Problems loom for conservative choice products in performance tests

Conservative choice products will be challenged by the Your Future Your Super (YFYS) performance test, with several problems and inconsistencies in the new regime set to be revealed, according to Chant West.

The research house’s general manager, Ian Fryer, said the performance test had so far only applied to MySuper products which overwhelmingly had growth-style portfolios.

“Already, we have seen the problems some funds have encountered when components of their portfolios have been measured against benchmarks that have slightly different characteristics,” said Fryer.

“This situation is likely to worsen when conservative choice products are subjected to the test.”

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Fryer said the industry had already seen how rational decisions could hurt funds in the performance test.

For example, funds had taken appropriate action by reducing the duration of their bond holdings and reallocating into defensive alternatives in response to the “overwhelming consensus” that interest rates were set to rise in the short to medium term.

But, Fryer said, defensive alternatives had been classified by the Australian Prudential Regulation Authority (APRA) as 50% growth so funds with exposure to those assets came up short when measured against an inappropriate benchmark.

“Secondly, the benchmark indices that APRA uses for fixed interest have no ‘risk awareness’, so they are longer duration (6-7 years) than most funds’ actual exposures.

“The seven-year return to June 2021 for short duration bonds (about 0-3 years) was 2.4% a year compared with 4.1% a year for the broader bond market (typically 6-7 years duration) based on a 50/50 split between Australian and international bonds.”

He said this discrepancy had hurt a lot of funds in the 2021 MySuper performance test and, unless yields rose significantly, it would hurt many more funds with conservative options in the 2022 choice performance test.

Fryer believed APRA and Treasury made the right decision when they changed the benchmarks to better cater for unlisted assets, and that an urgent review was needed now to achieve a similar improvement in the treatment of defensive assets.

“That might mean allowing funds to split alterative assets into different categories (ie growth and defensive) either based on volatility or a look-through to the underlying assets, where practical,” he said.

“Or it could mean splitting fixed interest exposures into different duration ranges (with different benchmarks), or allowing funds to split shorter duration holdings into a mix of benchmark-duration bonds and cash, but it may be very hard to get this data historically as an input to the test.

“If nothing changes, we may end up with the bizarre result that sees the conservative options of many funds fail the test, with all the implications for future cashflow, even though the same funds may pass the test for their growth-oriented options.

“Where then will older members and retirees be able to invest if they want to take a more conservative approach?”

Fryer said the test failed to measure the most important thing: whether the fund was pursuing an investment that was appropriate for its members.

“By taking those crucial asset allocation decisions out of the picture and simply focusing on implementation, it ignores the most potent source of added value. And unfortunately, the nature of the test is influencing how funds invest by encouraging short-termism and managing investments to ensure a fund doesn’t fail the test. This is not in the best interests of members.”