Superannuation fund trustees facing the prospect of an annual performance test under the Government’s proposed Your Future, Your Super changes face a very difficult choice when selecting fund managers, says Whitlam Zhang, manager research and strategy at Parametric.
“Active managers will have to substantially reduce their risk budgets, compared with the way things work now. Taking the passive option carries its own risks,” Zhang says.
“Fund trustees will have to think creatively and make some tough decisions. Tax-managed strategies will have a role to play. In the quest for delivering the best financial results for members, sometimes it helps to focus on the simple things, such as paying less tax and reducing fees.”
Under the proposed performance test, each year the Australian Prudential Regulation Authority will construct an individual benchmark for every MySuper product based on the product’s strategic asset allocation, taking into account fees, tax and other relevant assumptions. Each product will then be compared against its custom benchmark.
Products that underperform their net investment return benchmark by 0.5 percentage points per year over an eight-year period will be classified as underperforming.
Trustees whose products fail the test will be required to notify members in writing. Products that fail the test two years in a row will not be permitted to accept new members until their net investment performance improves.
Zhang says: “Clearly this will change the way super funds think about fund manager selection. It will raise the bar for how much conviction is needed before selecting a fund manager.
“It will also lower the appetite and patience of investment teams in strategies that may suffer large drawdowns for long, drawn-out periods of underperformance.”
Asset managers whose investment universe differs from their benchmark may also be less attractive. These might include alternative asset managers that pursue niche strategies.
To work within the constraints of low risk appetites, trade-offs will have to be made. These might include shifting allocations from private markets to listed markets and significantly reducing the amount of active risk taken within listed asset classes.
Those funds that have suffered poor relative performance in recent years will be most under pressure when the new regime takes effect.
A retreat to the “safety” of passive investing comes with its own risks, says Zhang.
“By definition a super fund investing passively cannot fail the performance test but whether it is the right investment decision for the fund is another matter.
“Some of the shortcomings of going down the passive route include: not all asset classes can be accessed passively; the fund will have few options for customising and tailoring portfolios to suit members expected outcomes; and the expectation for returns may be lower.
“Indices can vary greatly within an asset class and selection of an index can potentially introduce as much active risk as an active fund manager. And in the passive investment universe there is no flexibility to incrementally add value through tax management.
“Fund trustee should consider tax-managed passive investing, particularly in listed equities portfolios, which are generally the biggest drivers of risk and return in a super fund portfolio.
“As the performance test is net of fees and taxes, paying low fees for passive management and reducing taxes paid will increase the chances of outperforming the test,” notes Zhang.