Persistent low growth, increased debt and demographic change globally has seen a flow on effect to asset prices with markets more likely to exhibit periods of volatility as it adjusts to these structural and disruptive changes.
For investors, particularly those nearing or in retirement, it may be timely to focus on providing some downside risk protection in their portfolios whilst seeking investment growth. The impact of downside risk on investors especially retirees, can be devastating as they may not have the time or ability to recoup potential losses from drops in the market.
Extending the life of your retirement nest egg
Over the last 50 years, there have been 8 times where the S&P500 fell more than 20% over a period of at least 3 months, with an average decline of approx. 35%^. That’s a severe market drop one in every 6 years. When you consider that the average Australian retiree has $110,000Δ in super and needs $40,000 p.a. income to live ‘comfortably’* it’s not unlikely that you may outlive your savings.
The hypothetical example above shows how investing in a strategy which manages downside risk using index put options (solid line) compared to one which doesn’t (dotted line), can lessen the impact of market drops to a portfolio of an investor approaching or in retirement. Let’s assume the investor has saved $200,000 by the time he reaches age 65. In both scenarios, the investment earns 9% p.a. except in year 2, 8 and 14 when the stock market falls by 20% in those years. He withdraws $10,000 p.a. and increases this drawdown by 2% each year to keep pace with inflation.
The cumulative effect of a few market drops has meant the portfolio invested with protective index puts has two dimensional benefits:
Extended the life of your retirement income: adding security for an additional 16 years before your money runs out.
Extended the size of your retirement wealth: approximately $120,000 better off after 20 years.
^Past performance does not guarantee future results * AFSA Retirement Standard 2016 Δ AIST 2015
Why managing risk is important as you near retirement
Investors who are in the accumulation stage and building wealth can benefit from falling markets as they can buy more investments with the same dollar amount. These investors often have time on their side for the market to recover and the value of their portfolio to increase (if they stay invested!).
However, limiting your investment exposure to risk becomes more important when you need to start drawing an income from your retirement wealth. The challenge is the need to preserve your hard-earned savings whilst needing to keep up with inflation to ensure that you have enough for the length of retirement.
What are some types of risk?
Market risk is well known to most investors, let’s look at three others which become significant when you start to draw down from your savings:
Loss aversion risk – some investors are naturally more cautious and conservative than others, particularly if they are in retirement. Being too sensitive to losses could have a long-term negative impact on your portfolio as you may forgo growth opportunities
Longevity risk – is the risk of outliving your savings. In Australia, latest data from the ABS shows that both men and women are living longer, 80.3 and 84.4 years respectively.
Sequential risk – and potentially the most damaging to a retiree. A fall in the market at the start of drawing down on your allocated pension can make it harder for your portfolio to recover potential losses than if the losses occur later in retirement. When the value of your portfolio is reduced, you need to sell more shares to draw down the same amount of cash. This in turn leaves you with less investments to generate future growth.
Our approach to downside protection
Our Global Titans fund aims to buffer the impact of severe volatility on the downside for money that’s needed for retirement by using the following simple but effective approaches:
The Global Titans Fund uses ASX index put options over a portion of the portfolio to reduce the impact of catastrophic falls in the market on your investment.
What are index puts and how do they work?
Index put options are derivatives that can be used to protect your investment if stock markets fall. It gives the holder (in this case the Global Titans Fund) the right but not the obligation to exercise the option for a cash payment if the underlying index falls below a certain level at any time before the expiry date of the contract. Much like insurance, there is a premium attached when purchasing options. Put options become more valuable as volatility increases and the underlying index declines.
Why do we use ASX index options to cover a global equity portfolio?
Developed markets are generally highly correlated, when markets fall they usually fall together. The advantages of using ASX index puts to provide broad market protection are twofold – they present reasonable value (best put in place when volatility is low and markets are high) and can be monitored during local trading hours.
We can take strategic currency positions to reduce capital risk when we consider these risks to be high and can also raise the cash holding in our fund.
We invest in a what we consider ‘exceptional’ companies: large, resilient, highly profitable global businesses who have superior return on invested capital ratios and focused on shareholder returns. These types of companies are more likely recover quicker when markets fall.
The value of downside protection
At Insync, we believe reducing the risk of absolute loss lays the foundation for successful investing. The outcomes which downside protection can provide gives investors the confidence to invest for the long term.
DISCLAIMER: Investment in the Insync Global Titans Fund may be made on an application form attached to the Insync Global Titans Fund Product Disclosure Statement (PDS) which is available from Insync (ABN 29 125 092 677, AFS License 322891) at the web address http://www.insyncfm.com.au under the ‘How To Apply’ tab. The information contained in this presentation is general information only and does not take into account your personal objectives, financial situation or needs. Before acting on the information contained in this presentation you should obtain a copy of the PDS and consider the appropriateness of the information in regard to your personal objectives, financial situation and needs before making any decision about whether to invest, or to continue to hold. The repayment of capital and performance in the Fund is not guaranteed by Insync or any other party. Opinions constitute our judgment at the time of issue and are subject to change. Investment guidelines are internal only and are subject to change without notice. Past performance is not an indicator of future performance.