The introduction of the YFYS performance test and subsequent move by super funds towards more passive strategies has put these funds in the difficult position where they are less able to protect members from large market draw downs, Bellmont’s Michael Block says
The introduction of the ‘Your Future, Your Super’ (YFYS) legislation has pushed superannuation funds to become more passive in their investment strategies as any significant tracking error against the performance assessment benchmark can have dire consequences for the fund.
An unintended consequence of YFYS is that funds have relatively few tools to reduce portfolio volatility or protect members from market dislocations, according to Michael Block, Chief Investment Officer of Bellmont Securities.
“Because of the existential threat that YFYS poses, a super fund spends vast amounts of its time making sure that it does not fail the YFYS test. And in order to do that, every good strategist would say that there’s a limited tracking error away from the benchmark that a fund should take and this is considerably less than what is optimal in the current climate,” he says.
“The bottom line is, now that everybody knows what’s in YFYS, as opposed to when it was introduced, no one will ever fail again. But it does mean that there will be many more lower-risk, index-hugging style investments, which is not a great idea at the moment.
“I can’t guarantee that active managers will win, but I can guarantee that passive managers will always underperform the index. So if you want a shot at doing something different or protecting members when equities fall, you have some active management,” he says.
Now that everybody knows what's in YFYS, as opposed to when it was introduced, no one will ever fail again. But it does mean that there will be many more lower risk, index-hugging style investments, which is not a great idea at the moment
If investors are to face a future of lower returns and a more volatile market environment, then generating excess returns will have a more meaningful impact on the returns delivered to members.
Block illustrates how much more important alpha is in a low-return environment.
“If a passive portfolio makes 9 per cent and with active management you lift it to 10 per cent, then nobody really cares that much. The alpha is only 10 per cent of the total return.
“But if we enter a world where there are low returns, let’s say 3 per cent, and you can turn 3 into 4 per cent, then that alpha is now 25 per cent of total return.
“So in a world where everything’s turning passive, at least in an institutional sense, I can see very good reasons to do the opposite. And guess what? Non-YFYS-regulated super funds and wealth managers have so many more degrees of freedom available to them, like utilising portfolio insurance, more active management, smart beta and many alternatives just to name a few.
“I believe that wealth management clients will be willing to pay for more active management, if they get enhanced returns and risk controls, hence I have made the move away from super.
“Don’t get me wrong, there are still some constraints in the wealth space such as less economies of scale and more complexities in managing portfolios because of the need to use platforms.
“Contrast this to super, where at this point in time, funds are not doing enough to protect members from major dislocations,” he says.
Making Big Calls
Block has held a number of CIO roles, including CIO of Australian Catholic Superannuation. At this fund, Block and his team implemented a dynamic asset allocation framework to protect the fund’s largely older member base against sharp drawdowns.
“When interest rates got to less than 1 per cent for 10-year bonds in Australia, I divested all bonds. Not some. All,” he says.
“And obviously it’s turned out to be a wonderful thing, with interest rates rising to 4.5 per cent. But why didn’t every super fund do that? Please tell me why you’d be prepared to lock your money up for 10 years at less than 1 per cent?
“Sounds like return-free risk to me!”
Earlier in his career, he made another significant call when the Australian dollar fell below US$0.60. It has happened only a few times in history that the domestic currency has traded below this threshold and Block considered the probability of it mean-reverting to a much higher level.
“When the Australian dollar got to US$0.52 in 2003, I fully hedged my international equities. The Australian dollar rose to about 80 cents, which meant I had 40 per cent outperformance over many of my international equity peers,” he says.
“If you make 40 per cent outperformance in one year, you can lock it in and still have 3 or 4 per cent outperformance for more than a decade. That is more alpha than some managers make in a lifetime” he says.
But instead of making these calls, most super funds are afraid to deviate from the benchmarks too much and for good reason. If they fail the YFYS performance test once, they have to write to members about their poor performance, risking an exodus of members. But if they fail twice they are closed to new members.
To avoid failing the test, many funds refrain from making big calls and instead focus on minor tilts in the strategic asset allocation to eke out additional returns compared to peers.
Do you know why private credit is pretty much the only game in town? It's because the benchmark under the YFYS performance assessment for private credit is the investment grade benchmark, which you beat easily
“You can change your asset allocation and it can have little or no effect on your YFYS benchmark because the benchmark moves as you change your asset allocation,” he says.
“So why do funds spend so much time and money on stock selection and so little time on dynamic asset allocation?” he says
It is one of the reasons why private credit strategies have proven very popular among Australian super funds in recent years. Under the benchmarks used in the YFYS performance test, private credit, is measured against the Bloomberg Global Aggregate Corporate Index.
This index includes only investment-grade-rated instruments, using the middle rating of rating agencies Moody’s, S&P and Fitch. But private credit is usually unrated and often includes instruments below investment grade, which offer a higher yield to compensate for the higher risk taken.
“Do you know why private credit is pretty much the only game in town? It’s because the benchmark under the YFYS performance assessment for private credit is the investment grade benchmark, which you beat easily,” he says.
“You’ve got around a 90 per cent chance of private credit beating a Barclays Global Agg Index and beating it by a long way,” Block says. “So, if your private credit strategy returns 15 per cent and the index makes 5 per cent and you allocate 10 per cent of the portfolio to private credit, you’ve now just beaten the YFYS benchmark by 1 per cent per annum,” he says.
Volatility Ahead
There are many market participants who expect market conditions to become more volatile and result in lower average returns going forward. Active management in this environment is important, not only because alpha becomes a larger part of total returns, but also because it allows managers to reduce risk and navigate any future dislocations.
“In today’s environment, you would do well to increase the amount of active management in your portfolio,” Block says.
“Unfortunately, the risk is if you do that in a YFYS regime and you even get a tiny bit wrong, for example, you just put a tiny little bit too much emerging markets or value stocks in your international equity portfolio, they shut down your fund,” he says.
David Hartley, one of my mentors and who's a very clever man, always said the ultimate aim is to get down to a cohort of one... You don't have to put everyone in a mass-customised product
At Bellmont Securities, Block is responsible for the asset allocation and construction of the firm’s model portfolios, including a series of highly customised portfolios for select financial planner groups. He sees plenty of room for active management and risk-minimising strategies to protect clients from sharp declines in their portfolios.
It also helps Bellmont works in partnership with financial planners, who, in contrast to many super funds, often have a wealth of data about their clients’ circumstances. They know what assets they might have outside of super, what assets their spouses hold and any savings they might have. It helps in customising their portfolios to align with clients’ objectives.
Ultimately, you want to get to a point where an investment portfolio is tailored to the individual, rather than take an off-the-shelf product, Block says.
“David Hartley, one of my mentors and who’s a very clever man, always said the ultimate aim is to get down to a cohort of one. And, you know, that’s what bespoke can do. You don’t have to put everyone in a mass-customised product,” he says.
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