Australian Catholic Superannuation and Retirement Fund & Parametric launch joint research paper ‘Optimality Is in the Eye of the Beholder: The Science and Art of Equity Portfolio Construction’
Superannuation funds chasing alpha in their multi-manager equity portfolios need to tread cautiously to manage the impact of real-world implementation costs, according to research conducted by Australian Catholic Superannuation and Retirement Fund (ACSRF) in a unique collaboration with global implementation manager Parametric.
The research, by Chris Drew, Investment Manager, ACSRF, Mahesh Pritamani, Senior Researcher, Parametric, and Raewyn Williams, Managing Director, Research, Parametric, shows that the more a super fund invests in active management, the greater the impact of taxes and other implementation costs.
The groundbreaking research examines not the common research theme of different components super funds can use to create multi-manage equity portfolios but, rather, how to combine them in an optimal way. The research adopts the ‘real world’ perspective of a super fund subject to concerns like risk and fee budgets, taxes and transaction costs.
Drew, Pritamani and Williams explore two ways a super fund can limit tax leakage resulting from an active multi-manager program – by including a passive core to have less of its overall equity portfolio exposed to the tax damage done in the active program and by employing tax management in the core portfolio to help shelter the gains generated by the multi-managers from tax.
“Ironically, a super fund will get the best out of its active managers by reserving some allocation for a tax-managed passive core in the portfolio.”
The authors say the stronger a fund’s sensitivities are to the real-world issues of peer and benchmark risk, investment management fees, taxes and transaction costs, then (absent a holistic implementation solution like Centralised Portfolio Management) a higher allocation to a tax-managed passive core becomes the optimal solution.
“A high conviction in the skills of active managers (and the fund’s skill in choosing such managers) can counteract this effect; however, if the fund’s active-management conviction is flagging, there will be more incentive to increase the investment in passive management.”
“High conviction in active management creates something of a paradox—unless the fund wants to ignore the impact of taxes (which we do not advocate). It strengthens the case for a tax-managed core allocation to provide some damage control over the tax impact of active management. Otherwise, only a resolutely pre-tax-focused fund could see paying away asizable portion (in our hypothetical example, more than 40%) of the fund’s excess returns in tax as the optimal solution.”
The authors say that super funds lacking strong conviction in active management might be better suited to finding that “sweet spot” that covers an array of skill levels, but still satisfies its risk and fee constraints
“Within this sweet spot, super funds have the capacity to maximise the after-tax excess returns over a range of possible skill levels.”
“It is healthy for a superannuation fund to approach scientifically the task of optimising a blend of equity portfolio ingredients, seeking to solve for a specific set of fund objectives and constraints. But it may be unhealthy for a fund to finish there without stepping back to survey the broader sweet spot of equity portfolio combinations available with a little more flexibility.”
Drew, Pritamani and Williams conclude by arguing super funds need to challenge some of the industry’s strictures to improve member outcomes. They include:
• Unwillingness to revisit alpha expectations;
• Need to consider the trade-offs between uncertain alpha and controllable costs like tax, brokerage fees and commissions;
• Targeting headline fee outcomes rather than net outcomes for members;
• The appropriateness of tracking error as a definition of risk;
• The relevance of a fund’s standing in its peer universe.
“In this way the industry can advance the science of equity portfolio design beyond the realms of specialised (and valuable) quant techniques and into the heartland of a superannuation fund’s mission – what really creates a best-fit, enduring, real-world equity portfolio for its members.”
For more information or copy of the research paper, please contact:
Simrita Virk at Shed Connect
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