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.
Why the YFYS review should dig deep on systemic risk
The new new review of Your Future, Your Super announced on Wednesday looks to be focused on refreshing the benchmarks super funds are compared against to make sure they’re able to invest in things like renewable energy and affordable housing without taking on more tracking error. This is a positive step but one that doesn’t go far enough.
Aside from being a poorly designed piece of regulation, YFYS is the expression of a view, formed by the previous government but happily adopted by APRA, that a larger and more concentrated superannuation industry is a good thing. YFYS has supercharged fund consolidation at the same time it’s pushed them closer to the benchmark. A proper review of YFYS should consider the impact that could ultimately have on members.
The Thinking Ahead Institute’s initial submission to the YFYS consultation – aptly titled The Road to Hell is Paved With Good Intention, and released in the halcyon days of December 2020 – warned that three things were likely to happen as a result of YFYS: aggregate costs would rise; long-term returns would fall; systemic risk would likely increase.
It’s easy to argue the toss on the first two; costs have seemingly come down and super funds in aggregate have mostly continued to generate robust returns. But systemic risk is a topic worthy of more regulatory and governmental attention.
“One of the implicit aims of the reforms is to compress the range of investment outcomes – by cutting off the underperforming tail,” the Thinking Ahead Institute submission says. “If that was the only effect on the range of investment returns then we would have no problem. However, the career risk point (ed: caused by fear of diverging from benchmarks) makes it reasonable to assert that this is unlikely to be the only effect.
“We believe is it likely that herding behaviour will increase and further narrow the range of achieved investment returns. This, in turn, increases the correlation of member outcomes, meaning that when the DC system fails to deliver the expected, or hoped-for, returns, it fails to deliver them for all members at the same time. This then has implications for the pillar 1 (Age Pension) system and taxpayers.”
Updating benchmarks to give funds more leeway around nation-building assets will do little to change the new industry dynamic – one where funds get bigger while their members move up the risk spectrum through crowding around the benchmarks. This is not entirely a YFYS problem; as others have noted, very big investors tend to start crowding around liquid market benchmarks anyway and get their ‘alpha’ elsewhere. But YFYS creates existential consequences for doing something else, even when it’s justified.
A real review of YFYS would consider whether the industry and industry behaviour it’s creating poses a potential risk to members. Additional or altered benchmarks don’t actually dissuade funds from benchmark-aware investing, with all the problems that brings; tweaking bad regulation results in bad legislation squared, not a stupendous innovation in measuring how much good super funds are doing for their members.
Still, a more fulsome review of YFYS would only address one part of the (potential) problem. Large funds are no longer gobbling up small funds (when SG inflows might be $20 billion a year, there’s not much sense in spending time and money on getting a few billion more) but APRA continues to encourage fund mergers even in the absence of poor performance in the belief that small funds (sometimes in outflow) lack the investment firepower of their bigger brethren and so are less capable of adding value for members.
This represents an intervention in the market to decide the final shape of the market with seemingly little idea of how and how well the market will function as a result, and one that itself deserves interrogation.
