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How will Your Future, Your Super reforms impact ESG investing?

ESG investing challenged by push to benchmarking

While the government’s Your Future, Your Super (YFYS) reform package, which took effect last July, has been widely derided by the industry, it is the first step in a move to requiring the industry to improve its efficiency, transparency and accountability.

One of the unexpected consequences of the YFYS changes is the fact that it pressures super funds, particularly where they are underperforming, to achieve the desired ESG outcomes as well. Many are concerned this may mean the end of ESG investing, given that most benchmarks are traditional market-cap-weighted indices.

The regulator APRA supports the Government’s YFYS reforms as they are a further step in the superannuation regulatory framework. These developments are critical in light of the increasing size and complexity of the superannuation industry.

  • Implementation service provider Parametric recently released a research paper titled “Can ESG Investing Survive Your Future, Your Super?” The research paper explores the different ways these new reforms will affect super investment funds. One of the main concerns highlighted in the report is that the “emergence of the YFYS reforms present a challenge to super funds that could threaten the pace and scale of their ESG efforts.”  There is the possibility that “super fund portfolio tracking error will face downward pressure as funds jockey to meet these new performance requirements.”

    Usually, a moderate level of tracking error is expected for the implementation of ESG objectives into portfolio construction. But here is where the problem lies: the new reforms punish products for having additional tracking error. David Post, senior investment strategist, responsible investing, at Parametric says: “It’s our view 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.”

    Trustee-directed products designated as ESG options are most at risk.

    Under the YFYS regime, there is a way to achieve an optimal result where funds can achieve the desired ESG outcome yet at the same time manage active risk. To do this, it requires a more complex optimisation tool capable of finding the right balance under the scheme. 

    This year APRA conducted performance tests on MySuper funds, with 13 products failing. It plans to expand this list next year to include trustee-directed products in the testing regime. These new rules will affect MySuper funds that have ESG built into them, and trustee-directed products designated as “ESG Options.”

    Parametric says, “given that around 40 per cent of total Australian assets under management are estimated to be managed according to ESG principles, the impact could be very significant.” However with the use of “optimisation techniques,” a meaningful level of ESG can be achieved at modest level of tracking error and still achieve meaningful ESG impact.

    Although Your Future, Your Super may not tick all the boxes for responsible investing, the use of optimisation-based portfolio construction tools in super funds will help achieve a better and more desired ESG outcome while also managing active risk.

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