For super funds and their advisers

YFYS won’t be the end of ESG: Parametric

•3-Jennifer-Sireklove

The problems with Your Future Your Super (YFYS) run deep – among them, how super funds will manage ESG within the confines of low tracking error strategies. But it’s not the end of the road.

Under the YFYS reforms, implementation manager Parametric believes tracking error will face downwards pressure as funds try to stay on the right side of the test. The problem is that a moderate level of tracking error – potentially, too high a level – is a by-product of negative screening and ESG integration, two popular techniques for achieving ESG goals.

If ESG was still a “nice to have”, as it was just ten years ago, that might be less of a problem. But it’s now a major driver of inflows across the industry, and many funds are leveraging their green credentials to win the marketing war for new members. On top of that, it’s expected that APRA will soon codify trustee duties on climate change, refining their recent guidance. Funds can’t afford to ignore ESG – but at the same time, it could well be their downfall where the performance test is concerned.

“These new reforms now penalise products for taking on this additional tracking error. Trustee-directed products designated as ‘ESG options’ will be most impacted,” Parametric wrote in a paper titled ‘Can ESG Investing Survive Your Future, Your Super?’. “This leads us to an important question: Can ESG incorporation still exist as super fund portfolios become more sensitive to tracking error?

Parametric’s answer is yes –  but with some caveats.

Parametric’s researchers – Jennifer Sireklove, managing director of investment strategy (picture at top), David Post, senior investment specialist, and Josh McKenzie, analyst – found that YFYS is not “the end of the road” for ESG, and substantial emissions reductions are still possible. For Australian equities, and using portfolio optimisation techniques, both screening and ESG integration allow for ESG objectives to achieved with less than 50 basis points of additional tracking error.

“When considering these two portfolio construction techniques, how far funds are willing to venture above or below these levels will depend on their willingness to trade off risk for ESG outcomes,” the report says.

“The capability to constrain risk through portfolio optimisation in particular may prove a powerful tool for funds navigating the YFYS performance test. In an integration approach, optimisation affords finer risk controls, meaning risk budgets can increase to accelerate ESG outcomes or tighten to stay within the limits of the performance test.”

And while screening lacks the flexibility of integration, it does have other advantages – mainly the fact that “it excels in its transparency and lack of ambiguity”, providing concise messaging that aligns with the government’s push to improve transparency and accountability for super fund members. Many funds are already applying blanket screens to companies that are involved in gambling, tobacco, and cluster munitions or other controversial weapons.

“Importantly, both screening and integration result in portfolios that hold companies with business involvement and practices that can and should be influenced by active ownership, particularly through proxy voting and engagement,” the report says.

“Utilised directly, through their asset managers or via organisations such as the Australian Council of Superannuation Investors, these tools are integral to super funds who wish to influence their portfolio companies to pursue policies and practices consistent with net zero specifically and their ESG interests and fiduciary responsibilities more generally.”

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