Active managers face headwind in Oz test

The challenges facing Australian superannuation funds in pursuing the best possible retirement outcomes for participants while passing a new performance test the government introduced last year are proving a headwind for managers of contrarian, high-active-share equity strategies.

The annual performance test, a centerpiece of the Your Future, Your Super reforms passed by Australia's Parliament in 2021, imposes severe penalties on funds whose annualized investment returns for their strategic asset allocations trail government-designated benchmarks by 50 basis points or more for a rolling eight-year period.

The test — focusing on performance relative to each fund's strategic asset allocation targets, as opposed to rewarding outcomes designed to produce the largest possible retirement pools for participants — has made tracking error a first-order consideration for super funds.

"The YFYS performance test is a new framing of what constitutes underperformance and a notable departure from the primary focus on long-term member return outcomes" linked to inflation-plus targets, said James Gunn, senior consultant on Melbourne- based investment consulting firm Frontier Advisors' equity research team.

Under the test, active management and allocations to higher tracking error are direct sources of regulatory risk, "particularly over short time periods," Mr. Gunn said.

With the reforms, "the landscape has shifted," agreed Annika Bradley, Brisbane-based director of manager research ratings for Asia-Pacific with Morningstar Inc. and previously an independent consultant advising super funds and wealth managers. The propensity of super funds to allocate to contrarian, high-active-share managers has diminished in an environment where benchmarks have gone from an afterthought to being front and center, she said.

To a large extent, the degree to which super funds will focus more on bench- mark-aware managers going forward will likely be determined by how close they came to failing that first performance test for the fiscal year ended June 30, 2021, analysts said.

Funds trailing their benchmarks by an annualized 50 basis points or more for that first test were obligated to inform their members of that fact and point them to super fund competitors with superior results. Funds that fail two years in a row will be restricted from taking in new members — a formula some industry veterans have described as a virtual death sentence, pressuring funds to merge their assets into bigger, better-performing funds.

"If you're right on the edge of failing," then yes, tracking error has become the No. 1 focus, "because it's sort of existential," said Jonathan Grigg, Melbourne-based director, investments, with consultant Willis Towers Watson PLC. By contrast, for funds comfortably ahead of that minimum performance hurdle, tracking error has become "more important but the urgency is not quite there," he said.

David Bell, executive director of the Conexus Institute, a Sydney-based research firm focused on Australian retirement outcomes, said while no definitive conclusions can be reached yet, anecdotal evidence points to funds in danger of failing the annual test reducing exposure to areas where the benchmarking process "creates noise," such as emerging market equities, which are benchmarked against a predominantly developed market index, while also reducing the overall degree of manager active risk.

But such benchmarking incongruities can offer opportunities as well as cautionary tales. For example, said Mr. Grigg, credit and high-yield bonds are measured against a global aggregate benchmark "so you can expect that to outperform over most eight-year periods," providing funds with a bit of a buffer, capable of offsetting underperformance elsewhere.

Of the 80 MySuper default, balanced super funds evaluated by the Australian Prudential Regulatory Authority for the industry's first performance test last year, 67 passed and 13 failed, with results ranging from annualized outperformance of 1.53 percentage points to underperformance of 1.28 percentage points.

Still, even at super funds that handily passed last year's test, some executives have grown more cautious about their manager lineups.

Bill Watson, CEO of Melbourne-basesd First Super, said his fund, while it cleared last year's first performance test with room to spare, has nonetheless lost its appetite for the kind of contrarian, high-tracking-error managers it retained in the past due to the heightened risks posed by tracking error going forward.

First Super posted last year's 11th best test results, besting its strategic asset allocation's benchmark results by an annualized 76 basis points. It has A$3.6 billion in assets.

Analysts say they see no signs yet of a dramatic move away from high-tracking-error managers or evidence that such managers are trying to reposition themselves as more benchmark-aware in order to sustain their business momentum in Australia.

Anecdotal examples, meanwhile, offer mixed signals at best, as is the case with Orbis Investments (U.K.) Ltd., a London-based manager with £26 billion ($31.8 billion) under management that's succeeded in building a multibillion-dollar book of business in Australia over the years with a battle cry of "There's value in being different."

With tracking error suddenly looking more like an existential threat than a building block of a long-term investment program, Orbis has lost a handful of clients during the fiscal year just ended June 30.

The firm's name has been dropped from the external manager lineups of:

• AustralianSuper, the A$261 billion Melbourne-based industry fund, which listed Orbis as managing A$5 billion in global equities for the fund as of June 30, 2021.
• CareSuper, the A$19 billion Melbourne-based fund, which listed Orbis as managing A$426 million in global equities as of June 30, 2021.
• TWUSUPER, the A$6.2 billion Melbourne-based fund, which listed Orbis as a manager as of June 30, 2021.

Among the three, AustralianSuper aced the performance test, beating the benchmark returns for its strategic asset allocation by an annualized 1.22 percentage points, while CareSuper exceed its benchmarks by an annualized 71 basis points. TWUSUPER, by contrast, passed the test with little room to spare, trailing its benchmark returns by an annualized 47 basis points.

Spokespeople at those three funds declined to discuss Orbis. A spokesman for Orbis likewise declined to comment.

But if tracking error were a factor in those terminations — Orbis' global equity strategy outperformed or trailed its benchmark by double-digits on three occasions between 2016 and 2021 — performance could have been an issue as well. The global equity strategy, after topping its benchmark by 13.14 percentage points in 2016 and 8.75 points in 2017 more recently lagged by 10.51 percentage points in 2018 and 12.24 points in 2021.

The fact that active, high-tracking-error managers often charge clients relatively high fees — an area of sustained regulatory scrutiny in Australia — could be compounding headaches for those managers now, said Morningstar's Ms. Bradley.

Willis Towers Watson's Mr. Grigg agreed: "When you look at it straight away and say, well, we need to get down tracking error and we need to get down fees, anything that's highly active and potentially costing you a lot is where people would naturally start (looking)."

At the end of the day, consultants say they see continued demand for highly active strategies going forward but it will be a more complex environment.

"YFYS does not in-and-of-itself exclude any particular strategy, but it does add an additional dimension to the portfolio construction process," with two risk management exercises now — optimizing the portfolio for long-term strategic risk/reward and for YFYS tracking error and excess return, noted Gwion Moore, Sydney-based head of investment strategy, Pacific, at Mercer LLC.

In that new environment, a contrarian, high-tracking-error manager needs to ask "how does my strategy ... impact strategic portfolio construction (and) how does it impact YFYS portfolio construction," Mr. Moore said. And finally, which super funds could make use of a strategy like that offered by Orbis for both of their optimization exercises, he asked. "I personally suspect most super schemes have YFYS risks that are pro-cyclical, which means that a contrarian strategy could be beneficial from both strategic and YFYS portfolio construction if sized appropriately," he said.

WTW's Mr. Grigg said his team is pushing clients to focus on overall tracking error, mixing and matching combinations of active strategies in a way that keeps risks at manageable levels as opposed to turning their backs on anything that comes with material tracking error.

In an equities portfolio, for example, there can be an individual manager with high tracking error but when integrated into a diversified portfolio of managers in the same asset class, "your overall tracking error comes down," Mr. Grigg said.

Frontier Advisors' Mr. Gunn likewise said asset owners willing to take a broader view of tracking error could continue to make use of contrarian, high-tracking-error managers, with a holistic approach to portfolio construction and long-term objectives, "rather than specifically ruling out higher-tracking error strategies upfront as viable strategies under the test."

The greater focus needs to be on "getting the configuration right for a broader range of objectives and understanding risk exposures, rather than a singular focus on reducing higher-tracking-error exposures," he said.

And with that broader view of tracking error, some market veterans say fixed-income segments such as credit could emerge as a winner.

Adam Kibble, investment director, fixed income and multiasset with Schroder Investment Management Australia Ltd., co-authored a paper in December contending super funds grappling with tracking-error concerns should focus more on fixed-income segments like credit, where relatively narrow benchmarks, vis-a-vis broader equity benchmarks, should facilitate outperformance for a given tracking error superior to other segments of the active management universe. So far, amid market volatility and a change of government in Australia which some say could portend tweaks to the new YFYS framework, there hasn't been a noticeable pickup in allocations to credit driven by tracking error considerations, but "when the dust settles and super funds have time to rethink how they allocate tracking error across different asset classes," fixed income could garner greater attention, he said.