If You Can’t Stand the Heat…

The publication of the Australian Prudential Regulation Authority (APRA) heatmap was always going to be a controversial exercise.

After all, I can’t think of a single other regulator around the world that produces something similar. It is usually the domain of consumer advocacy groups.

But APRA has a clear agenda: to weed out small and inefficient funds. And for this purpose, the heatmap provides an interesting view into the mind of the prudential regulator.

A quick analysis of the results over a five-year period shows some of Australia’s largest funds do well on a risk-adjusted basis. Unisuper, Cbus and AustralianSuper are all among the best performers against their simple and listed reference portfolios.

No surprise there.

Where it gets tricky is at the bottom end of the scale. We find several bank products and other retail funds, but one fund stands out: Maritime Super.

It is expensive with a fee as high as 2.3 per cent on a $10,000 balance.

Its performance against the simple reference portfolio – think of the reference portfolio as a bunch of cheap exchange-traded funds without any thought as to how the portfolio can be best constructed – is the lowest of all.

But asset consultant Frontier Advisors says this is where the problems with the heatmap start.

Frontier doesn’t discuss the case of Maritime Super specifically, but points to the fact APRA’s approach is based on returns, while many funds would be more sensitive to the overall risks in a portfolio.

In a paper on the new heatmap, the asset consultant comments:

“MySuper portfolios will typically be more diversified than the Listed SAA benchmark. As a result, they will be lower risk on risk measures such as drawdown magnitude, risk of a negative return and volatility.

“We think that many MySuper strategies will be biased to underperforming the benchmark portfolio outcome in strong market environments, but more likely to outperform in difficult periods and over the longer term.

“This is clearly an issue as it could encourage more risk taking in order to beat the benchmark portfolio, which is a distraction from focusing on member outcomes.”

Maritime Super has said as much in defence of itself, pointing out its membership base is much older than the average fund and they simply can’t afford to lose much of their balance.

If Maritime Super wanted to score better in the heatmap it could do two things: one, add high-growth, risky assets and simply focus on outperforming the reference portfolio, or two, add in more defensive assets so that its new reference portfolio becomes easier to outperform.

Neither option is particularly beneficial to members. Adding more government bonds to the mix at a time when yields are ridiculously low and volatility is high could be seen as a high-risk strategy in itself, even though the asset allocation would classify it as a conservative measure.

The idea that adding bonds to a portfolio will always reduce risk ignores the reality of investment markets.

Instead, adding assets that are classified as growth, but are at the lower risk end of that particular category, could make more sense at certain points in the cycle.

This nuance is lost in the heatmap.

There are other criticisms, many of them covered in an article by David Hartley.

Despite all of this, the heatmap also gives a fascinating overview of the industry and the regulator’s thinking.

For example, the heatmap sends out a clear signal in terms of what the regulator regards as reasonable fees.

Based on the colours in the APRA heatmap, the regulator believes a total fee on a portfolio of $50,000 should not exceed 1.15 per cent. Admin fees should not exceed 0.35 per cent.

You can deduce from this that the investment management fees should not exceed 80 basis points, a number that is more or less in line with the original Deloitte report that formed the basis of MySuper cost discussions during the Cooper review.

At the time, Deloitte estimated a fair cost for running a balanced portfolio including alternatives and active management would come down to about 89 basis points for a super fund with assets of $5 billion and 77 basis points for funds with $10 billion in assets under management.

The regulator’s use of the reference portfolio method is also not necessarily problematic in itself.

Several funds, including New Zealand Super, have done very well under this approach and without taking undue risk.

But there does seem to be room for tightening up the metrics as to what makes an asset defensive or not, especially where unlisted assets are concerned.

Arguably, the regulator has put a relatively high hurdle in place for investing in unlisted assets, while many institutional investors believe that in the current environment these assets have good defensive qualities.

We asked APRA if it is concerned the publication of the heatmap will have unintended consequences as some funds might adjust their investment approach based on these new benchmarks rather than on appropriate outcomes for members.

In response, an APRA spokesperson told us:

“APRA has considered carefully the risks associated with the heatmap publication. APRA’s investment risk specialists, in conjunction with supervisors, will continue to apply careful scrutiny to changes in investment strategy and asset allocation to ensure they remain appropriate to achieving the investment objectives of the option, in accordance with Prudential Standard SPS 530 Investment Governance.”

In many ways, this is only the start of the dialogue between the industry and the regulator and I for one will be keenly looking out for the publication of the next heatmap.

Wouter Klijn, 19 December 2019

__________

[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.