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Research finds YFYS test is constraining ESG activities

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The performance test has been found to have a constraining impact on the ESG, sustainability and carbon transition activities of super funds.

The current design of the Your Future, Your Super (YFYS) performance test makes it very difficult for funds to incorporate ESG, sustainability and carbon transition activities.

This is according to new research by The Conexus Institute, FTSE Russell, the Australian Sustainable Finance Institute (ASFI) and the Responsible Investment Association of Australasia (RIAA) published this week.

The research found that mainstream implementations of ESG, sustainability and carbon transition activities create unsustainably high levels of performance test tracking error, putting super funds at risk of failing the YFYS test due to a “false positive”.

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“Trustees are faced with a difficult decision between living with a heightened likelihood of failing the YFYS performance test at some point, or having to pare back the degree to which these activities are implemented,” explained Fiona Reynolds, chair of The Conexus Institute advisory board and director of ASFI.

An ESG portfolio implemented through exclusions, a carbon transition portfolio and investments in unlisted green assets were considered as part of the research.

A socially responsible growth investment option constructed using ESG exclusions was estimated to have a performance test tracking error of 1.5 per cent. The Conexus Institute has found that a tracking error of around 1 per cent is considered to be sustainable.

“It appears that it is not presently possible for a super fund to offer an SRI-style option based on exclusions — like those set out by RIAA — without creating an untenable level of YFYS performance test risk,” the research suggested.

“The performance test tracking error created through these exclusions is greater than the level identified as sustainable. This is before we consider the tracking error incurred through other portfolio activities such as managing risk to member outcomes.”

The research noted that this situation may change if BHP is moved off the UN Global Compact Controversy (UNGCC) exclusionary screen.

“However, this in itself portrays the instability inherent in offering these products in a YFYS setting: if a large stock is excluded by UNGCC, then the product may find itself instantly carrying an unsustainably high level of performance test tracking error,” it added.

Meanwhile, a carbon transition aligned portfolio constructed using Paris-Aligned Benchmarks and a low carbon proxy for the Australian equity market had a tracking error of 1.8 per cent.

“This important research shows unequivocally that there remains an inconsistency with the structure of the current YFYS performance test, and the ability of super funds to invest for the long term in a manner consistent with our national legislated climate targets of 1.5 degrees,” said RIAA CEO Simon O’Connor.

“This fundamental inconsistency must be fixed or it risks damaging the retirement outcomes of all Australians by incentivising short-term tracking error over and above the long-term financial interests of members.”

In its submission to the YFYS review, research house SuperRatings said that there is some evidence that options which take into consideration areas other than returns, such as ESG, sustainability and risk reduction, are being removed from the market due to issues around aligning their approach to existing benchmarks.

Research finds YFYS test is constraining ESG activities

The performance test has been found to have a constraining impact on the ESG, sustainability and carbon transition activities of super funds.

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Jon Bragg

Jon Bragg

Jon Bragg is a journalist for Momentum Media's Investor Daily, nestegg and ifa. He enjoys writing about a wide variety of financial topics and issues and exploring the many implications they have on all aspects of life.

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