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.
‘They’re open to change’: Glimmers of hope for a new YFYS test
The Your Future Your Super (YFYS) reforms likely set a new benchmark for poorly designed regulation. But just as the superannuation industry had begun to learn to live with their ‘unintended consequences’, the new Labor government announced a review that could see some of them rolled back – and tweaks to a test that most in the industry believe fails at its most important job.
“The ultimate issue with the performance test is that it’s not really aligned to what fund members need, not really aligned to long-term returns,” Ian Fryer, general manager of Chant West (photo at top), said on Thursday (October 13). “The efficacy of the test in determining good performance should be consistent with the consequences of the test. What we have now is a test that isn’t very good at measuring the quality of a fund’s performance and has existential consequences. That drives funds to not focus on long-term returns but on passing the test.”
“It’s possible that a fund can invest really well and provide really good long-term returns by making the right calls in different asset sectors through their strategic asset allocation (SAA) and still fail the test. It’s unlikely, but it’s possible. And the fact that it’s possible means that even big funds like AustralianSuper will be careful about how they invest just in case the stars align and the way they invest fails the test.”
Ideally, Chant West would like “a better test” – one that’s aligned with the long-term objectives of superannuation rather than short-term objective of just passing it. The test could be shifted from its focus on a benchmark portfolio return and towards a simple reference portfolio, which would allow the benefits of the SAA to flow through, but it’s “a little bit naïve” to think that one number can tell the whole story.
“We’re a proponent of multiple metrics over multiple periods,” Fryer said. “You might have something like what’s in there at the moment, but rather than having everything over eight years have it over three, five, and eight years. Have a risk-adjusted return metric that is also over three, five, and eight years. Maybe some peer comparison over three, five and eight years.”
“You could come up with nine tests and you have to pass five of them to pass. If you don’t, you’re gone. Another possibility is to have one test which is the main one, but if you fail that test you aren’t out; you might move to an APRA review where they have these other tests they can apply to make sure that one test was not a very helpful way of seeing your particular fund.”
But that one initial test would still dominate because funds will be cautious of winding up before an APRA review – so it’s “really important” to get that test operating in such a way that it doesn’t skew performance towards avoiding that consequences. Fryer says Treasury “is doing a great job at consulting” – a stark difference from the previous YFYS consultation process, which was a far cry from collaborative and left the reforms mostly unchanged.
“They’re really open to change, while recognizing that there is some inertia – that there is a test there at the moment that funds have built, rightly or wrongly, the way they do things around… There is some hesitancy for changing things, though it’s not a great test,” Fryer said.
“I think there’s some interest in looking to see if there can be multiple metrics rather than just one; single metric, no matter how you do it, is going to work in some cases and not in others. Whether it’s one test and then a whole bunch of others in a review or a whole bunch initially, I think there’s different views on that. Simplicity is good for the first one… Treasury is quite open to anything, but we as an industry have not been very good at presenting a combined face, so they’re getting lots of different views and trying to make sense of it all.”
