Reforms shine a light on advice

By Elizabeth Fry

The introduction of the Morrison government's superannuation reforms is good news for financial advisers as advice just got a lot more important.

Members are likely to struggle to understand the shortcomings of the controversial performance test for MySuper products as well as investment strategies, fees, and insurance cover.

"Members need to stay on top of these changes and make sure their investment options continue to meet their objectives even if their fund is passing the test, says Pendal chief executive, Australia Richard Brandweiner.

He notes that the prudential regulator sent a fail report card to 13 of Australia's default MySuper products after its first Your Future, Your Super review.

Yet, only seven percent of accounts in those products have been closed.

As Brandweiner sees it, the second letter will come out next year for those funds which failed the test. "Members may ignore one letter, but less likely a second," he adds.

"Having to stop accepting new members after a second failure is clearly significant and, again, will increase the need for advice" he argues.

There are other potential implications, however.

Brandweiner argues that unbiased and unconstrained investment thinking will be impacted by YFYS benchmarking.

This presents an opportunity for advisers to help create more tailored solutions for certain clients.

Misallocation of capital

"Importantly, YFYS tests are based on sector benchmarks rather than strategic asset allocation, which means success or failure is based on performance relative to arbitrary benchmarks selected by the prudential regulator, selected 'after the event'" says Brandweiner.

"That means you could have achieved your stated fund objectives, potentially even outperformed your existing benchmarks, but still fail the test.

It is also likely that the new reforms could bias more Aussie super money to be invested in passive or enhanced index strategies.

The trouble is, he goes on to say, increasing the allocation of capital to be in line with indices might not be in members' best interests. "Indices were never designed to be an optimal investment strategy in an absolute sense."

Investors, and indeed the system, may end up more exposed to unintended risks.

Unintended risks

For instance, a market cap-weighted index is, in effect, a momentum strategy that has greater and great exposure to high-priced securities.

"Looking at the tech wreck, or the 2007 banking crisis, it's the largest sector, the most popular sector, and usually the most expensive sector that people had the most exposure to before the correction," he says.

He also cites the UBS Composite Bond Index which houses longer and longer-dated government debt as interest rates fell.

"Effectively, this means the index is taking more and more duration risk, even as the price risk of duration has increased. So you can argue the performance test is pushing investors up the risk curve."

Aside from the misallocation of capital, there is a risk of lost opportunity with indexing.

In Brandweiner's view, a big switch to passive strategies will undermine the role of engagement as a way to create 'better beta' over time.

A wider problem for indexing is a barrier to stewardship which is fundamental to the effective governance of companies.

If it's true that more money goes into passive and enhanced passive strategies, that could come with less engagement than with active ownership of companies.

"Active managers hold company management accountable. We need this," he says, noting that active managers need to be across a company's strategy and can engage in ways that few others can.

While an increasingly regulated investment framework might become less appealing for investors wanting active managers, Brandweiner does not believe that investors will go entirely passive.

His client discussions reveal that clients are looking to adopt different approaches. "Some are looking for more benchmark risk-aware active strategies, others may have a larger passive core and adding in some far more active satellite strategies around those."

Would Pendal alter its business model?

"We're active; never passive. By definition, indexing is backward-looking -  our role is to look forwards, anticipate change and position our clients' portfolios for the future," he says.

"We believe we can do this well, and we have demonstrated our ability to add value over many, many years."

Pendal recently posted a 41.5 percent profit jump to $164.7 million underpinned by a fourfold increase in performance fees and the successful integration of US funds management group Thompson, Siegel & Walmsley.