APRA’s superannuation performance benchmark elevates derivative and overlay efficiency
Global Investment Insights
with Michael Armitage, Founding Director, FundLab Strategic Consulting
APRA’s superannuation performance benchmark elevates derivative & overlay efficiency
Superannuation Investment Committees will be under the microscope with announced APRA performance benchmarking.
*****
Performance matters, and funds not seeking to improve their performance metrics will likely be forced to close to new membership.
*****
While APRA’s performance test proposal may still need more definition, the government’s objective is clear. Fund fees and performance for members will be measured and laggards will be penalised.
The intended outcome is to reduce the number of poor performing funds, and force mergers of sub-optimal operators. Performance matters, and funds not seeking to improve their performance metrics will likely be forced to close to new membership.
Efficiency is key
With increased scrutiny over costs and performance, investment efficiency will be key for fund competitiveness moving forward. Arguably, derivative overlay solutions may be some of the ‘lowest hanging fruit’ available to funds for significant improvements in efficiency and reduction in costs. Further, the use of derivatives can provide significant advantages for funds seeking more robust control over liquidity risk, which has been an area of importance given fund allocations to illiquid assets.
For specialist overlay managers offering more active solutions, high cost hedge fund allocations can be replaced with custom rules-based programs offering cost reduction and more transparency. Whether through the introduction of tail risk strategies or multi asset absolute return solutions, institutions can gain more internal portfolio risk control through partnerships with overlay specialists.
*****
With increased scrutiny over costs and performance, investment efficiency will be key for fund competitiveness.
*****
Several of the largest superannuation funds have implemented derivative overlay solutions to take advantage of improved efficiency, reduce fees and minimise tracking error. With increased scrutiny on performance and tracking error, all funds will likely need to adapt to stay relevant.
Whether large or small, funds will find fiduciary relationships with experienced overlay managers an attractive value proposition to increase competitiveness. Overlay managers extend the capabilities of a fund’s investment team and provide operational and investment sources of ‘alpha’.
Low cost passive exposures
While the debate between active vs. passive investing and the potential for government creating unintended consequences will intensify, a rational expectation is that funds will utilise more low-cost passive holdings in their strategic asset allocation to reduce fees. This has already been a trend as funds have sought areas to reduce traditional beta management fees to meet higher costs typically associated with alternatives including unlisted asset classes.
Derivative overlay strategies provide significant opportunities for management fee savings. For example, within passive equity holdings several funds have increased their usage of Total Return Swap (TRS). TRS provides significant management fee reductions with minimal tracking error relative to active management and potentially other passive vehicles.
*****
For superannuation funds with high allocations to illiquid assets, improving the liquidity profile of the fund through derivatives is attractive.
*****
An important feature of TRS, is the ability to hold exposure without being fully funded allowing the portfolio higher levels of cash to meet other liquidity needs. For superannuation funds with high allocations to illiquid assets, improving the liquidity profile of the fund through derivatives is attractive.
In a TRS contract, the performance of an equity index is exchanged for a Libor-linked floating leg. Pricing (swap rate) is driven by several factors including supply/demand, borrow (price to short an index) and forward rates. Recent pricing of MSCI Dev World Index TRS has seen investors earning over the total index performance, providing a potential source of constant alpha and potentially zero management fees for a contract period.
Further, funds may have the opportunity to earn more excess return through fully funded longer contract maturities or notes tied to the swap with a counterparty. Pricing will vary on market demand and counterparty.
As most SAA policies will hold fixed exposures to international equities, TRS on international equity beta can provide significant outperformance relative to other passive and active investments. At a minimum, funds should investigate these solutions to understand the playing field and advantages other funds hold.
Defensive portfolio solutions
As risk free rates approach zero, portfolio diversification benefits of government bond allocations are diminished given a restriction for potential capital gains. Further, as bond and equity correlations may rise, funds are seeking efficient defensive alternatives for their portfolios. Defensive overlay solutions provide value propositions that improve portfolio efficiency and lower headline costs.
*****
As bond and equity correlations may rise, funds are seeking efficient defensive alternatives for their portfolios.
*****
Many superannuation funds allocate on a fully funded basis to their hedge fund and defensive alternative allocations. However, while promising in their diversification benefits, fully funded positions limit the overall portfolio impact unless allocations are substantial. Additionally, the relatively high level of management and performance fees of hedge funds will restrict usage given the renewed competitive focus on fees.
Funds may consider notional funding within individual manager mandates or utilise TRS on alternative strategy indices to be more capital efficient. However, mandates still incur high fees and TRS for portfolio protection (instead of risk exposure) introduces added concern on counterparty issues.
Higher capital efficiency and lower cost can be captured using explicit derivative overlay solutions.
In the recent performance of February and March 2020, the Eurekahedge Long Volatility Index (an index of long volatility hedge fund managers) gained +31.35% net. over those two months. Long volatility managers were one of few places of positive performance in the market meltdown of 2020.
However, to gain a significant level of protection for the equity heavy portfolios of superannuation, a significant allocation to this category would have been needed to offset the negative period. For example, a 5% fully funded allocation into long volatility would have contributed roughly +1.5% to a portfolio in this period where most ‘balanced’ funds fell -15 to -20%.
Explicit rules-based overlay solutions instead invest a pre-determined annual budget for protection. Typically, while capital utilised is much smaller, the amount of portfolio ‘crisis alpha” impact can be much larger. Additionally, the execution costs of overlay managers are a fraction of high hedge fund management and performance fees.
The example below outlines the modelled performance of a naïve put strategy with a 1.5% annual budget over a 98.5% equity portfolio[i]. Over the 2-month period of Feb-March 2020, the put strategy added over 18.5% to the performance of the portfolio – illustrating high capital efficiency using derivative overlays for a crisis.
In practice, funds can determine their annual budget to manage for a particular risk appetite. Because less capital is used within a defensive overlay that is managing explicit risk, a fund can remain in higher growth/return assets that are protected through the overlay. This added return may provide compensation for the annual budget for protection.
*****
Because less capital is used within a defensive overlay that is managing explicit risk, a fund can remain in higher growth/return assets that are protected through the overlay.
*****
Additionally, explicit risk management through derivatives reduces over-reliance on diversification as the sole risk management strategy for a portfolio. As systemic risk cannot be diversified away, portfolio overlay strategies are more robust.
*****
Explicit risk management through derivatives reduces over-reliance on diversification as the sole risk management strategy for a portfolio.
*****
For example, most alternative and hedge fund strategies did not have positive performance in Feb-March of 2020. Further, few superannuation funds held any allocation to Long Volatility managers, highlighting strategy and manager selection risks are common within hedge fund allocations.
Source: Bloomberg, OptionMetrics, Perennial Solutions Group. Tail strategy invests in S&P 500 net total return combined with medium tenor far out-of-the-money puts, 1.5% premium spend pa, with a simple rule for monetisation.
Growing capabilities to meet a new competitive environment
Institutional investment teams globally have been utilising derivatives for decades to provide more flexibility, lower costs, manage portfolio exposures efficiently and control risks. This includes teams that are in-sourcing former derivative specialists, partnering with external overlay managers or both.
Service level relationships can vary depending upon need, including:
Advice and execution services
Custom systematic rules-based solutions
Alpha seeking investment strategies – combining rules based with discretionary strategies
The fiduciary relationship of an overlay manager aligns with the interests of members and acts in partnership with the fund’s investment team extending their in-house capabilities.
As the government has highlighted, funds will need to increase their competitiveness to survive. Extending capabilities within derivatives and overlay solutions will be critical in that pursuit.
[i] Tail Strategy is a rules-based strategy of SP500TR+ rolling 5M 70% puts with a simple monetisation rule, spending 1.5% pa
Disclaimer
This material has been prepared by Fundlab Strategic Consulting and is intended for educational purposes and to provide background information only. Past performance (whether actual or simulated) is not a reliable indicator of future performance, and no representation or warranty, express or implied, is made regarding future performance.
All information contained within this publication is general advice only, as the knowledge levels and needs of all individual and corporate investors vary greatly this publication should not be used solely as a decision-making tool, further opinions and information should be sought before making an investment decision. It is the recommendation of Global Investment Institute (GII) that you seek the opinions of a fee-for-service, independent investment adviser before making any investment decision.
The authors, directors or guest writers may have a financial interest as investors, trustees or directors in investments discussed or recommended in this document. It has been assessed by the editors that these financial interests have not had an impact on the material contained here within.
All material appearing in GII’s Global Investment Insights is copyright, reproduction in whole or part is not permitted without written permission from the Publisher, GII.