ESG another unintended consequence of YFYS

The Government’s Your Future, Your Super legislation and the Australian Prudential Regulation Authority’s superannuation fund performance test may act as a drag on ESG investment, according to Morgan Stanley’s implementation business, Parametric

This is because there exists a moderate level of tracking error (divergence from the benchmark) as a by-product of ESG investment approaches such as screening and integration.

Parametric Senior Investment Strategist, David Post said it was the company’s view that that super fund portfolio tracking error, a key driver of YFYS performance test outcomes, will face downward pressure as funds jockey to meet their new performance requirements.

Post said Parametric’s analysis indicates funds can achieve desired ESG outcomes and manage active risk, but they may have to employ more sophisticated optimisation tools to find the right balance under the YFYS regime.

Under the YFYS performance test, each year the Australian Prudential Regulation Authority (APRA) will construct an individual benchmark for every product based on the product’s asset allocation. Each product will then be compared against its benchmark.

Products that underperform their net investment return benchmark by 0.5 percentage points per year over an eight-year period will be classified as underperforming.

Trustees whose products fail the test will be required to notify members in writing. Products that fail the test two years in a row will not be permitted to accept new members until their net investment performance improves.

“The new rules have implications not only for MySuper products that incorporate ESG but also trustee directed products designated as ‘ESG Options’,” said Josh Mckenzie, Analyst at Parametric.

“Given that around 40% of total Australian assets under management are estimated to be managed according to ESG principles, the impact could be very significant.”

Parametric analysed approaches to two popular ESG practices, exclusionary screening and integration, to determine whether meaningfully different portfolio ESG characteristics can be achieved at low levels of additional tracking error.

Screening is used to exclude companies with undesired activities from a portfolio. Integration refers to a quantitative portfolio construction process that uses company-level ESG characteristics, such as emissions intensity, to be considered alongside other risk characteristics such as sector, country, or fundamental style factors.