Super funds have slashed their active risk budgets in response to the YFYS performance test and the challenging market environment. This means funds have to be smarter about their remaining budget and avoid uncompensated risks, Northern Trust Asset Management’s Scott Bennett says.
The Your Future, Your Super (YFYS) performance test has caused superannuation funds to slash their active risk levels, in some cases by almost half, according to Northern Trust Asset Management.
But as funds reduce their active risk budget, it becomes even more important that investors make sure they get compensated for the risks they take in all market environments and avoid having high levels of noise in their equity portfolios, Scott Bennett, Head of Quantitative Investment Solutions for Australasia at Northern Trust Asset Management, says.
At a 150 basis points tracking error, there is a relatively high likelihood that you fail the YFYS test hurdle of 50 basis points over that rolling eight-year period
“If you look at the average active risk levels at most superannuation funds, they generally come to about 150 basis points across the equity program, at least,” Bennett says in an interview with [i3] Insights.
“At a 150 basis points tracking error, there is a relatively high likelihood that you fail the YFYS test hurdle of 50 basis points over that rolling eight-year period.
“So to be compliant with the YFYS framework, you would have to adjust your active risk levels well and truly below 50 basis points. Now, I don’t think anyone’s going to go to that extent, but we are seeing an increase in the use of passive investments to drive down tracking error.
“So what was effectively 150 basis points of expected tracking error on the overall equity component, and even realised tracking error, that has really come down to a point where a lot of investors are looking at sub 100 basis points tracking error across the entire equity book.”
Yet, Bennett still sees a lot of uncompensated risks in investors’ portfolios, especially relating to sector and location exposures. Although most funds have a good grasp on managing style biases, they tend to be less aware of sector skews, he says.
“In our most recent Risk Report, a four-year analysis of global institutional portfolios, we saw overwhelmingly that there was nearly two times more exposure to these unintended or uncompensated risks within the portfolio [than in the previous report],” he says.
“Those risks are primarily things such as sector risks and geographical or country-related risks.”
Often a sector or country skew exists because the asset owner is targeting certain style factors, including quality, value or momentum exposures. But as they target these factors, other biases are introduced to the portfolio.
“In pursuit of bringing these factors into the portfolio, investors may take on large exposures to energy, for example, or a big bias away from the US in favour of Europe. When we look at these risks through time, they don’t necessarily contribute to the overall long-term return expectations at the total portfolio level,” Bennett says.
“When you bring in that active risk budget, it is important that investors understand the risk they are taking and that they focus on the compensated risks within the portfolio.
“Because those uncompensated risks may impact your ability to meet the Your Future, Your Super test.”
Investors can ask their external managers to revise their tracking error targets, but this has proven to be somewhat challenging because there are cycles in active management where one style under or outperforms.
Many growth managers have underperformed over the past 12 months to 31 March 2022. But when we look at the performance of value managers, then they actually haven't outperformed by the same amount as the growth managers have underperformed. So if you are very reliant on style diversification, then there are periods where that can potentially fail
“We have seen this specifically in global equities of late, where we saw a very large sell-off in growth stocks throughout the past 12 months as interest rates were rising. Based on our analysis, many growth managers have underperformed over the past 12 months to 31 March 2022,” Bennett says.
“But when we look at the performance of value managers, then they actually haven’t outperformed by the same amount as the growth managers have underperformed. So if you are very reliant on style diversification, then there are periods where that [diversification] can potentially fail.”
As investors face a heady brew of increased competition from other super funds, meeting Consumer Price Index-plus objectives in a high inflation environment and subdued growth, going passive is certainly not without its risks either.
Bennett makes the case for adding enhanced strategies with a higher information ratio than pure passive approaches, but that don’t have the high tracking error of fully active strategies.
He sees an increasing demand for running completion portfolios of enhanced strategies that correct any outsized tilts resulting from high-conviction strategies elsewhere in the portfolio.
“What we’re seeing from investors is a desire to have much more robust controls over the level of tracking error that they are taking within their strategies. Quantitative-based solutions can be much more specific in targeting that tracking error and also much more specific in targeting those macro risks that can go largely unnoticed in traditional portfolio constructs,” he says.
“For example, we manage an Australian equities portfolio for a local superannuation client which is effectively a dynamic portfolio that responds to changes stemming from the underlying active managers they use.
“This portfolio makes sure that their active risk levels, factor and sector exposures are managed within certain tolerances at the total fund level, while still allowing the underlying active managers to pursue those high-conviction ideas.”
An added complexity to the demands facing investors is the move towards more environmentally and socially sustainable investment strategies. Although arguably this will protect members from disasters in the long term, it will, again, add to tracking error in the short term.
Bennett, therefore, argues that it doesn’t make sense to wield blunt divestment tools and cut out exposure to vast areas of the energy, materials and utilities sectors, which he collectively refers to as the EMU sectors.
Instead, investors are better off dissecting these sectors and taking higher exposures to those companies that are better in navigating the transition to a cleaner and more socially responsible economy.
It is important to be forward-looking and identify those companies that are delivering solutions for tomorrow and not just avoiding the risk but actually trying to position the portfolio for those opportunities. Those companies may have relatively high emissions today, but they are on a pathway to reducing those emissions aggressively going forward
“We think it is very important that, as we manage the transition away from fossil fuels, deal with water scarcity and increase renewable energy, that we don’t take such a blunt approach as simply excluding particular sectors or companies,” Bennett says.
“We believe there are multiple levers that you can pull to improve the overall sustainability. For example, take energy, materials and utilities, while on average they generate very high levels of carbon, there is quite a significant range of carbon intensity within each of those sectors.
“You can actually identify leaders in that space that are much more progressive and find those best-in-class providers that are driving the change and providing the solutions for tomorrow. That means you can still maintain your exposure to that EMU conglomerate relatively tightly.
“It is important to be forward-looking and identify those companies that are delivering solutions for tomorrow and not just avoiding the risk but actually trying to position the portfolio for those opportunities.
“Those companies may have relatively high emissions today, but they are on a pathway to reducing those emissions aggressively going forward.”
This article is sponsored by Northern Trust Asset Management. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[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.