It’s a move aimed at improving efficiency, transparency and accountability across Australia’s $3.3 trillion superannuation sector, but the new performance test for MySuper products under the federal government’s Your Future, Your Super reforms has been met with deep trepidation across the industry.

In a virtual roundtable titled “Your Future, Your Super, performance testing”, hosted by Investment Magazine and sponsored by Metlife, investment managers at funds large and small have expressed concern that optimising their portfolios to ensure they pass the performance test may involve adverse trade-offs against investment performance or diversification.

Capturing the mood of the room, Kylie Willment, Chief Investment Officer for the Pacific region of Mercer’s Institutional Wealth business said as she worked through governance frameworks to manage the test’s requirements with her team, there was potential conflict between passing the test and delivering ideal member outcomes.

Willment said in the past, all proposals she had put to the trustee board had included as primary metrics their total expected return, the probability of meeting the fund’s CPI objective, and risk metrics around total risk and drawdown risk. Post-performance test, those recommendations will likely include the risks associated with the Your Future, Your Super benchmark.

Actions needed to minimise the chance of failing or maximise the chance of passing might come alongside a recommendation to either reduce expected return or increase expected risk, and “that’s where the conflict is potentially going to come in,” Willment said.

“So our intention, and it’s very much still a work in progress, is to try to come up with a process and governance model that…tries to align those things as much as possible,” Willment said. “I don’t know that you’re ever going to get them completely aligned. And I’m pretty sure you’re not going to get to a…probability of meeting the test of a hundred [percent] without perhaps compromising your expected return and risk.”

Damien Graham, CIO of Australia’s second largest fund Aware Super, said he saw problems lining up the fund’s convictions in “active risk we feel is high quality” with risks introduced by the performance test. The way liquid alternatives are benchmarked could lead to a “high hurdle to have a lot of your portfolio in liquid alternatives…[and] has gone against the ability to allocate risk in a high-quality fashion there,” Graham said.

Aware had also enjoyed a long exposure to A Shares on the Chinese stock market, which had led to “huge amounts of alpha” but was also very volatile. The fund was still working through the details and had yet to form a view, but this did look to be a challenging position against the performance test.

Con Michalakis, CIO at Statewide Super, was more cynical. Members want absolute returns, leading funds to manage to a CPI plus target, Michalakis said. But the performance test is “really a business compliance thing”.

“No board or management team or trustee wants to put up with failing a test,” Michalakis said. “So you’ve got these different competing interests… what are you managing to here?”

A concern for insurer MetLife was that the heat of discussion around the performance test could sideline the importance of insurance in superannuation.

Chesne Stafford, chief customer marketing officer at Metlife, said it would be possible for a consumer to switch funds and lose necessary cover unintentionally, and education around this topic would be important.

“It could be an easy decision to pick something based on absolute numbers on fees and returns at a given point in time, and easily ignore that really important piece which is insurance,” Stafford said.

Optimising for the benchmark

Strategies funds adopt to ensure they don’t run into problems with the performance test will vary enormously depending on things like the size and sophistication of the fund and the fund’s investment philosophy.

David Bell, executive director at The Conexus Institute, said smaller, less resourced funds will inevitably have a difference in their discussions when compared to the nation’s largest funds.

“There’s going to be other funds where the level of maturity, the level of experience, level of knowledge just isn’t going to be there,” Bell said. “And so risk aversion to failing the test might dominate and that may really start to impinge on managing for member outcomes.”

A fund’s decided tolerance for failing the test–be it five per cent or ten per cent, for example–will significantly affect the way it manages its portfolio, he said.

But a fund’s approach to the performance test will also depend on whether the fund happened to pass the first test. Graeme Miller, CIO at Telstra Super, said the most significant driver of how a fund is likely to react to the test is how much “headroom” the fund has today against the test, based on historic performance through a time when nobody knew the criteria they were being tested against.

“The more headroom you’ve got, the less constrained you are in terms of what you can do,” Miller said. “Conversely, the less headroom you’ve got, the more your strategy gets entirely dictated by and ultimately dominated by the test itself.”

This would lead funds without headroom to “shut down all active risk in the portfolio,” as this was the only logical thing to do to ensure survival, he said. Funds who had failed might even be inclined to “take a massive swing” in risk terms to try and get back in the black, he said.

Bill Watson, CIO of First Super, said the dire consequences of failing the performance test meant the imperative to pass it had surpassed all other priorities in the annual member outcomes assessment that funds need to conduct.

“If you want to maintain scale, the viability of your fund, sustainability, and deal with outflows, the only member outcome you’ve really got to try not to fail is the Your Future, Your Super performance test, because of the impact that it has on the business,” Watson said.

The death of conservative options

Anna Shelley, chief investment officer at AMP Wealth Management, noted conservative options would be hard-hit by the performance test, including those in the Choice environment which never had the sole aim of beating a benchmark test but rather served other purposes. AMP Wealth Management’s managed volatility funds, for example, were “obviously faring very, very poorly against the test”.

Members choose conservative options knowing they will receive modest returns in exchange for lower volatility and risk, Shelley said, but managing to a performance test “throws a real curly one there,” Shelley said. “What is our fiduciary duty here?” she asked the table.

Bell said the treatment of fixed income and alts in the test makes managing conservative option portfolios extremely difficult. Diversification will be punished by the test, along with measures to reduce risk within sectors, he said.

“Explicit portfolio protection is probably off the table now for nearly every fund,” Bell said.

Miller said this was an outcome that left members poorly served. “In the Your Future, Your Super world, any strategy that has got low equity beta or, essentially, low credit or duration beta, is a very risky strategy,” he said. “Even if it reduces risk in an in an absolute sense, it introduces significant Your Future, Your Super risk.”

There were also widely held concerns that investments with strong long-term returns could be penalised if the pathway to those returns is slow. Investments will now be “path dependent”, demanding interim returns as well as those in the long term, and this will require extra governance measures, speakers said.

Kim Bowater, director of consulting at Frontier Advisors, said she was concerned it could be “much tougher” for asset owners to have conviction on long-term assets that don’t promise immediate returns.

“My concern is that the path and the shorter timeframe means that we’re less comfortable than we might have been with a long-term investment approach, where we think this is going to work out over the long term and the path is less important,” Bowater said.

Sean Brereton, Investment Manager at Vision Super, said Vision had always managed to absolute return, absolute risk and peer risk, but the performance test added an additional risk to be managed against, which could lead to shorter investment timeframes.

“None of those things were [saying]: ‘Here’s a very specific period, and if you fail in this period you’re done,’ and that changes things quite a lot,” Brereton said. “Specific time periods really matter way more than they ever have in the past. So I do think tat tends to give much, much more focus on shorter term risk measures.”

The first fails

Mark Rider, the relatively new CIO at Christian Super, shared his insights as one of the thirteen funds to fail the first test for the 2020/21 financial year. Christian Super began changing its approach around three years ago, he said, having taken a more conservative approach after the financial crisis which led to poor performance against the benchmark.

Getting to a pass by next June and avoiding a devastating second strike will be “quite a hurdle to jump”, Rider said, as a lot of “underperforming…water was under the bridge before [the fund] was aware that this was going to be the benchmark.”

“The history of the fund will suggest we probably won’t get there,” Rider said, despite the fund experiencing the strongest performance it has recorded in the first half of this year. “The runway we have is too short,” Rider said.

Since sending out its letter advising members of the test results a week prior to the roundtable, Rider said he had seen “a pickup in outflows and switching out of the fund” but it was still a little early to comment on the reaction.

Colonial First State’s MySuper Lifestage investment option within First Choice Employer Super also failed the first performance test. Scott Tully, general manager at Colonial First State Investments, said he’d “been in the bunker for about a month putting together commentary and responding to clients.”

“We’ve had a very large focus on a relatively small amount of total funds, but when you get that public disclosure, it obviously becomes very intense,” Tully said.

Tully said a “value tilt” in 2018/19 had gone against the fund’s results, but he had “reasonable confidence” in closing the gap and avoiding a second strike. But running investments through models and looking at probabilities of success or failure were “a little bit of a work of fiction” when the end outcome is a binary pass or fail.

“Would I be comfortable with a five percent chance of failure?” Tully said. “Well, I might think that’s okay in a probabilistic sense, but I’m pretty sure the business isn’t going to be too comfortable with any failure. But having said that, because we do need to have some active outcomes, we need to take some risk to get us over the line.”

EISS Super was another fund on the list of 13. Yasemin Onat, trustee director and chair of investment committee at EISS Super said the fund’s “conservative investment philosophy…has been an issue retrospectively.”

“We’re grappling now with what is our fiduciary duty,” Onat said. “Is it to not fail a test a second time and be closed to new members, or to protect on downside when, say, markets are having a reaction to Covid.”

Impact on Choice funds and ESG strategies

Damien at Aware said he believed when Choice options are tested starting next year, “there will be a large number of options that fail,” particularly options that are explicitly designed to not follow the benchmark. Aware’s retirement focus solution–a defensive option focussed on managing downside risk–could fail next year under the test, he said.

This new “benchmark risk” will be a challenging dynamic, potentially impacting some ESG strategies as well, he said.

“So when we’ve advocated with government, we’ve said we don’t think that Choice products that are purposely designed to not follow the benchmark should be included in the test,” Damien said. “Obviously we’ve lost that discussion.”

Mark Rider said he believed we are seeing the “collision of two great trends here. One is towards the Your Future, Your Super performance test. The other one, of course, is responsible investing.”

The tendency for funds will be to reduce tracking error with the benchmark, Rider said. But funds meeting members’ expectations that they be responsible investors need to have a stomach for greater tracking error, and this will lead to an inherent tension in funds’ understanding of their fiduciary duty.

But how this impacts consumer confidence in Choice products remains to be seen. Miller said he believed there would be “dozens, perhaps even hundreds” of choice products that fail next year’s test, and this may ultimately water down the impact of a test failure.

“I just wonder whether in fact that may almost reduce the stigma of being on the list and the fulness of being on the list,” Miller said. “Being in a crowd of hundreds is a more comfortable place to be than in a crowd of 13.”

Graham said it was likely different cohorts would react differently to a failure of the performance test, with younger members likely to be more apathetic, while older members approaching retirement would be more likely to switch.

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