always a bit of a trade-off, for example: risk of loss, risk of losing purchasing power, risk of underperforming peers, risk of underperforming stated objectives and risk of underperforming a benchmark might require quite different actions. Sometimes, these risks will be in sharp conflict,” he says. “We devised a dashboard of risk metrics covering all these risks at Sunsuper (where he was CIO for 10 years until 2015) and were able to make informed trade-offs. With their new test, the Government has made it so punitive to underperform their interpretation of the benchmark that there’s one risk that is now paramount and it’s not a risk that necessarily has relevance to member outcomes.”