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.
YFYS kneecaps climate investing, needs new benchmarks: RIAA
The Your Future Your Super (YFYS) performance test promotes a short-term view on climate risk that will ultimately kneecap returns, the Responsible Investment Association of Australia (RIAA) said in its submission to Treasury’s consultation on the reforms.
“The test’s failure to account for longer time horizons and the integration of responsible investment approaches into decision-making means that the longer-term risk context could be ignored or undervalued,” RIAA, which is headed up by Simon O’Connor (photo at top), wrote in its submission.
“Risks such as climate change and biodiversity loss are systematic and long-term and it is in the best financial interest of members to account for and address these risks particularly in light of the long-time horizons of fund members.”
The test “runs contrary to sound climate risk management” and “inadvertently” goes against the interests of those funds that are committed to net zero carbon emissions by 2050 – in line with the government’s own policy and legislation – by using benchmarks that aren’t aligned with the same trajectory.
“Consistent with our legislated climate targets, it would be appropriate for benchmarks to be aligned with these same Paris Agreement targets,” the submission said. “Furthermore, there appears an inconsistency with backward looking performance tests whilst regulatory guidance, notably APRA guidance on managing climate change risks (CPG 229), stress the importance of managing for short and long term climate change risks.”
To alleviate some of those issues, RIAA proposes a range of potential benchmarks, including the European Commission’s Paris-Aligned Benchmark, which involves a 50 per cent reduction in emissions compared to a fund’s parent index in year one; a seven per cent year-on-year reduction of emissions relative to the fund itself; and exclusions on tobacco and controversial weapons.
Also on the table for RIAA is a similar bespoke reference portfolio to that of the NZ Super Fund, which allows it to consider the climate transition in addition to its own model of asset allocation. NZ Super recently moved around $25 billion – or 40 per cent of its overall portfolio – to Paris-aligned benchmarks.
“Private index providers have also developed many such appropriate forward looking benchmarks that better consider climate transition, such as FTSE Russell (LSEG) utilising a Paris-Aligned Benchmark based on the Transition Pathway Initiative which measures how the world’s largest and most carbon exposed companies are managing the climate transition and applying index exclusions for companies that generate over 50 per cent of revenue from environmentally sustainable activities and investments,” RIAA wrote in its submission.
Recent research undertaken by RIAA, FTSE Russel, the Australian Sustainable Finance Institute, and the Conexus Institute found that exclusionary investment strategies were almost impossible to implement within the constraints of the YFYS performance test without creating “an untenable level of YFYS performance test risk”.
“In short, trustees face a difficult challenge: they have multiple portfolio objectives but a limited budget of performance test tracking error to implement these with,” the research said. “These objectives include return enhancement, risk management, diversification, and accounting for ESG, sustainability and climate transition.”
“Trustees are faced with a difficult decision between living with a heightened likelihood of failing the YFYS performance test at some point or having to pare back the degree to which these activities are implemented, which may be inconsistent with investing in accordance with the long-term financial interests of members, and/or with members’ sustainability preferences.”
