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YFYS performance test reshapes portfolio construction
When constructing MySuper and choice portfolios, all funds will need to assess the priority they attach to not failing the Your Future Your Super (YFYS) performance test and this will impact the portfolio quality, according to the analysis by Willis Towers Watson.
The study confirmed that even funds that were currently well positioned against their YFYS benchmark were likely to be confronted with the possibility of failure at some stage and this risk be reduced through more closely hugging the underlying indices used for the performance test.
Therefore, funds would need a very strong governance framework and clear beliefs on the weight they give the YFYS test in order to ‘stay the course’ when performance would fall below expectations, and the risk of failure would escalate.
“In short, funds should have a ‘game plan’ for how to deal with underperformance as it unfolds in real time,” the firm said.
According to the analysis, funds would need to address where the performance test ranks relative to other metrics of portfolio quality and what probability of failing the performance test would be acceptable, and what would be the most appropriate timeframe over which to assess this.
Avoiding test failure should be a high priority for funds, but this should not override the obligation to act in members’ best financial interests.
Following this, Willis Towers Watson said trustees could use a framework that assessed their portfolios across a range of factors, such as expected return, risk (e.g., frequency of negative returns and tail risk), liquidity, fees, sustainability, along with the risk of failing the YFYS test.
Additionally, the firm developed a framework incorporating the YFYS performance test into the portfolio construction process, where the super funds would need to determine:
- The likely implications of failing the test;
- The weight placed on passing the test relative to other factors when assessing the overall quality of their portfolio and member outcomes;
- The probability of failing the performance test deemed acceptable and the timeframe over which this will be assessed;
- The overall level of active risk or tracking error they are willing to take relative to the YFYS benchmark and the level of outperformance this is expected to generate at the total option level;
- The areas in which they have most conviction in taking active risk (in terms of the expected reward relative to the specified YFYS asset class benchmark) and whether this results in any differences to the desired or ‘optimal’ portfolio before YFYS considerations; and
- How frequently total fund outcomes relative to the YFYS benchmark will be assessed, and in what circumstances these should lead to changes in the level of active risk being taken. This should include consideration of the actions that can be taken as relative performance deteriorates to reduce the likelihood of failing the test.
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