How APRA’s performance test fails sustainable investors

Sustainable investors may receive APRA letters informing them that their super fund has failed a performance test — even though it’s doing precisely what was intended. Pendal’s ANTHONY SERHAN explains

• APRA testing compares super funds to unscreened, cap-weighted indices
• Sustainable funds that screen out sectors like fossil fuels are left at a disadvantage
• Find out about our sustainable Aussie equities Pendal Horizon Fund

THE federal government’s Your Future, Your Super annual testing regime for super funds is disadvantaging investors seeking to do good with their savings by investing in sustainable or impact funds, says Pendal’s Anthony Serhan.

Sustainable investing is a fast-growing part of the superannuation industry. Responsible investing now influences strategic asset allocation for most super funds in Australia (55% up from 39% in 2019).

But the YFYS test administered by the Australian Prudential Regulation Authority benchmarks super funds against pre-set, cap-weighted, broad-based indices — without regard to factors like the environmental impact of the underlying companies.

“If you’re investing in a sustainable way, you can be investing a long way from unadjusted market capitalisation weighted indexes,” says Serhan, Pendal’s distribution director.

“In Australia, an investor who wants to support net zero carbon emissions will not want to invest in anything related to fossil fuels — but that takes out a huge chunk of the market.

“Yet you’re being compared to something that does include those fossil fuels stocks, as well as other sectors of concern including tobacco, gambling and armaments.

“That’s clearly going to create noise. While it’s reduced over longer periods, the YFYS test is dealing in basis points — so if there’s a significant move at the start or end of a reporting period it will still impact the results.

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“And while the eight years used in the test is a long period, some of the themes addressed in sustainable strategies are multi-decade.”

Serhan says the result is that some investors will receive letters informing them that their super fund has failed the performance test — even though it’s doing precisely what they intended it to do.

“It is highly probable sustainable super funds will fail the test at some point because they are not owning certain parst of the market.

“Is that a good policy outcome? Probably not.”

Impact on global equities

And it’s not just investors in Australian equities that are disadvantaged by APRA’s tests.

Global sustainable investors tend to be underweight developing countries that naturally have fewer large companies fitting ESG criteria.

Yet they are now compared to indexes that fully weight emerging markets and pay no regard in the allocation process to issues such as human rights and the rule of law, corporate governance standards, or environmental impact.

“What do you do about that? If you’re a sustainable manager you’re likely underweight emerging markets which creates a mismatch between the index and your portfolio — that either creates noise or you’re going to have find a way to close that gap,” says Serhan.

Potential solutions

Serhan says the solution for APRA would be to adopt more flexible frameworks to assess super funds, judging them more on performance against their stated aims rather than against a passive index approach.

The APRA tests are likely to see a convergence of portfolios around the stated benchmarks which will push some investors to self-managed super funds where there is currently greater flexibility to do good with their super savings while investing for retirement, he says.

“The market cap weighted indices are simply a reflection of what has worked in the past — they are not a reflection of where markets are going in the future and they certainly don’t reflect which companies will be the winners from the move to net zero.”

So, what should you do when you get that letter saying your fund has failed APRA’s tests?

“Take a look at the fund and make your own assessment — is this fund delivering what I wanted it to deliver?” says Serhan.

“The letter will point you to government websites or super comparators — but these are very poor forms of financial advice.

“Instead, just ask yourself and your financial planner: am I happy with the returns and what the fund is achieving in the way it invests my money?”