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.
‘No easy answers’, but YFYS review starts asking the right questions
Announced last week, Treasury’s new review into the Your Future Your Super (YFYS) regulations aims to improve the sophistication of the test amidst evidence that it is influencing investment decisions “to the detriment of member outcomes”, including by discouraging investment in particular asset classes that might otherwise be in their best financial interests.
And while it’s tempting to think of this latest review as just another episode of regulatory tinkering – the second in the three years since the performance test first went into effect – there’s a decent chance that the industry will finally get a good outcome from it.
“Treasury’s done a really good job with this discussion,” Geoff Warren, ANU associate professor and Conexus Institute research follow, tells ISN. “It shows they understand the issues well, and with each of the alternatives they’ve put up they’ve done a good job of identifying the positives and negatives of all of them, scoping out the issues around them all.”
“They were quite upfront about the issues with the existing test, and they were quite balanced.”
The consultation suggests four options for improving the test, the first being to keep the current metric. The other options include an alternative single measurement (i.e. Sharpe ratio), a multi-metric framework to provide “a more fulsome assessment of performance”, or an altogether different framework to be suggested in submissions to the consultation (i.e. an individualised member test, a measure of the real costs that members face, or net returns).
“I agreed with 90 per cent of it; I was reasonably impressed by it,” Warren says.
Warren expects the submission process won’t focus on the “right and wrong” of the different options, with stakeholders instead effectively picking the best option. One of the few sticking points for Warren – which will likely be teased out during the submissions process – is the inclusion of peer comparison metrics in a number of the proposed alternative options, which tend to provide a distorted view of performance.
“It’s quite possible for all the funds to be doing a good job and some to be doing a little bit worse than the others, but they still all deserve to stay in the game,” Warren says. “It reminded me of studies on sports, where the difference between the best and the worst athletes is very narrow.”
“It also encourages herding; you can get rid of benchmark hugging, but then you have a risk of translating it into herding.”
A more fulsome review
While there was a review of the YFYS performance test just last year, the need to implement any changes before the performance test ran again “limited how comprehensive” that review could be, Chant West general manager Ian Fryer tells ISN, and only small tweaks were made to the existing model.
“It’s pretty clear this time that I think Treasury is keen for a more fulsome review and the minister has said a number of times now that they want to look at the performance test and come up with an enduring model.”
“There’s no easy answers, as you can see in the pros and cons of the methods that they propose. At the end of the day, we have to stay focussed on net returns to members and not get lost in fees and hypotheticals vs actuals and so on.”
KPMG national sector leader for asset and wealth management Linda Elkins
The current test has served its purpose of weeding out some underperforming funds, Fryer says, but it has a distortive effect on how all funds approach their investment strategy and it’s now time to focus funds on what they should be doing: generating strong long-term returns for a given level of risk.
“(The new review) raised a lot of issues and laid it all out there. Where this consultation has some advantages was in the proposals brought up in the last consultation about what an enduring test might look like and they’ve been able to put those out and get feedback on those.”
Fryer also questioned the efficacy of peer comparison metrics, saying that it’s difficult to come up with a benchmark that “isn’t arbitrary and is appropriate” (if a large number of funds did extremely well, those that didn’t do quite as well could fail) and said that Chant West supports option 2C: risk-adjusted returns relative to a simple-reference portfolio.
An evolving test
But while Linda Elkins, KPMG national sector leader for asset and wealth management, believes the consultation is “well formed”, she doesn’t think this will be the last time the industry is asked to provide its views on the shape of the test.
“The idea that the test needs to evolve and mature is a good one, and I don’t think this will be the last time (a review is undertaken),” Elkins tells ISN. “Because of how funds are investing and the scale of funds, all of that is going to be constantly evolving, so the performance test and the way we measure success is going to need to keep up with that.”
“There’s no easy answers, as you can see in the pros and cons of the methods that they propose. At the end of the day, we have to stay focussed on net returns to members and not get lost in fees and hypotheticals vs actuals and so on; at the end of the day it’s got to be all about what members receive.”
The consultation also canvasses the industry for options to test retirement product performance, one piece of evidence for Elkins’ view that the test will continue to iterate, while she also agrees that the performance test has led to more similar investment performance across funds.
“I strongly suspect that the standard deviation of performance as a comparison of MySuper products has narrows; the range of outcomes you used to get across that field used to be a lot wider than it currently is.
“I’m not sure that’s good or bad. People are becoming more similar in what they do, but when you think of the concept of MySuper it really should be an option that is safe not matter which one you land in… I don’t think you want a big variation in that. It should be safe for people who don’t choose.”
