Performance Test – more questions as well as answers

A Better Year

Unlike the inaugural Performance Test, APRA has not yet published specific metrics on a fund-by-fund basis. We anticipate that this will be provided later in the year as part of the APRA Heatmaps, at which point we will be able to draw more concrete conclusions on outcomes of the Performance Test. On face value, performance from the MySuper universe has improved over the last 12 months, with 5 failing products in 2022 as compared with the 13 that failed the inaugural test. There are likely several reasons behind the improvement:

1. FY2022 has been a strong year for performance versus composite benchmarks used in the YFYS performance test. Key examples include fixed interest (particularly short duration tilts, which materially outperformed full duration exposures), alternatives (many alternative strategies have delivered positive absolute returns and therefore significantly outperformed the equity/bond composite benchmark) and private equity (which we discuss further shortly).
2. The industry is now acutely aware of the importance of high-quality reporting to APRA. There was previously some issues with the accuracy of reporting of particular asset allocation information to APRA that resulted in unrewarded tracking error risk versus the Performance Test. Many of these inaccuracies have been corrected over the year and Superannuation funds have significantly improved internal processes around APRA reporting.
3. Several failing funds have merged over the past 12 months.

We believe private equity exposures have been a particularly strong contributor to improving Performance Test outcomes. The valuation methodology for private equity means in many cases these exposures haven’t experienced the same volatility experienced by the (listed) equity benchmarks. Clearly this worked in the favour of the industry in FY2022, but the reverse occurring (the listed market rallying into the end of a financial year) presents a material risk. There is a regulatory focus on unlisted asset valuations at present, particularly from APRA’s review of SPS530, SPG530 and SPG531. This may extend to the Performance Test, for example through the addition of a more suitable benchmark for the private equity asset class, which we would welcome.

Lower administration fees also contributed to better returns

An additional but important trend we have noted over the year is a significant reduction in administration fees. In 2021 the median RAFE (i.e. tax adjusted administration fee) for the MySuper universe was approximately 0.33%. The Performance Test has created a strong incentive to reduce administration fees given the differential between the RAFE for a product and the median for the universe over the last 12 months only is applied to the entire 8-year p.a. metric. JANA estimates that the median RAFE has fallen to around 0.27% over the past 12 months, which APRA will see as a success. We believe the pace of the reduction will slow from this point on and will be driven by economies of scale from merger activity rather than Performance Test driven.

Unintended consequences in the spotlight

Since the ‘Your Future, Your Super’ policy was first announced in October 2020, there have been several criticisms of the Performance Test. FY2022 results draw our attention to two of the challenges JANA has previously raised.

Firstly, we have noted the time horizon for the Performance Test does not necessarily correspond to a full market cycle and hence represents an unfair assessment horizon for performance. We note that some products that failed the test by a sizable margin in 2021 have passed in 2022. There is a risk that members will have switched out of those products over the 12 months and hence not benefitted from the performance rebound.

Somewhat related to this, the second challenge we have highlighted is the potential for funds to take less tracking error risk. We believe the reduction of tracking error risk is a rational decision for those managing a product that is close to the pass/fail hurdle given the implications of failing the Performance Test. Just as an individual member may see worse investment outcomes by switching out of an underperforming product and thereby missing a recovery in performance, funds may close out active positions to reduce tracking error and thereby miss out on the market recovery in those active positions. The decision to close out a short duration tilt in fixed interest or a value tilt in equities would have been very costly to returns over FY2022.

Where to from here?

One of the earliest decisions from Stephen Jones MP was to announce a review that will consider the unintended consequences of the ‘Your Future, Your Super’ policy and whether changes are required. We expect the above challenges will be raised by the industry during this consultation and make it more likely we will see changes to the 2023 Performance Test.

The industry has spent a significant amount of time understanding the Performance Test and, barring a disastrous period for alpha, we don’t expect to see a trend of increasing products failing. Our observation is many investment teams are considering the implementation of trigger mechanisms that if breached, would be the catalyst for some course of action. For example, one such trigger might be the reduction in administration fee or tracking error by a specified amount should the cumulative probability of failing the Performance Test over the next (say) 5 years rise above a certain level. JANA has spent significant time developing our modelling capability to assist with this decision-making process and would be happy to discuss further.