Chant West general manager Ian Fryer said that so far, the performance test has been applied only to MySuper products, which, overwhelmingly, have growth-style portfolios.  

“Already, we have seen the problems some funds have encountered when components of their portfolios have been measured against benchmarks that have slightly different characteristics,” Mr Fryer said. 

“This situation is likely to worsen when conservative choice products are subjected to the test. 

“We are living through a period of exceptionally low interest rates globally, and the overwhelming consensus is that interest rates are set to increase in the short to medium term. Given that outlook, funds have taken appropriate action in recent years to reduce the risk for their members by reducing the duration of their bond holdings and/or reallocating out of bonds and into defensive alternatives.” 

Mr Fryer noted that the industry has already seen how those rational decisions have hurt funds in the performance test.  

“Firstly, defensive alternatives have been classified by APRA as 50 per cent growth so funds’ exposures to those assets have come up short when measured against an inappropriate benchmark,” he noted. 

“Secondly, the benchmark indices that APRA uses for fixed interest have no ‘risk awareness’, so they are longer duration (6-7 years) than most funds’ actual exposures. 

“The seven-year return to June 2021 for short duration bonds (about 0-3 years) was 2.4 per cent a year compared with 4.1 per cent a year for the broader bond market (typically 6-7 years duration) based on a 50/50 split between Australian and international bonds. 

“This discrepancy hurt a lot of funds in the 2021 MySuper performance test and, unless yields rise significantly, will hurt many more funds’ conservative options in the 2022 choice performance test.”

Mr Fryer believes APRA and Treasury made the right decision when they changed the benchmarks to better cater for unlisted assets, and an urgent review is needed now to achieve a similar improvement in the treatment of defensive assets. 

“That might mean allowing funds to split alternative assets into different categories (i.e. growth and defensive) either based on volatility or a look-through to the underlying assets, where practical,” he explained. 

“Or it could mean splitting fixed interest exposures into different duration ranges (with different benchmarks), or allowing funds to split shorter duration holdings into a mix of benchmark-duration bonds and cash, but it may be very hard to get this data historically as an input to the test.

“If nothing changes, we may end up with the bizarre result that sees the conservative options of many funds fail the test, with all the implications for future cash flow, even though the same funds may pass the test for their growth-oriented options. 

“Where then will older members and retirees be able to invest if they want to take a more conservative approach?” 

Above all, the test fails to measure the most important thing, which is whether the fund is pursuing an investment strategy that is appropriate for its members, according to Mr Fryer. 

“By taking those crucial asset allocation decisions out of the picture and simply focusing on implementation, it ignores the most potent source of added value. And unfortunately, the nature of the test is influencing how funds invest by encouraging short-termism and managing investments to ensure a fund doesn’t fail the test. This is not in the best interests of members,” he continued.

“Ultimately, all these issues illustrate the main problem with the performance test – it tries to boil down a fund’s performance into one number that will determine whether it passes or fails. And while Treasury has identified benchmarks for each asset class, some funds have been targeting different benchmarks, often slightly more conservative benchmarks – maybe because of their older members or because of the real prospect of rising interest rates.  

“The result is that those funds, or those conservative investment options, may fail the test simply because they have been targeting different benchmarks, even though they have been doing this in the best interests of their members. 

“While there is a clear attraction for a ‘bright line’, pass/fail test, unfortunately, the test is less ‘bright line’ and more ‘blunt instrument’ which is why we will see more and more problems with this performance test.”