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Overabundance of objectives?

Neil Maines discusses the trade-offs required when balancing investment objectives.

18th March 2021 / 6 mins read
Neil Maines
Consultant
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The importance of superannuation to society means superfunds are rightly assessed against rigorous investment objectives. Focus has traditionally been on investment returns versus a CPI-based target and versus peer products with similar exposures to ‘growth’ assets, with the Standard Risk Measure (SRM) the dominant risk objective. These objectives are typically codified in the Product Disclosure Statement (PDS).

However, policy developments over the last decade, and specifically in more recent years have spawned an increasing number of considerations and new “objectives” (which we’ll refer to as secondary objectives) that also need to be balanced against more traditional objectives.  

The introduction of ‘Superannuation Prudential Standard SPS515 – Strategic Planning and Member Outcomes’ has driven a welcome focus on retirement adequacy-based investment objectives, which in short mean greater consideration regarding the expected, and range of projected retirement incomes for various cohorts of a fund’s membership. The APRA “heatmaps” followed SPS515, which bring together a range of metrics that attempt to highlight how well a fund is promoting high quality outcomes for the membership. Amongst other things, the heatmaps seek to highlight funds with higher costs and/or weaker performance and therefore act as a further constraint to incorporate into the objective setting process. If that wasn’t enough, more recently, the Performance Test component of the Treasury ‘Your Future, Your Super’ proposals will add a listed index-based benchmark lens against which funds are assessed, where failure to pass the test will result in Trustees being unable to accept new members.

So where does this leave us? 

For the discussion that follows, let’s go back a step. A reasonable place to start for portfolio design is as follows:

  1. A portfolio should aim to meet the beneficiaries’ return and risk requirements over a specific time horizon (i.e. per the Product Disclosure Statement) with reasonable chance of success (e.g. ~70% chance of achieving return target); 
  2. Client-specific beliefs, circumstances, constraints and competitive advantages influence the approaches to portfolio execution.
  3. Over time, because markets are not stationary, a combination of structural and cyclical forces impact on investment strategy and execution as the market throws up opportunities and risks that need to be considered and managed.  

Constraints are important considerations since these impact on the choices / trade-offs for portfolio construction. Examples include: 

  • Liquidity requirements; 
  • Time horizon;
  • Sensitivity to risk;
  • Sensitivity to sequencing risk (e.g. demands on benefits in years of negative returns);
  • Fee budgets / sensitivities.

As we’ve noted above, we now have a suite of secondary objectives gaining increased focus:

  • Peer relative performance;
  • Heatmap performance and fee assessments;
  • Your Future Your Super Performance Test reference portfolios. 

Too many masters?

Understandably, members want the best possible returns, product choices, access to services at a competitive cost. Trustees want the same for members, but also want to maintain strong rankings in peer ranking tables, have good results in the APRA Heatmaps and pass the Your Future Your Super performance test. All of this has to be achieved whilst navigating markets and managing constraints. 

Unsurprisingly, all of the above is not necessarily compatible. A simple yet very topical example is the construction of the defensive component of a portfolio. Historically, bonds and cash have provided the requisite defensive characteristics, namely portfolio diversification and downside protection (during equity market weakness). The record low yields on bonds and cash calls into question the downside protection characteristics provided by these asset classes going forward. One of the strategies being considered by many investment teams is to tilt toward defensive areas within different asset classes, such as equity managers that adopt a ‘quality’ bias or allocations to “core” unlisted assets. These strategies would likely assist with meeting CPI+ and SRM targets but could significantly hamper performance versus the YFYS Performance Test given the benchmarks used are broad market indices that don’t incorporate the lower risk of ‘quality’ equities. These tensions are very important given the implications of failing the Performance Test are business critical.

Below we outline a simple framework that superfund decision-makers can use to effectively navigate these challenges. The number of objectives against which superfunds are assessed and the number of constraints faced means there will likely be trade-offs required, but the framework will help to quantify and help decision-makers make these trade-offs and also help ensure all areas of the superfund are aligned on where priorities lie. 

A Simple Framework

SPS515 mandates a superfund undertake a Board approved strategic objective setting exercise on an annual basis. The objectives agreed will cover all areas in which the superfund operates and must have clear links to the provision of high-quality outcomes for members. Setting investment objectives logically fits into this process and we believe could be undertaken concurrently. We believe a range of superfund stakeholders should be involved in the investment objective setting process including representatives from the Board, management, and the Investment Committee. This group of decision-makers could undertake the following steps.

  • Step 1: List and agree an ‘order of priority’ for the range of different investment objectives and constraints.  The objectives stated in the PDS (typically a CPI+ and SRM objective) will likely be at the top of the list but stakeholders may have different views for the others, for example, should being a bottom quartile fund for costs be prioritised above outperforming peers? 
  • Step 2: Once the order of priority has been agreed, tolerance for probability and magnitude of underperformance can be discussed and quantified, for example, agreement might be made to limit the probability of underperforming the CPI+ objective to 20%, and cap underperformance to 1% in 95% of scenarios. 
  • Step 3: Once the above has been agreed, a range of high-level asset allocations can be tested to try and fit the agreed criteria. The trade-offs between objectives can be tested as part of this step, for example a slight reduction in probability of meeting a CPI+ objective can be assessed against a higher probability of beating the ‘Your Future, Your Super’ Performance Test.
  • Step 4: Once objectives are agreed, they are cascaded to all relevant stakeholders within the business, in particular the investment team.

Involving decision-makers from across the business will ensure there is alignment and that everyone is ‘pulling in the same direction’, for example, internal investment teams will know the order of priority between outperforming the Performance Test and minimising the magnitude of a negative absolute return and can manage the investment portfolio accordingly.

The objectives agreed between funds will likely differ significantly because of differences in competitive advantages, management competitive positioning, previous success in meeting objectives, membership profile, etc, but a simple example output could look like the below:

Table

JANA Response

Whilst the above framework is simple in theory, putting it into practice can be challenging. A range of tools are needed to assess and quantify the trade-offs between conflicting investment objectives and constraints. JANA clients will be familiar with Solve; our stochastic modelling tool that is already being used to assess a number of investment objectives. 

JANA continues to innovate Solve to assist superfunds manage the more ‘recent’ secondary investment objectives. For example, as we covered in our September 2020 thought piece, we have developed a tool that can assess retirement adequacy of an investment product. This tool allows funds to define representative member cohorts and stochastically project the balance of the representative members through the accumulation and decumulation phase. Undertaking the projections stochastically is important because this allows for downside (rather than just the expected) outcomes to be considered. Our experience thus far is that this analysis has been primarily undertaken for accumulation products, but the framework can be easily adapted to post-retirement menu design in the future.

JANA is also in the process of developing Solve to incorporate the ability to undertake analysis on the probability of outperforming the ‘Your Future, Your Super’ Performance Test. As of the current date, the mechanics of the Performance Test (particularly the applicable asset class benchmarks against which a fund’s performance is compared) are still to be confirmed by APRA. JANA will provide more information on this topical area as more regulatory clarity is obtained.

Takeaways – No Easy Solution

The number of investment objectives coupled with the challenging market environment makes it highly unlikely that there exists a silver bullet asset allocation that will provide a satisfactory probability of meeting every investment objective. It is therefore all the more important for all decision-makers within a superfund to be aligned regarding the order of priority, and that this is cascaded down effectively to investment teams to ensure the portfolio is being managed accordingly.

Please contact your JANA consultant if you would like to discuss any of the tools to assist with objective setting further, or if the facilitation of an objective setting session would be of interest.

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