Tracking error management needed for YFYS test

Superannuation funds close to failing the Your Future, Your Super performance test will need to tighten its tracking error significantly and reduce its investment time horizon for taking active risk, according to Schroders.

In its fixed income report, Schroders said there was an imperative to increase the focus on managing tracking error to a fund’s strategic asset allocation (SAA) benchmark.

“If tracking error is to become the key risk management tool, then maximising an investment portfolio’s information ratio [IR], the return for active risk, will be key to minimising the risk of failing the performance test,” it said.

“…a portfolio tracking error of 2% to 3% is the sweet spot for those funds with the luxury of an eight-year investment time horizon for their active risk. Funds closer to failing their performance hurdle will have a shorter time horizon, so will run with a lower tracking error budget.”

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Schroders noted the key to delivering the highest information ratio at the total portfolio level was accessing consistent, uncorrelated alpha from the broadest opportunity set available.

“When considering default funds with very high allocations to growth assets, these funds have very narrow breadth of alpha opportunities and rely very heavily on selecting the best equity managers to deliver their implementation alpha. In the YFYS environment this is a high-risk strategy,” the report said.

“In a YFYS environment, the lower risk strategy is to diversify sources of active risk. Therefore, we expect funds to reduce their allocations to active growth assets in their SAA to increase the diversity of alpha across more asset classes and create more symmetry for their tactical asset allocation (TAA) decisions.

“Both will likely improve the potential information ratio at the total portfolio level. Given the multiperiod test horizon, consistency versus the SAA becomes the key, particularly for those close to or already underperforming.”

Schroders noted the two main asset classes were tracking error could be managed most effectively were fixed income and listed equities as the selected benchmark indices would be accessed passively with close to zero tracking error.

“This is not the case for unlisted property, unlisted infrastructure and alternative assets and strategies. Specifically, for alternative assets and strategies, like hedge funds and commodities, managing tracking error is far more problematic and may require a re-think,” it said.

“These assets and strategies are captured under the Australian Prudential Regulation Authority’s [APRA’s] ‘other’ benchmark, a mix of traditional bonds and equities.”

The fund manager said it believed fixed income strategies had two “very significant” advantages in the YFYS framework.

The first advantage was low fees and the second was due to the indices APRA has selected for fixed income. Fixed income benchmarks by nature could be more readily segmented into risk buckets (such as by term, rating and carry).