New research from global implementation specialist Parametric has found that the government’s Your Future, Your Super (YFYS) reforms could impact the rapid adoption of ESG investing within the superannuation sector.
The firm, which is part of Morgan Stanley Investment Management, said that a moderate level of tracking error was a by-product of ESG investment approaches including screening and integration.
“It’s our view that super fund portfolio tracking error, a key driver of YFYS performance test outcomes, will face downward pressure as funds jockey to meet their new performance requirements,” said Parametric senior investment strategist for responsible investing, David Post.
While super funds can achieve desired ESG outcomes and manage active risks according to Parametric’s analysis, they may need to employ more sophisticated optimisation tools to find the right balance under YFYS.
As part of the reforms, the Australian Prudential Regulation Authority (APRA) conducts a performance test annually which compares each super product to an individual benchmark based on its asset allocation.
Products that underperform by 0.5 percentage points each year over an eight-year period are classified as underperforming and all products that fail the test are required to notify their members in writing.
Thirteen funds failed the inaugural performance test in August last year, while funds that fail for two years in a row are not allowed to accept new members until their net investment performance improves.
Trustee-directed products will also be assessed under APRA’s performance test in the future.
“The new rules have implications not only for MySuper products that incorporate ESG but also trustee directed products designated as ‘ESG Options’,” said Parametric analyst Josh Mckenzie.
“Given that around 40 per cent of total Australian assets under management are estimated to be managed according to ESG principles, the impact could be very significant.”
Parametric said it analysed approaches to two ESG practices, exclusionary screening and integration, “to determine whether meaningfully different portfolio ESG characteristics can be achieved at low levels of additional tracking error”.
The firm said that by using optimisation techniques, super funds can trade off active risk for responsible investment outcomes and achieve modest levels of predicted tracking error and still achieve meaningful ESG impact.
“Your Future, Your Super is not the end of the road for responsible investing, but super funds will benefit from the use of optimisation-based portfolio construction tools with a focus on navigating the performance test,” Mr Mckenzie said.
“What super funds will need are better and effective active risk controls.”
