Change is the only constant when it comes to the Performance Test

The next round of ‘Your Future, Your Super’ Performance Test assessments is fast approaching, with the next calculation period to the 30 June 2022. MySuper products will be tested for the second time whilst Trustee Directed Products (‘TDPs’), defined as multi-asset Choice products where the superfund Trustee controls the strategic asset allocation (SAA), will be assessed for the first time.

Since the policy was first announced by Josh Frydenberg in October 2020, the Performance Test has undergone several changes, most notably the addition of new benchmarks for unlisted asset classes and the change in time horizon for the comparison of a product’s administration fee (formally referred to as the ‘Representative Administration Fee and Expenses’ or RAFE) versus that of the median product from the universe from the full 8 years to the last 12 months.

JANA believes there’s likely significant change still to come that could have a material impact on a product’s Performance Test metric. We outline some of the most significant examples below, what it may mean for Performance Test outcomes, as well as our recommended course of action.

Impact of years rolling off the metric

One of the most significant drivers for potential change in fund Performance Test outcomes over the coming years is that from 2023 onwards, years will begin to ‘roll off’ the calculation period for the Performance Test metric (i.e. the Performance Test is conducted on a 8-year p.a. rolling basis). A lot of focus has been placed on the impact of performance from 1 July 2021 to 30 June 2022, most notably that the resurgence in the fortunes of value stocks will have benefitted many products, as will the recent rise in bond yields for products that have held a short duration fixed interest position. However, attention should also be given to years that will roll off the metric as a particularly strong or weak year rolling off could impact the upcoming metrics significantly.

Our analysis indicates that for many funds in the industry, FY2015 was a particularly strong year with the majority of the alpha generated in Q2 2015. There were multiple sources of alpha during this period but an underweight to Australian Equities during a sharp sell off for the asset class is likely the key driver. The implication here is that FY2015 will roll off the metric for the 2023 Performance Test and Funds should be aware that the hurdle may therefore increase. JANA has recently completed the development of a model that can analyse the pass/fail probabilities in future years that incorporates years rolling off and look forward to discussing this with clients over the coming weeks.

Methodology uncertainty

We believe that updates to the YFYS regulation will be required because of developments with APRA’s asset allocation reporting forms, which have led to some uncertainty about the methodology that will be used for the Performance Test this year and in future. For the 2021 Performance Test cycle, APRA based the assessment on asset allocation data collected through form SRF533. APRA has since released a new, more detailed asset allocation reporting form, SRF550 and has confirmed that information provided as part of SRF550 will be used to conduct the test for Trustee Directed Products. APRA has not confirmed whether the strategic asset allocation data used for the calculation of the Performance Test for MySuper products for the June 2022 assessment will be drawn from reporting under the SRF533 or SRF550 form.

The challenge is that the information collected as part of the new SRF550 reporting forms is significantly more complex, and the current YFYS regulations do not articulate how the additional information collected will impact the Performance Test calculation. Two key areas where a change to the new reporting form could impact outcomes, and where APRA will need to provide further clarity are outlined below:

• Currency hedging: For the SRF533 form, a currency hedge ratio could be specified for each asset class. For international equities, the hedge ratio provided drives the proportion of hedged and unhedged international equity benchmarks. With SRF550, funds can still specify currency hedging ratios for each asset class or, if the foreign currency exposure for a product is set at the total portfolio rather than asset class level, the fund can instead specify a portfolio level foreign currency exposure.

There is currently no regulatory clarity on how this information will impact the Performance Test methodology. This will have most importance for funds’ that hedge at the portfolio level, and where foreign currency exposure is higher than the strategic asset allocation to international equities.

• Granularity of SAA information: One of the major differences between SRF533 and SRF550 is that the latter requires two sets of strategic asset allocation information to be provided, labelled the ‘strategic sector’ and the ‘strategic subsector’. These provide different levels of granularity. APRA define the former as SAAs agreed by the Board and the latter as those agreed by a Board delegate, such as the CIO. The uncertainty here stems from the fact that the current YFYS regulation was released prior to SRS550 being released and there is currently no clarity on what granularity of SAA information will be used in the Performance Test.

It is important to be aware that whilst there are a range of Performance Test methodology uncertainties stemming from SRF550, the quantum of the impacts will likely vary significantly. For example, in sensitivity analysis undertaken by JANA, we estimate the impact of APRA/Treasury’s decision regarding the methodology for currency hedging will be reasonably modest in most cases. However, the decision on whether to use strategic sector or subsector information will be significant and could easily be the difference between a pass or a failure.

JANA considers it unlikely that there will be any key trends in impact on Performance Test metrics that result from a regulator clarifying the methodology for a particular area of uncertainty. For example, APRA confirming that strategic sector level information will be used will likely benefit some products but hamper others.

Other areas of regulatory uncertainty

The methodology uncertainties described above are challenging enough but there are a range of additional Performance Test uncertainties. We discuss some of these below:

• Benchmark uncertainty: We believe the decision to introduce unlisted property and infrastructure benchmarks in 2021 improved the test considerably. Our understanding is that policymakers are considering the introduction of additional benchmarks. This may be driven by the larger number of asset class categories in SRS550.

Whilst we believe the test could be improved further with new benchmarks (particularly the replacement of the 50% equity/50% bond benchmark for the ‘other’ asset class), retrospectively modifying a benchmark could change a Performance Test metric considerably.The direction of the change will of course depend on the change in benchmark. For example, the introduction of a credit benchmark would almost certainly hamper outcomes for the majority of products given credit exposures are currently benchmarked against fixed interest benchmarks for the purpose of the Performance Test, and typical credit portfolios have outperformed fixed interest over the past eight years. On the other hand, we expect that a change to the ‘other’ benchmark is likely to improve outcomes for most products. Potential alternative benchmarks could include a hedge fund index, such as those produced by HFRI or benchmark that assumes a certain level of return in excess of cash.

• RAFE uncertainty for TDPs: Information regarding RAFEs for the MySuper universe has been publicly available for some time via the APRA Quarterly MySuper Statistics data release. This allows for analysis on how the median RAFE is trending over time, albeit with a little bit of uncertainty given the aforementioned change in time horizon for the RAFE assessment has incentivised funds to reduce their RAFE. However, there is currently no publicly available information on RAFEs for TDPs which makes similar analysis impossible. Furthermore, the fact that funds were required to self-nominate the products they believed fit the description of a TDP means there is no one source for the Choice products that will be assessed.

A recent APRA Information Paper¹ showed the distribution of administration fees for Choice products, but even this is of limited assistance because we don’t know what proportion of these are TDPs, and the value of the account balance used to calculate the RAFE. APRA do plan to release this information in the near term but until this occurs, the distribution of potential median TDP RAFEs is large.

• Products in scope: JANA has been very vocal that one of the key drawbacks of the Performance Test is that the current benchmarks hamper products with an ESG/sustainability focus. This is particularly problematic in the TDP space given investors will have made a deliberate choice to hold such a product and hence there are strong arguments against penalising these products if they underperform benchmarks that have not been adjusted for the investment universe. Last year saw senior level APRA personnel make comments about the benefits of excluding such products but to date no action has been undertaken.

What we think funds should do now

It isn’t an exaggeration to say that the above makes it almost impossible to estimate an exact Performance Test metric with much confidence, particularly for TDPs. This will be of little comfort to fund stakeholders given the implications of failing the test. However, there are still sensible steps that can be undertaken in advance of regulatory clarity:

• Regulator engagement: Our view is that funds should be engaging with regulators to seek clarity on the above issues as a matter of urgency. The consequences of failure mean that the Performance Test will be a constraint for the majority of products that will need to be integrated into the investment process. However, the volume of areas where clarity is outstanding makes this very challenging and it is reasonable for funds to be asking for regulatory clarity as soon as possible.
• Modelling governance: It is almost certain that we will see a regulatory update between now and August that clarifies at least some of the uncertainty regarding the Performance Test methodology and benchmarks. We believe an important step funds should be working on now is ensuring the governance processes are in place that will allow models to be quickly updated (and, importantly, tested) when changes are announced. For example, in a scenario where HFRI indices are announced as the replacement for the 50% equity/50% bond benchmark, a well-designed Performance Test replication model would be easily able to integrate this.
• Conduct sensitivity analysis to determine products that will be a clear fail or pass. For example, analysis may show that a certain product will likely be a fail no matter how policymakers specify the methodology. For these products, a decision on the appropriate course of action can be made today, for example to modify the active management parameters, reduce fees, close the product, etc.
• Plan for how products that have been identified as being at high risk of failing the test will be dealt with. Funds will be able to undertake sensitivity analysis to determine key products that may fail the test. Key products may include MySuper products, products with a significant volume of FUM, etc.JANA cautions against taking significant action for a product that will likely be close to the pass/fail hurdle, such as closing the product, before the final methodology is specified. However, for these products, the sensitivity analysis may help guide decisionmakers regarding the most appropriate course of action. For example, if the metric is expected to be close to the hurdle under various possible methodologies, a sensible decision today may be to reduce the tracking error.There will likely be some products where the decision around methodology will have a significant impact on the metric. In this case it will be challenging to identify a suitable course of action today but undertaking analysis now can ensure the fund has clarity regarding which products are in this position and a plan can be drafted for how these products are dealt with when regulatory clarity is provided.

Takeaways

The regulatory uncertainty coupled with the impending Performance Test calculation is a challenging environment to operate a product and we hope for a smoother process in subsequent years. As noted above, we caution against undertaking significant action in the short term and instead using the time to plan for when regulatory clarity is provided. JANA has been significantly uplifting our quantitative capabilities to assist and we look forward to discussing in the near future.

¹https://www.apra.gov.au/sites/default/files/2021-10/Choice%20sector%20performance%20-%20improving%20outcomes%20for%20superannuation%20members.pdf