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.
With the advent of Your Future Your Super (YFYS) Australia’s super funds are more closely examining their indexing options. The trick is ensuring member outcomes don’t suffer.
Benchmark-relative risk is now top of mind for super funds, with specialist implementation manager Parametric seeing a substantial uptick in the number of funds taking an interest in its indexing capabilities as they confront the potentially catastrophic implications of underperforming the YFYS benchmarks.
“Many funds are coming to Parametric and asking about our custom indexing capabilities, because they’re looking for things that are low fee and tight to the benchmark,” Paul Bouchey, Parametric global head of research, told this masthead.
“We’ve been doing this kind of work in Australia for over ten years, but a lot of our focus has been around centralised portfolio management… In the last six months to a year, the conversation has shifted.”
But as funds move to reduce tracking error, they also face the possibility of hugging the benchmark so closely that member returns themselves become sub-optimal.
To alleviate the issue, Parametric is trying to offer the middle ground solution of an “enhanced index”, with tolerable levels of active risk and a chance of outperformance through factor exposures or multi-factor portfolios and sees new potential mandates coming down the pipeline.
“We’ve seen a lot of interest in momentum, in the Australian equities in particular. Having a very small tilt towards momentum stocks allows you to have some active performance in what is, essentially, an index,” Bouchey said.
“You get the low-cost, you get a little bit of active risk – and then you can layer in tax management, another value add you can pick up. You’ve gone to passive, but you potentially picked up some factor alpha and some tax alpha. We’re giving them that middle ground – there’s still some value add you can do in your passive portfolio. You don’t have to give up everything.”
Whitlam Zhang
While Whitlam Zhang, Parametric’s Australia manager for research and strategy, believes that super funds will still look to active managers and that the need for value add and outperformance “hasn’t gone away”, there will be greater scrutiny placed on the conviction behind and consistency of outperformance as the YFYS changes roll through the industry.
“To be honest the appetite for higher active risk and higher tracking error strategies has definitely dropped dramatically,” Zhang told this masthead last week (July 29).
“Even with our strategies, that we consider pretty-low tracking error, pretty low active risk, there’s higher sensitivity than we’ve ever seen before of the amount of risk that we’re allowed to take. Before, when we were talking 50, 60, 70 basis points funds would think of that as all the same thing – it’s all low. Now it’s ‘No – 50 basis points. Don’t go higher than that’.”
The possibility of failure also raises questions around how members will behave when they receive notification that their fund has underperformed the benchmarks. Zhang believes that funds face up to a 20 per cent chance of failing the performance test, and that while brand loyalty – an area that funds have invested in heavily in recent times – will help some funds weather the reputational storm, “it’s not the crutch to lean on too heavily”.
“I don’t think brand loyalty will get many funds through this, but we’ll have to wait and see,” Zhang says. “The first test and the results that come out of it will be a market test of fund engagement and whether all this time and effort that funds invest in marketing and branding actually results in members sticking to them, or whether they’re going to rush to the Your Future website and find a new one. We’re all in new territory here – we’ve never been in such a competitive environment that is highly incentivising people to move.”
Some members are excited for retirement, while others approach it with a “real sense of shame and fear”. Funds are going to have to figure out how to cater to both groups or risk failing them all.
Opening up early access to super for housing would have a negative effect on the balances of even those members that don’t dig into their savings, with funds forced to adopt more conservative investment strategies and hold more liquid assets.
The circa $88 billion industry fund for workers in health and community services reckons that alleviating the affordable housing crisis will boost its other investments by easing the cost of living and inflation.
