Super funds could face high risk of failure under ‘Your Future, Your Super’ performance test

As many as 20% of superannuation funds may fail their ‘Your Future, Your Super’ performance’ test in any given year and if a fund fails the test once there is a probability of around two thirds that it will fail it again the following year, according to modelling by leading implementation manager Parametric Portfolio Associates LLC (Parametric).

Whitlam Zhang, manager research and strategy at Parametric said, “Our analysis shows that even failing the test once puts a super fund in a precarious situation. The probability of a second failure is very high because the next performance test will include 87.5% of the same data – that is, seven of the eight years being measured will be the same.”

Under the new performance test, each year the Australian Prudential Regulation Authority will construct an individual benchmark for every MySuper product based on the product’s asset allocation. Each product will then be compared against its 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, “It will require quite a performance turnaround the next year to bring the fund back to safer ground. Any fund whose strategy is to rely on their brand strength and member loyalty to survive the occasional single failure should think twice.”

Zhang says that to reduce the probability of failing the performance test, a fund needs to either decrease its level of tracking error or increase its expected information ratio.

“The good news is that tracking error is within the control of a super fund. While it cannot be controlled to a fine degree, it can be dialed up and down.”

A fund can dial down risk in order to reduce the probability of failure by taking the following options: increase allocations to low tracking error strategies, such as passive or enhanced passive investing; implement stricter rebalancing rules to reduce active risk from straying from their strategic allocations; and ensure that the fund’s risk reporting includes total risk and benchmark relative risk.

Zhang says increasing the expected information ratio is difficult, “Anyone can tell you that generating excess returns is hard enough, let along delivering it in a risk controlled and predictable manner.”

“It means that investment teams will need even higher conviction in their fund managers in order to compete in this market. Investment strategies that will do well in this regime are solutions that can deliver excess returns in a relatively more predictable manner,” notes Zhang.