The Reserve Bank of Australia (RBA)’s unprecedented commentary that super funds herding around benchmarks poses risks to the financial system’s stability is another indicator of Your Future Your Super performance test’s unintended consequences.
In its latest half-yearly Financial Stability Review, the central bank said that superannuation has posed “little risk to the financial system” in the past, but the explosive growth of assets under management and more recent practices including “the rise in herding around common benchmarks” mean funds’ investment actions will be more acutely felt.
The RBA historically has not weighed in on systemic risks in superannuation, but since the stresses exposed by the COVID-19 pandemic, it is starting to take more notice of the pension industry, especially its share of domestic bank funding and FX hedging.
The RBA’s review expressed worries around super funds’ increasing claims on banks – both through debt securities and equity holdings.
According to its observations, super funds now directly hold nearly one-third of bank short-term debt securities and more than one-quarter of equity issued by domestic banks. The real exposures are likely to be larger since the RBA’s observations did not track investments through managed funds.
“Superannuation funds have the potential to amplify shocks in the financial system,” the RBA said in the review.
“This could occur if the investment actions of superannuation funds were to become more correlated or concentrated in times of generalised market stress – for example, in response to members’ correlated reaction to a shock.”
A recent example is the shock induced by super funds during the pandemic when they increased the sale of bank debt securities back to issuing banks, which in turn increased funding costs across the financial system.
Therefore, it seems that there are two areas of concerns from the RBA, which is that the superannuation industry has become too big, and is acting increasingly in unison when it comes to investment actions.
David Bell, executive director of the Conexus Institute*, said that YFYS contributes to herding behaviour, but a large amount of herding behaviour would exist regardless.
“It’s all about market structure,” he said.
“So size of industry and overlap of activities amongst individual funds are important. The increasing size of the system is a fact, as is the increasing concentration as the industry consolidates.
“The strategic activities undertaken by funds, namely, to have significant exposures to growth assets, is the core area of [investment action] overlap and is driven by peer group. YFYS further sharpens this overlap because funds manage performance test tracking error to a set of specific benchmarks.”
The RBA’s concern about funds herding around common benchmarks stems from the influence the YFYS performance test has on funds’ security selection. For example, funds’ investments in Australian shares are assessed relative to the S&P/ASX300 Total Return Index.
Penalties for failing the performance test are potentially severe – including being closed to new members. As a result, funds tend to hug the benchmark to avoid relative underperformance, investing in stocks in weightings that tend to reflect their index weighting. Financial stocks, including banks, currently comprise about 30 per cent of the S&P/ASX300 Index.
Despite its anxieties over funds’ herding mentality and the possibility of amplifying shocks to the system, the RBA acknowledged that super funds can also support the system’s financial stability in a counter-cyclical manner, including when volatility spikes and asset prices fall.
“The sector also has structural features that help limit the build-up of systemic risks. For example, most superannuation funds are defined contribution funds, which do not offer guaranteed returns to members, and funds are restricted in their ability to borrow,” it said.
But it called for super funds to strengthen their liquidity management to avoid the occurrence of synchronised asset sales in some domestic markets to raise cash, including to deal with policy changes such as the Early Release Scheme or capital calls for private assets.
“Over time, a reduction in the flow of net contributions into the sector, and the eventual transition to outright cash outflows (as more and more members enter the decumulation phase of retirement), will also present new challenges for liquidity management,” the RBA said.
“However, these developments will be gradual and largely predictable.
“The management of liquidity risk will require ongoing vigilance, including in respect to margin calls on foreign exchange hedges.”
*The Conexus Institute is an independent think tank philanthropically funded by Conexus Financial, publisher of Investment Magazine.
