Learn to love the benchmark

The Stanley Kubrick movie, Dr Strangelove or: How I stopped worrying and learnt to love the bomb, is considered by many to be among the best movies ever made. The movie is set in the 1960’s when the threat of nuclear annihilation hung over Western and Eastern-bloc societies alike. The key message of the movie was nuclear Armageddon will happen, so stop worrying and get on with your life.

The recently enacted Your Future, Your Super (YFYS) law has generated similar existential fears amongst the superannuation industry. This fear has been particularly evident amongst alternative investment specialists who have highlighted the many shortcomings of the backward-looking benchmark. This article takes a different view and considers the benchmark from a forward-looking perspective. Based on Frontier modelling, we show there is nothing to fear about allocating to alternatives under the YFYS framework and, in fact, alternatives present an opportunity for outperformance – but only if you understand the vagaries of the test.

The ‘other’ benchmark

Under the YFYS legislation, investment decisions now need to consider performance relative to a specific asset class benchmark. For standard asset classes, such as equities and bonds, the comparison is straightforward as the use of benchmark indices is widely accepted and understood. The key consideration for these asset classes is the degree of risk to take relative to the YFYS benchmark. To the extent that an equity manager’s alpha is uncorrelated to the market over the eight-year evaluation horizon, outperformance against the YFYS benchmark will be just as likely if the market returns 10% or -10% over that horizon. Put another way, it doesn’t matter if you think equities are over- or under-valued, what is important is active risk.

Contrast this with alternative investments. For alternatives judged against a 50-50 equity-bond benchmark, performance is as much to do with the return on stocks and bonds as it is with manager skill. If equities outperform for an extended period, even the best alternative investment may struggle to overcome the YFYS benchmark. Indeed, over the last seven years the 50-50 benchmark (adjusted for fees) has achieved returns of 7.2% p.a. For the most part, alternatives have not kept pace with this return. On a backward-looking basis, funds would have been better off simply piling into equities and bonds!

While the performance test is backward looking, investment portfolios are not. Asset allocations are based on forward looking return assumptions, either implicitly or explicitly. While we can’t go back in time and change asset allocations, we can position portfolios for the next eight-year horizon, and this is where alternatives start to look interesting.

Forward looking returns

To understand why, consider the construction of the YFYS ‘other’ benchmark. It is 50% bonds and 50% equities, with half of the equities hedged to Australian dollars. Frontier provides return forecasts for these asset classes (and a wide range of others) which can be used to generate return expectations for the 50-50 benchmark. The table below shows Frontier capital market assumptions for the components of the 50-50 benchmark. Total returns for equities and bonds are expected to be moderate to low over the next ten years.

Using these assumptions as a starting point we can create expectations for the 50-50 benchmark. The table below shows the necessary inputs. Based on our assumptions, the 50-50 portfolio is expected to earn 3.8% p.a. over the next 10 years – more or less what we would expect over the eight-year performance time horizon. Essentially, from a YFYS perspective, this is the number an alternatives allocation needs to beat!

The typical alternatives sector has a return target expressed in terms of a margin above cash or CPI. Similarly, most managers in the sector target a cash plus return. Conveniently, Frontier also provide capital market assumptions for both cash and CPI. Without wanting to torture the data too much, we can translate the nominal return expectations of the benchmark into margins over CPI and cash. The table below shows the return forecasts in terms of nominal returns, and margins over cash and CPI.

Rather than being something that alternative investors should fear, the performance benchmark presents a rather modest hurdle in nominal, cash and CPI plus terms. With moderate expectations for bond and equity returns, the 50-50 benchmark is actually a reasonable, if not soft, benchmark for alternatives to overcome. That is, if capital markets perform in line with our expectations. If capital market outperform these assumptions, the benchmark becomes harder. Similarly, if our assumptions are too optimistic, the benchmark will be easier. Rather than judging alternatives against their historic returns, investors should be looking forward and considering the future potential for alternatives to outperform the YFYS benchmark. Based on Frontier capital market assumptions, alternative investors (and their trustees) should stop worrying and learn to love the benchmark.

Author:
Scott Pappas
Principal Consultant, Head of Alternatives and Derivatives