YFYS causes ESG tracking error

The Your Future, Your Super (YFYS) reforms presents a challenge to the rapid adoption of environmental, social and governance (ESG) investing in the Australian superannuation sector, according to research.

Global implementation specialist Parametric, part of Morgan Stanley Investment Management, said a moderate level of tracking error was a by-product of ESG investment approaches, such as screening and integration.

David Post, senior investment strategist, responsible investing at Parametric said: “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”.

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Post said Parametric’s analysis indicated funds could achieve desired ESG outcomes and manage active risk, but they may need to employ more sophisticated optimisation tools to find the right balance under the YFYS regime.

Under the YFYS performance test, each year the Australian Prudential Regulation Authority (APRA) would construct an individual benchmark for every product based on the product’s asset allocation. Each product will then be compared against its benchmark.

Products that underperform their net investment return benchmark by 0.5 percentage points per year over an eight-year period would be classified as underperforming.

Trustees whose products fail the test would be required to notify members in writing. Products that fail the test two years in a row would not be permitted to accept new members until their net investment performance improves.

APRA released the first MySuper performance tests results in August, with 13 products representing $56 billion of assets failing. Next year, APRA would start including trustee directed products in the testing regime.

Josh Mckenzie, analyst at Parametric, said: “The new rules have implications not only for MySuper products that incorporate ESG but also trustee directed products designated as ‘ESG Options’.

“Given that around 40% of total Australian assets under management are estimated to be managed according to ESG principles, the impact could be very significant.”

Parametric analysed approaches to two popular ESG practices, exclusionary screening and integration, to determine whether meaningfully different portfolio ESG characteristics can be achieved at low levels of additional tracking error.

Screening is used to exclude companies with undesired activities from a portfolio. Integration refers to a quantitative portfolio construction process that uses company-level ESG characteristics, such as emissions intensity, to be considered alongside other risk characteristics such as sector, country, or fundamental style factors.

The research found that by using optimisation techniques funds could trade off active risk for responsible investment outcomes and achieve modest levels of predicted tracking error and still achieve meaningful ESG impact.

Mckenzie said: “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. What super funds will need are better and effective active risk controls.”

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