One of the most common investment pitfalls is to back the current winner. All too often investors pile into the best performing share, asset class or fund manager over the past year in the hope that its success will be repeated. This type of naïve momentum strategy can pay off in the short term, but investors quickly find that prior successes are not so easily replicated.

Very rarely does this kind of momentum strategy hold up in the world of managed funds, even over relatively short periods of time. For example, looking at three-year rolling returns for global growth managers, it’s clear that performance can get shuffled around a lot. Those who have outperformed over the previous three years can easily find themselves near the bottom of the pack over the next three years. Equally, those languishing near the bottom can suddenly find themselves out in front of the pack.

Following the winner can make you a loser: Global growth manager return rankings (2016 versus 2019)

Source: iRate

Obviously, if your manager research is focused on performance, you need to take a long-term view. The challenge, however, is that your analysis will inevitably be limited to those managers who have built up a sufficient track record. There’s also the classic survivorship bias problem: researchers tend to focus on the performance of those funds that have managed to remain in existence over their period of analysis. For active managers, medium- and long-term market dynamics can also have a significant impact on performance. For example, there will be periods when the market favours growth managers and periods when it favours value managers. Just because growth has outperformed value over the past decade doesn’t mean it will continue to outperform in the next. A change in market fundamentals can upend even the most thoroughly researched investment theses.

This all creates a significant conundrum for quantitative research. While qualitative research methods are sometimes criticised for being subject to arbitrary rules, in fact it’s the opposite that proves the case. Determining which quantitative metrics are relevant for which managers over which timeframe is difficult to do with a high degree of precision or confidence. Determining which are the main predictors of future performance is nigh impossible.

So how do successful researchers overcome this challenge? Clearly, quantitative measures are essential in assessing which funds are capable of delivering on their investment objectives. But they are far from the only measures that should inform your investment decisions. Qualitative factors should ideally make up the bulk of your research, but they tend to play a back-seat role because gathering the qualitative intelligence required to pick successful managers is a resource-heavy, time-consuming task. This can result in its own form of selective bias, where researchers focus on those factors that are relatively easier to measure and compare.

The limitations of quant-only research

Selecting the right manager involves looking at more than just past performance. It’s about delivering future outperformance based on an in-depth assessment of individual investment teams. This means understanding how people, strategies, and capabilities come together to position fund managers for success. When it comes to selecting for future success, qualitative research is not merely a filter or a heuristic, it’s the backbone of your entire research process.

While you might be able to get away with poor manager selection when the bull market is raging, the real test comes when the market reaches a turning point. Given the troubling signals from financial markets over the past six months, this is something many investors are starting to take very seriously. Market turning points pose a real challenge for fund managers and have a way of pushing their process and discipline to their absolute limit. In times like these, product recommendations and manager selection really count, and advisers can quickly find their own processes exposed when things go wrong.

Identifying future outperformance is an artform, not a science. Lonsec’s entire research process is built around understanding the range of qualitative factors that determine manager success and giving advisers the tools to select investment products based on individual client needs. Our analysis is based on an onsite assessment of investment teams, combined with a rigorous peer review process that safeguards the quality and integrity of our investment product ratings. Looking back over the past 10 years, our qualitative process has proven its worth. Lonsec’s Recommended and Highly Recommended managers have outperformed their respective benchmarks, even during a period where the long-running beta rally has pushed passive investment strategies ever higher, casting shade on many active managers who have struggled to offer value in this environment.

Performance of Australian equity managers rated Recommended or higher by Lonsec

Performance of global equity managers rated Recommended or higher by Lonsec

Source: iRate. Average performance is calculated based on historical monthly performance of managers currently rated.

Despite the fact that some active managers struggle to beat the market, we know that there are some that can consistently outperform. But identifying them has little to do with their past performance and much to do with having the right people, resources and processes in place to deliver on their mandate. Looking back through history, there have been funds that have been highly successful, producing people who went on to found their own funds and enjoy similar success. For new funds and products entering the market, there’s often no track record to speak of, meaning qualitative factors are the only means to measure the likelihood of success. If you screen these products out simply because you don’t have enough performance data, you risk missing out on new innovations and strategies that could prove highly valuable.

People and resources

Arguably the most important factor to consider when assessing a fund is the people responsible for making the investment decisions. Your research should take into account the size of the team, its quality, its stability, and its key person risk. Is the team large enough to carry out its mission? Does its analysts have the right level of experience and a track record of success working together? Is the fund overly reliant on a single person whose departure could adversely affect the fund’s performance?

Your research should also examine the culture and structure of the fund. Does the investment team demonstrate a real passion for investing? Do they treat it as a business or a profession? Do they have a stake in the fund’s long-term performance?

Investment philosophy

One of the most telling tests of a fund manager’s capability is to ask them to explain their investment philosophy as simply and concisely as they can. A fund’s investment philosophy should not be a string empty words displayed on the manager’s website and then largely forgotten. An effective philosophy is regularly consulted to ensure that all investment decisions ae consistent with the fund’s purpose. Your research should examine the fund’s philosophy to see if it is consistent and lived out through its investment decisions.

Is the manager sticking closely to its mandate or is it stretching it too far? Is it remaining true to label and delivering on investors’ expectations, or could it end up surprising investors when the market turns? Does the manager exercise patience and buy/sell discipline, or are they liable to panic? While this is fundamentally a qualitative research exercise, this is one example where quantitative research can play a crucial supporting role. For example, Lonsec considers key valuation metrics, performance across differing market conditions, and output from style research tools using holdings-based style analysis software.

Research process

Once the soundness of the investment philosophy has been established, the next step is to ensure that the fund has a robust process in place to identify securities and incorporate them in their portfolio. This involves everything from the idea generation process to the intellectual property and software used to value assets. If the size of the manager’s investable universe is very large, what process do they have for narrowing down their list of potential opportunities? What attributes are they looking for when searching for the right stocks, bonds or properties?

What macro or market themes are they looking to take advantage of? How do they carry out their fundamental analysis and what valuation methods do they use? Do their people and systems have the appropriate breadth and depth to carry out their research process? Lonsec typically requests that managers explain multiple investment theses as a means of demonstrating the investment process at work and gauging consistency with the fund manager’s stated investment style and objectives.

Partnering with a research house to achieve in-depth qualitative research at scale

Developing an effective qualitative research model requires a lot of work, but the real challenge is in supporting the process with the right people and resources. Most investors don’t have the data or the capabilities to be carrying out in-depth qualitative research at scale, which is why they partner with a research house like Lonsec. For investors committed to generating long-term outperformance, a world class research effort is required to be able to identify and evaluate those managers that can generate consistent outperformance from the thousands of managers out there.

Using alternative investment to address pre- and post-retirement issues

Walter Davis, Alternatives Investment Strategist

Ashley O’Connor, Investment Strategist, Invesco Australia

Introduction

Investing in financial markets requires investors to balance return and risk, short-term and long-term goals, and cyclical and structural factors. To do so effectively, investors must also balance the human emotions of greed and fear. Greed drives investors’ desire to build wealth by seeking investments with attractive return potential, while fear drives investors’ desire to avoid losses by investing in low risk investments.
These two emotions are particularly acute for individual investors who have identified (and become emotionally attached to) a specific goal for their savings, be it retirement, funding a college education or buying a house. In such situations, investors want to ensure they generate attractive returns on their investments so they have sufficient wealth to fund the event, while at the same time avoiding damaging losses that could permanently impair their ability to do so. This issue is even more complicated for investors seeking to provide for a comfortable retirement, given the significant variables involved (such as the unknown duration of retirement and highly variable expenses) and the potentially devastating consequences of failure to achieve the goal.
This challenge is not limited to individual investors. Institutional investors, such as defined contribution pension plans, defined benefit pension plans, insurance companies and government-sponsored retirement plans, all face a similar dilemma. In many cases, these investors have plans that are underfunded and need to generate strong returns to meet future liabilities, while at the same time avoiding losses that would undermine their ability to do so.
In technical terms, the two primary risks that these individual and institutional investors face are longevity risk and sequencing risk. Translated, longevity risk is the risk of living longer than your savings last, while sequencing risk is the risk of large negative returns occurring at a time that makes losses difficult to recoup.
The solution to longevity risk is to seek investments that offer attractive return potential in order to help build sufficient wealth to fund retirement. Conversely, the solution to sequencing risk is to seek stable, low-risk investments in order to avoid potentially devastating losses that could permanently impair the investor’s ability to fund retirement. The challenge for investors is to build a portfolio that balances these competing needs.
This paper will explore the issues and challenges associated with longevity and sequencing risk, especially in the current market environment, and examine how alternative investments offer investors potential solutions for these risks.


Longevity risk

While longevity risk can be simply explained as the risk of living longer than your savings last, this risk is exacerbated by the fact that many of the variables associated with this risk are unknowable. For example, no one knows how long they or their spouse will live, or whether or not they will face unexpected costs in their retirement.

In 2011, the National Institute on Aging, National Institutes for Health, US Department of Health and Human Services, and World Health Organisation produced a report entitled Global Health and Aging. Several of the key findings of the report illustrate the complex and changing nature of longevity risk.

The challenges associated with longevity risk have implications not just for individuals and families trying to save for retirement, but also for society, governments, defined benefit pension plans, defined contribution pension plans and insurers. Specifically, the individuals and entities charged with helping people save for retirement need to ensure that they are doing two things: 1) saving and investing a sufficient amount, and 2) earning a return on their investments that enables them to have sufficient assets to afford retirement.

Unfortunately for investors, the ability to achieve attractive returns has been hindered by the fact that equity returns have declined sharply since 2000 on a global basis. Using the US as an example, in both the 1980s and 1990s, the S&P 500 generated an annualised return of over 17%.1 Between 2000 and 2010, however, equities experienced two bear markets and posted a negative annualised return of less than -1%1 for the decade. Since 2010, equity returns have rebounded, generating an annualised return of over 13%,1 through May 2017. For the period since 2000, equities have achieved an annualised return of just under 5%,1 well below the returns achieved in the 1980s and 1990s. As a result of declining equity returns, the returns achieved in the classic 60% stock, 40% bond portfolios have similarly declined, as shown in the chart below. While this example focuses on the US, the story of falling returns is consistent globally as most developed economies have experienced similar declines in returns.

Just as equity returns have declined, so too did interest rates as central banks responded to the Global Financial Crisis by drastically cutting rates in an attempt to support the markets and economy. In some parts of the world, interest rates have turned negative, causing investors to pay for the safety of low-risk investments. The current low level of interest rates, which can be seen in the below chart2, has dramatically impaired investors’ ability to earn an attractive yield on lower-risk assets.

While the decline in interest rates accelerated after 2000, interest rates have steadily been declining over the past 30 years as bonds have enjoyed a historic bull market. Again using the US as an example, during the 1980s the yield on 10-year US government bonds ranged between approximately 7% and 10%.3 In the 1990s, yields declined but remained attractive, ranging between approximately 5% to 8%.3 In the 2000s, yields fell further and generally ranged between approximately 2.5% and 5%.3 Since 2010, yields have often fallen below 2% and today yield approximately 2.3%.3 The US experience with falling rates is broadly consistent with the experiences of other developed economies around the globe.
Taken collectively, an investor saving for retirement faces the following challenges related to longevity risk:

 The need to fund a retirement of unknown duration, which could last far longer than expected due to increasing life expectancy
 The risk of increased expenses and medical costs in retirement due to illnesses associated with extended life expectancy, such as dementia
 A prolonged period of modest equity returns and low yields on low-risk government bonds.

In order to address this risk, there are two steps that investors can and should take: 1) increase the amount of money being set aside for retirement, and 2) seek to prudently increase the return potential of the portfolio. As the chart below illustrates, even modest increases in return can significantly improve an investor’s ability to fund retirement.


Sequencing risk
Sequencing risk is the risk of large losses occurring in a portfolio at a time when it is difficult to recoup them. For example, a 45-year-old who incurs large portfolio losses has 20 years before reaching the retirement age of 65, and therefore has a long time horizon over which to recover. The situation is very different when a 65-year-old incurs large losses in their first year of retirement. This also tends to be when an investor has the greatest amount of invested wealth during their life to date, making them more vulnerable to large losses. Such losses can force the retiree to return to the workplace and/or may require a more limited retirement than planned.

A primary reason that losses are such a concern to investors is that after a loss is incurred, the investor must achieve a return greater than the percentage of the loss in order to recoup the loss. This is due to the fact that the losses reduced the size of their portfolio and thus require a higher return to offset the smaller portfolio size. This point is illustrated in the diagram below;

For example, if an investor loses 50% on a $100,000 portfolio, the size of the portfolio shrinks to $50,000. The investor must then achieve a 100% return on the remaining $50,000 portfolio in order for the portfolio to return to its pre-loss size of $100,000. The larger the size of the loss, the greater return, and the longer it will take, to recover the losses. The impact of such losses on an investor is highlighted in the chart below.

When building a portfolio, volatility and risk of loss should always be a primary focus of investors, as market downturns occur more regularly than many investors realise. Many investors, however, have short memories and discount the potential risk of incurring outsized losses, despite several historical examples of large market declines, as shown below:

  • Dow Jones Industrial Average (DJIA) — In 1929, the Dow hit an all-time high of 381.17, before declining 89% to 41.22 in 1932. It took until 1954, a period of 25 years, before the index achieved a new peak.3
  • DJIA — On October 19, 1987, the DJIA declined 22.6%, the largest one-day decline (in percentage terms) in its history. It took 15 months for the index to return to pre-crash levels, and 24 months for it to hit a new peak.3
  • Japanese Nikkei — The Nikkei hit an all-time high of 38,916 on December 29, 1989. As of May 31, 2017, the Nikkei sat at 19,650, approximately 50% below its all-time high.3
  • NASDAQ — On March 10, 2000, the NASDAQ hit a record high of 5048.62 before declining approximately 80% by October 2002. It took 15 years for the index to achieve a new peak.3
  • S&P 500 — The S&P 500 hit a then record high of 1565.15 on October 9, 2007. From that lofty level, the index declined 56.8%, due in large part to the Global Financial Crisis, hitting a low of 676.53 on March 9, 2009. Over five years later, in March 2013, the index achieved a new peak.3

In order to mitigate sequencing risk, investors have long been counselled to reduce the risk of their portfolios as they age by shifting away from stocks toward bonds and cash equivalents. A common rule of thumb for investing was to subtract the investor’s age from 100 to determine how much to invest in stocks, with the remaining balance being invested in bonds and cash equivalents. Under this rule of thumb, a 30-year-old would invest 70% of their portfolio in stocks, while a 65-year-old would invest 35% in stocks. This same general principal can be seen in target date funds, as these funds typically reduce the risk exposure of the portfolio the closer they get to the target date.

This approach works well for the select few investors and pension plans that have comfortably funded their retirements and plans, but presents a challenge for investors who are dealing with underfunding or issues related to longevity risk. Furthermore, this approach worked much better for investors in the higher return era of the 1980s and 1990s, when equities achieved annualised returns of 17% and 10-year US government bonds yielded 5% to 10%.1 Since 2000, however, it has become much more challenging with equities having achieved annualised returns of less than 5% and 10-year US government bonds yielding between 2 and 3%.3 Additionally, investors in bonds may potentially face a bear market when interest rates inevitably increase from their current low levels.

The investment strategy of steadily reducing risk over time involves a clear return and risk trade-off. Specifically, by decreasing the allocation to equities and increasing the allocation to cash and bonds, investors are reducing the return potential of their portfolios in order to decrease the risk of their portfolio. This approach helps the investor address sequencing risk, but potentially exacerbates the investor’s longevity risk.


Balancing longevity risk and sequencing risk

Just as investors need to balance greed and fear, they need to strike a balance in addressing longevity risk and sequencing risk. Longevity risk pushes investors to invest in riskier assets in order to achieve higher returns and grow their portfolios, while sequencing risk does the opposite and pushes investors to increase their exposure to low-risk assets in order to reduce the risk of losses. Addressing the conflicting nature of these risks is critical, and extremely challenging, for investors.

While there is no magic solution to this issue, investors’ ability to balance these competing risks can potentially be improved by looking beyond traditional investments in stocks and bonds and considering alternative investments.

Alternatives have the potential to provide investors with unique return and risk characteristics that can help them address the issues of longevity and sequencing risk. Specifically, there are some types of alternatives that have the potential to address longevity risk by generating returns equal to, or greater than, equities, or generating current income well above that of bonds. There are other types of alternatives that have the potential to address sequencing risk by offering investors downside protection and volatility reduction. Lastly, there are some types of alternatives that can help investors simultaneously address both longevity and sequencing risk by generating equity-like returns with lower volatility and lower drawdowns than equities.


What are alternative investments?

While there is no one common definition for alternative investments, Invesco defines alternatives as investments other than publicly traded, long-only equities and fixed income. Based on this definition, investments that have any of the following characteristics would be defined as alternative investments:

  • Investments that invest in illiquid and / or privately traded assets, such as private equity, venture capital, and private credit.
  • Investments that engage in “shorting” (i.e., seeking to profit from a decline in the value of an asset), such as global macro, market neutral and long / short equity strategies
  • Investments in asset classes other than stocks and bonds, such as commodities, natural resources (i.e. timberland, oil wells), infrastructure, master limited partnerships (MLPs), and real estate.

(Please note that the above definition is intentionally broad and inclusive. Different investor types often have their own unique definition of alternatives and may classify specific investment types differently.)

Alternatives can be broadly categorised as liquid or illiquid. Liquid alternatives predominantly invest in underlying instruments that are frequently traded and regularly priced, and provide investors with the ability to redeem their investment on a regular basis, be it daily, monthly or quarterly. Alternative mutual funds, alternative Undertakings for the Collective Investment of Transferable Securities (UCITS) funds and most traditional hedge funds are examples of liquid alternatives. Alternative mutual funds and UCITs are available for investment by retail investors, high net worth investors (i.e., individuals with a net worth in excess of $5 million) and institutional investors (i.e., pension plans, foundations, endowments and sovereign wealth funds). Traditional hedge funds, however, are typically only available to high net worth and institutional investors.

Illiquid alternatives predominantly invest in underlying instruments that are privately traded, priced on a periodic basis (often quarterly) and require investors to hold the investment over a prolonged period (typically several years) with little to no ability to redeem the investment prior to its maturity. Private equity, venture capital, direct real estate, private credit, direct infrastructure and natural resources are examples of illiquid alternatives. The availability of illiquid alternatives varies from country to country and is dependent on each countries individual regulatory environment. Generally speaking, illiquid alternatives are typically only available to institutional investors and high net worth individual investors, and are not typically available to retail investors.

When looking at alternatives, Invesco divides the universe into two baskets: alternative asset classes and alternative investment strategies:

  • Alternative asset classes are investments in asset classes other than stocks and bonds. Investments in real estate, commodities, natural resources, infrastructure and MLPs are all examples of alternative asset classes. Alternative asset classes can be accessed through either liquid or illiquid investments. Examples of liquid alternative asset investments include investing in real estate through REITS, investing in the equity and / or bonds of publicly traded infrastructure companies, or investing in commodities by using futures. Examples of illiquid alternative asset investments include direct, private market investments in real estate, natural resources, and / or infrastructure.
  • Alternative investment strategies are investments in which the fund manager is given increased flexibility with how to invest. The manager is often given the ability to trade across multiple markets and asset classes such as stocks, bonds, currencies and commodities, as well as given the ability to short markets. Common hedge fund strategies such as global macro, long / short equity, market neutral, managed futures and unconstrained fixed income are all examples of alternative strategies.

Strategies such as global macro, market neutral, long / short equity, and managed futures all typically invest on a long and short basis. The ability to short has the potential to significantly impact the return stream of these investments, as shorting gives these strategies the potential to generate positive returns in a falling market environment. At a minimum, the use of shorts provides these strategies with a powerful tool to potentially limit losses during such an environment.

Additionally, alternative investment strategies often are frequent users of derivatives, such as futures, forwards, options and swaps. While derivatives are often misunderstood and viewed as risky, within the context of alternative investment strategies, derivatives are commonly used to improve portfolio diversification, hedge out market risks, help protect on the downside and efficiently establish market exposure.

Given the myriad alternatives available to investors,4 one of the major challenges for investors is to understand the unique aspects of the various strategies. To help investors navigate this challenge, Invesco has created the below framework that organises the alternatives universe into six unique categories based on an investor’s investment objectives. The first five alternative categories (Alternative Assets, Relative Value, Global Investing and Trading, Alternative Equity and Alternative Fixed Income) represent liquid alternatives, while the sixth alternative category, Private Markets, represents illiquid alternatives.


How alternative investments can help mitigate longevity and sequencing risk

The ability of alternatives to help investors mitigate longevity and sequencing risk can be seen when looking at the historical performance of alternatives. To this end, the table below shows the historical performance of the various categories within Invesco’s Alternatives Framework compared to equities (i.e. S&P 500) and fixed income (i.e. Barclay U.S. Aggregate Bond Index). (Please note that the data used for the various categories of the framework reflect quarterly returns rather than monthly returns. While the liquid alternatives categories all have monthly returns available, the indexes used for private markets only report returns on a quarterly basis. In order to ensure consistency, quarterly returns were used.)

Examining the historical performance of these various alternative categories allows investors to gain a better understanding of the performance characteristics of each category, as well as how different types of alternatives can help address the challenges of longevity and sequencing risk. Based on an examination of the historical performance of the various categories, the chart below illustrates which risks the various alternative categories are best positioned to mitigate:

As a general rule, alternative investment strategies are effective tools to help reduce sequencing risk, while illiquid alternatives are well positioned to help reduce longevity risk. By combining both liquid and illiquid alternatives within a portfolio, investors can simultaneously address both longevity and sequencing risk.


How to implement alternatives into a portfolio to address longevity and sequencing risk

Once investors have made the decision to allocate to alternatives to address longevity and sequencing risk, they then need to decide how best to implement that decision. Invesco believes that the asset allocation process is as much an art as it is a science, and that there is no one-size-fits-all approach. That said, there are key issues that every investor should address when considering adding alternatives to their portfolio. Specifically, investors contemplating adding alternatives to their portfolio in order to meet longevity and sequencing risk should consider the following questions:

  • What risk or risks are they seeking to address? Determining the risks an investor is seeking to address will drive the decision as to which alternatives to add to the portfolio. Investors primarily concerned about longevity risk will focus on alternatives that have the potential to deliver returns equal to, or greater than, those of equities. Investors primarily focused on sequencing risk will focus on alternatives that can reduce performance volatility and risk of loss. Finally, investors concerned about addressing both longevity and sequencing risk will focus on those alternatives that can simultaneously address both risks and/or will seek a combination of alternatives that can address each risk individually.
  • Which types of alternatives do they have access to? Many liquid alternatives strategies are available to all investors in familiar structures such as mutual funds or UCITs. Private market strategies, however, are typically only available to high net worth and institutional investors.
  • What are the risks associated with the alternatives they are considering? As with any investment, alternatives have unique risks associated with them. It is important that investors fully understand all associated risks before investing.
  • How much should they invest in alternatives? The percentage an investor allocates to alternatives varies widely. For most investors, a typical allocation to alternatives would range between 5% and 30%. There are several institutional investors, however, such as the Yale Endowment, that allocate over 50% of their portfolio to alternatives.5
  • Should the allocation to alternatives be funded from equities or fixed income? The decision of how to fund the allocation varies greatly from investor to investor, and is often driven by the investor’s return and risk objectives for both the portfolio and the investment being considered.

The answers to these questions will significantly impact which alternatives an investor uses, how they incorporate them into their portfolio, their impact on the return and risk characteristics on the portfolio, and subsequently, their effectiveness in addressing longevity and sequencing risk.

To illustrate the potential impact of incorporating alternatives into a portfolio, consider the following scenarios:

  • An investor is seeking to address both longevity and sequencing risk.
  • The investor’s current portfolio is 60% equities and 40% bonds.
  • Retail investors only have access to liquid alternatives (i.e. cannot invest in illiquid alternatives), and allocate evenly across the five liquid alternative investment categories.
  • High net worth and institutional investors have access to both liquid and illiquid alternatives, and split their allocation evenly between liquid and illiquid alternatives. These investors opt to gain exposure to alternative assets through direct, private market investments, rather than through liquid alternatives, due to the higher return potential of private market investments. Additionally, their exposure to liquid alternatives is evenly allocated across the liquid alternative investment categories, excluding Alternative Assets given they can access this exposure in direct/illiquid markets.
  • To fund their allocation to alternatives, investors allocate proportionally away from stocks and bonds (i.e. a 20% allocation to alternatives will be funded by reducing exposure to equities by 20% and reducing exposure to fixed income by 20%)
  • Investors allocate either 20% or 30% of their portfolio to alternatives.

Based on the above assumptions, the chart below illustrates the impact of adding alternatives to a portfolio:

In each of the above cases, an investor seeking to address both longevity and sequencing risk would benefit from higher returns and lower risk by including alternatives in their portfolio. Each portfolio’s compound annual return increased, thus helping the investor address longevity risk. At the same time, both risk (as measured by standard deviation) and maximum decline decreased, helping the investor address sequencing risk.

While the above example is relatively simple, it illustrates how the use of alternatives can help investors address longevity and sequencing risk by simultaneously boosting return and decreasing risk. Furthermore, by thoughtfully deciding which alternatives to allocate to, investors can alter the return and risk characteristics of their portfolios in order to most effectively address their unique needs vis-a-vis longevity and sequencing risk.


Summary

Investors must address the conflicting natures of longevity risk and sequencing risk if they are to invest successfully. These risks are especially acute for individual and institutional investors seeking to provide for a comfortable retirement.

The solution to longevity risk is to seek investments that offer attractive return potential in order to help build sufficient wealth to fund retirement. Conversely, the solution to sequencing risk is to seek stable, low-risk investments in order to avoid potentially devastating losses that could permanently impair the investors’ ability to fund retirement. The challenge for investors is to build a portfolio that balances these competing needs.

While there is no magic solution to this issue, investors’ ability to balance these competing risks can potentially be improved by looking beyond traditional investments in stocks and bonds and considering alternative investments.

Alternatives have the potential to provide investors with unique return and risk characteristics that can help them address the issues of longevity and sequencing risk. Specifically, there are some types of alternatives that have the potential to address longevity risk by generating returns equal to, or greater than, equities, or generating current income well above those of bonds. There are other types of alternatives that have the potential to address sequencing risk by offering investors downside protection and volatility reduction. Lastly, there are some types of alternatives that can help investors simultaneously address both longevity and sequencing risk by generating equity-like returns with lower volatility and lower drawdowns than equities.


Alternative investments at Invesco

Invesco is a leading provider of alternative investments on a global basis, and believes there are four aspects of its alternatives capabilities that collectively differentiate Invesco from its competitors:

  • Proven and experienced portfolio management — Invesco has been managing alternative investments since the early 1980s, and currently has over 350 investment professionals managing over $155 billion in alternative assets.6
  • Diverse array of alternatives capabilities and offerings — Invesco’s alternative capabilities span the entire alternatives universe with offerings across all six alternative categories: Alternative Assets, Relative Value, Global Investing and Trading, Alternative Equity, Alternative Fixed Income and Private Markets. Furthermore, Invesco’s offerings are available in a variety of structures, as we understand the importance of delivering offerings in the manner our clients prefer.
  • Experience working with retail, high net worth, and institutional investors — Invesco has extensive experience working with and meeting the needs of retail, high net worth and institutional investors. Approximately two-thirds of Invesco’s $858B US in AUM is from retail and high net worth investors, while one-third is from institutional clients.7 Furthermore, Invesco is committed to providing our clients with industry-leading thought leadership on alternatives, in order to help them better understand the unique nature of this asset class and effectively implement alternatives into their portfolios.
  • Robust risk management and corporate governance infrastructure — As a global company with a long history, Invesco understands the importance of building a strong risk management and corporate governance structure to support our offerings, including alternatives.

Given the strength of its alternatives capabilities, Invesco is well-positioned to help investors address the issues of longevity and sequencing risk through the inclusion of alternative investments in their portfolios. To learn more about Invesco alternative capabilities and specific offerings, please contact your local Invesco representative or visit our website at www.invesco.com.

 

1 Source: Zephyr

2 UK 2007 is based on British Banking Association data — discontinued.

3 Source: Bloomberg

4 Alternative investments are subject to various regulatory requirements that vary across the globe. Furthermore, there are often suitability requirements that an investor must meet in order to invest in alternatives. For this reason, not all alternatives may be available to all investors.

5 Source: Yale Endowment 2015 Annual Report

6 As of June 30, 2017.

7 Source: Invesco Ltd. as of March 31, 2017


About risk

Short sale risk. Short sales may cause an investor to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, exposure to potential loss is unlimited.

Alternative risk. Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate.

MLP Risk. Most MLPs operate in the energy sector and are subject to the risks generally applicable to companies in that sector, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. MLPs are also subject the risk that regulatory or legislative changes could eliminate the tax benefits enjoyed by MLPs which could have a negative impact on the after-tax income available for distribution by the MLPs and/or the value of the portfolio’s investments.

Important information

This document has been prepared only for those persons to whom Invesco has provided it. It should not be relied upon by anyone else. Information contained in this document may not have been prepared or tailored for an Australian audience and does not constitute an offer of a financial product in Australia. You may only reproduce, circulate and use this document (or any part of it) with the consent of Invesco.

The information in this document has been prepared without taking into account any investor’s investment objectives, financial situation or particular needs. Before acting on the information the investor should consider its appropriateness having regard to their investment objectives, financial situation and needs. You should note that this information:

  • may contain references to dollar amounts which are not Australian dollars;
  • may contain financial information which is not prepared in accordance with Australian law or practices;
  • may not address risks associated with investment in foreign currency denominated investments; and
  • does not address Australian tax issues.

Issued in Australia by Invesco Australia Limited (ABN 48 001 693 232), Level 26, 333 Collins Street, Melbourne, Victoria, 3000, Australia which holds an Australian Financial Services Licence number 239916.

 

In addition to the SuperRatings honours, Lonsec will also present a number of awards recognising excellence across the broader wealth management industry:

Lonsec Disruptor Award

Drawn from the Lonsec rated universe, products or issuers who have challenged the status quo.

Finalists
Allianz Retire+
VanEck Vectors MSCI International Sustainable Equity ETF
Vanguard

Lonsec Investment Option Award

Drawn from the Lonsec rated superannuation investment options and based on a qualitative assessment of the investment team and portfolio design to meet member needs.

Finalists
AustralianSuper Balanced (MySuper) Investment Option
Cbus Industry Growth
Sunsuper for Life (Balanced Fund)

 

Lonsec Sustainable Investment Award

Seeks to recognise and highlight the work of asset managers and key players incorporating ESG.

Finalists
Alphinity Sustainable Share Fund
Ausbil Active Sustainable Equity Fund
BetaShares Australian Sustainability Leaders ETF

 

Congratulations to all of the finalists for this year’s SuperRatings and Lonsec Fund of the Year Awards Dinner. A full list of the awards is available below.

SuperRatings MySuper of the Year Award

Awarded to the fund that has provided the Best Value for Money Default Offering.

Finalists
AustralianSuper
CareSuper
Cbus Super
First State Super
HESTA
Hostplus
QSuper
Statewide Super
Sunsuper
UniSuper

 

SuperRatings MyChoice Super of the Year Award

Awarded to the fund with the Best Value for Money Offering for Engaged Members.

Finalists
CareSuper
Cbus Super
Hostplus
Mercer Super Trust
QSuper
Statewide Super
Sunsuper
TelstraSuper
UniSuper
VicSuper

 

 

SuperRatings Pension of the Year Award

Awarded to the fund with the Best Value for Money Pension Offering.

Finalists
AustralianSuper
BUSSQ
Equip
HESTA
QSuper
Sunsuper
Tasplan
TelstraSuper
UniSuper
VicSuper

 

 

SuperRatings Career Fund of the Year Award

Awarded to the fund with the offering that is best tailored to its industry sector.

Finalists
Cbus Super
HESTA
Hostplus
Intrust Super
Mercy Super
TelstraSuper

 

SuperRatings Best New Innovation Award

Awarded to the fund that has developed and launched the most innovative product or service during the year.

Finalists
First State Super Explorer
Hostplus Self Managed Invest
Intrust Super SuperCents
Kogan Super
Raiz Invest Super
Sunsuper Adviser Online Transact

 

Infinity Award

Awarded to the fund most committed to addressing its environmental and ethical responsibilities.

Finalists
Australian Ethical Super
AMP
CareSuper
Christian Super
HESTA
Local Government Super

SuperRatings Momentum Award

Awarded to the fund that has demonstrated significant progress in executing key projects that will enhance its strategic positioning in coming years.

Finalists
Cbus Super
HESTA
Mercer Super Trust
Rest
Sunsuper
Tasplan

 

SuperRatings Net Benefit Award

Awarded to the fund with the best Net Benefit outcomes delivered to members over the short and long term.

Finalists
AustralianSuper
CareSuper
Cbus Super
Hostplus
QSuper
UniSuper

 

SuperRatings Smooth Ride Award

Awarded to the fund that has best weathered the ups and downs of the market, while also delivering strong outcomes.

Finalists
CareSuper
Cbus Super
CSC PSSap
HESTA
Media Super
QSuper

 

SuperRatings Fund of the Year Award

Announced on the night.

 

 

 

 

 

 

The Australian equity reporting season was weaker than expected with a third of companies having their FY20 earnings downgraded. At the sector level, Healthcare and Resources had impressive results whilst the Financials sector reported poor earnings. Dan Moradi runs through the key themes that emerged over the reporting season.

“How much can I spend?”

This question lies at the heart of so many conversations between a retiree and their adviser. Although not explicitly stated, this simple question ties in to so many other related concerns – Can I spend enough to be comfortable? Will I run out of money? What are my options if my health deteriorates? What about bequests?

All these questions boil down to one thing – a craving for certainty. While this is understandable from a retiree perspective, the key challenge for the financial advice industry is how much certainty can we provide in answering these questions, and how do we manage expectations?

With many changes taking place in the retirement products space and the baby boomer cohort starting to retire in greater numbers, it is an opportune time to consider how annuities may form part of a solution to address the issues many face in retirement.

August was a weak month for equity markets with continued concerns over trade tensions between the US and China. While equities sold off bonds, ‘bond proxy’ assets such as property generated positive returns. For the year to the end of August Australian bonds, as represented by the Bloomberg AusBond Composite 0+ Yr Index, returned an impressive 11.2%, outperforming Australian equities. Despite bond yields being at low levels and valuations generally indicating that bonds are overpriced, bonds have continued to provide diversification to equities in downmarket periods.

We continue to believe that bonds play an important diversification role within managed portfolios, despite valuations remaining high. From a portfolio perspective, the primary role of fixed income assets is to provide diversification, with the secondary role being to generate income. Lonsec’s portfolio construction process employs a fixed income allocation within the portfolios to provide a diversified exposure to duration, credit and absolute return bond strategies. We caution against ‘chasing yield’ in the defensive part of the portfolio as most high yielding bond assets tend to be correlated to equities, which work well when equity markets are performing well, but on the reverse will move directionally with equities in an equity market pull-back. In our most recent Asset Allocation Investment Committee, we did not change our allocation to bonds but we increased our exposure to ‘bond proxy’ assets such as global REITs providing some more defensiveness to the portfolios.

One of the lasting achievements of sports like golf and horse racing is the way the handicapping system can make it possible for athletes to engage in a close and enjoyable competition despite obvious differences in ability, experience or personal characteristics.  In Thoroughbred horse racing, the older steeds would otherwise win most races, hence the ‘weight-for-age’ system, whereby each horse carries a small additional saddle weight based on statistical analysis of the historical differences in ability by age.  The system has been working well for more than a century – so why can’t we do the same for measuring super investment returns?

In January this year, the Productivity Commission handed down its final report to the Federal government on its investigation into the superannuation system.  One of the terms of reference for the inquiry was the following:

‘The Productivity Commission should develop criteria to assess whether and the extent to which the superannuation system is efficient and competitive and delivers the best outcomes for members and retirees, including optimising risk-adjusted after fee returns.’

It is of course widely accepted in the superannuation industry that there is a trade-off between risk and return.  Moreover, there is a general consensus that performance comparisons should be done on the basis of products with a similar risk profile.

The most common risk metric tracks the amount of change in return over time (technically, it is the ‘standard deviation’ of the net investment return measured over a specified period, also known as ‘volatility’).  It should be noted that this is a measure of ‘market’ risk only – arguably a young investor saving for retirement should be more concerned about the risk of losing her capital (‘capital risk’) due to poor quality asset selection, but there are currently few metrics for this.  A ‘Standard Risk measure’ must be displayed on MySuper Dashboards  in accordance with the Corporations Act, and the SRM is essentially a Market Risk metric, expressed as the expected number of negative returns over a 20-year period, based on modelling of the fund’s investment strategy.

A long-standing proxy for Market risk has been the ‘Growth Ratio’ or the percentage of funds allocated to ‘Growth’ type assets, such as shares, property and, more recently, infrastructure.  There has also been much discussion about the methods used by funds to report the percentage of growth assets, particularly in relation to unlisted asset classes like property, infrastructure and hedge funds.

How good is the handicapping system used within our industry?  Despite some limitations, there seems to be a reasonable level of consistency across the different metrics, and returns are consistent with the expected risk / return trade-off.  The following graph is based on median rolling returns and volatility (risk) over the three-year period to 30 June 2019:

With the exception of ‘High growth’, the relationship between median risk and return is in line with expectations.  Even so, there is still a potentially wide dispersion of risk / return combinations within each classification. Is there a way to apply a handicapping system to enable a fair comparison across and within the risk profile categories?

The Productivity Commission was tasked with optimising ‘risk-adjusted’ returns.  The ‘Sharpe Ratio’ is one such metric – it attempts to adjust for the trade-off between risk and return (technically, it is a measure of excess portfolio return over the risk-free rate relative to its standard deviation).  It does this by giving a lower weight to excess return earned from taking additional risk.

We ran a test race with just five horses, based on the SuperRatings Option Type classifications, and here are the results:

Horse

Place

Risk-adjusted Return*

Actual return*

Market risk*

Balanced (60-76)

1

1.60

8.80

4.14

High Growth (91-100)

2

1.30

9.25

5.59

Conservative Balanced (41-59)

3

1.19

6.58

2.90

Growth (77-90)

4

1.13

9.68

5.30

Capital Stable (20-40)

5

1.05

4.81

2.16

Source: SuperRatings FCRS 30 June 2019
Risk-adjusted Return: Sharpe ratio
Actual Return: 3-year rolling net return % per annum
Market Risk: 3-year rolling Standard Deviation % per annum

On this basis, ‘Balanced’ was the horse to be on.  ‘High Growth’ can run faster, but the risk trade-off is too high (on this metric) to justify the extra speed.

What is ‘Conservative Balanced’ doing in third place?  It’s the second slowest horse in the race, but it gives its jockey a smooth enough ride to offset the performance difference.  This seemingly anomalous result reflects the current investment environment, with very low risk-free rates of return.  This option was able to achieve a higher excess over the risk-free rate per unit risk than any of the other options bar Balanced and High Growth.

Is Risk-adjusted Return (RAR) then a sensible metric for comparing different investment strategies?  One major weakness is that RAR takes no account of an individual member’s risk characteristics and assumes that the risk / return trade-off is the same for all members. Clearly this is not the case – younger members are less likely to be impacted by short-term fluctuations in market asset values, whereas members approaching retirement can be affected by sharp declines in market value immediately prior to retirement (‘sequencing risk’).  In the context of the table above, a member approaching retirement might value the stability offered by ‘Conservative Balanced’ enough to accept the lower return, whereas a younger member would (should!) be unhappy about the underperformance, given that market risk is not really an issue.

This suggests that a ‘weight-for-age’ handicapping system would make more sense for MySuper performance comparisons.  In fact, many fund trustees have already put this into practice via a ‘Lifecycle’ strategy, whereby each member’s risk exposure varies with age, becoming more conservative as retirement is approached. However, it is difficult to see much standardisation occurring in this area, given that there is not even consensus within the industry regarding the value of the Lifecycle approach, let alone the appropriate risk exposure for each age.

Despite these limitations, there is one group of members where there is broad general agreement across the industry.  Our analysis was based on MySuper default options – by definition, the investment strategy that will apply to superannuation fund members who do not make an active investment choice – generally those members who are less ‘engaged’, and typically the younger members for whom retirement is in the distant future, and accumulated super is relatively small.  As already indicated, market risk should be less of a concern for this group (although managing expectations after a share market crash can still be a challenge for fund communication strategies).

This graph shows 3-year rolling returns versus risk (standard deviation over 3 years) for all SuperRatings Balanced (60-76) options.  The highlighted options are the Top 10 by Risk-adjusted return (Sharpe Ratio).  These are the options that performed the best for a given level of risk over the 3-year period to 30 June 2019.

Risk-Adjusted Returns therefore have some value in highlighting the best performers for a chosen level of risk, but even within the constraint of just Balanced options, there is a wide range of risk experience.

The SIS Act and Regulations require that trustees must formulate an investment strategy taking into account at least ‘the membership profile (for example, members’ age and expectations, occupational profile …)’.  The investment strategy decision is likely to be a bigger determinant of performance outcomes than the fund’s ability to manage assets.  Thus we have the current situation where the trustee of one fund can decide that the appropriate default level of risk for a 50-year-old is a Balanced option, while the trustee of another fund can quite legitimately decide that a Capital Stable option has the appropriate level of risk.  There is potential here for uninformed commentators to label a fund as a ‘dud’ or underperformer simply on the basis of ‘first past the post’ outcomes, when the underlying reality is that the trustee is managing efficiently to its stated investment strategy.

Einstein is reputed to have said ‘Everything should be made as simple as possible, but no simpler’.  In the world of superannuation investment performance measurement, there may be no black and white answers, and we will have to wait and see before we place any bets on future performance measurement systems.

Active management has fallen out of favour among investors, reflecting changing investor preferences and the scars of the Global Financial Crisis, which have led investors to shun stock pickers and more elaborate strategies in favour of lower-cost, vanilla products. Investors today are focused far less on alpha generation, with its goal of outperforming benchmarks, and are now far more content in generating the majority of their returns from index funds or similar passive strategies.

The growth in passive management has been astonishing. In the last five calendar years, investors moved US$1.5 trillion into funds managed by Vanguard, one of the world’s largest managers of passive strategies. Blackrock, the second largest passive manager, took in US$685 billion over the same period. Vanguard now manages close to US$4.0 trillion globally in passive strategies and on average owns around 7% of every listed US company, according to Bloomberg data. As passive managers continue to suck up funds, active managers are struggling to get a positive message through.

Passive managers don’t apply any security selection, meaning the money simply flows into passive or index strategies that replicate benchmarks like the S&P/ASX 300 Index in Australia or the S&P 500 Index in the United States, with Exchange Traded Funds making it easier than ever before for investors to gain relatively cheap passive exposure.

At its core, passive investing is a momentum strategy. It buys more of those stocks that go up in price and sells more of those that fall in price. Passive strategies tend to work best when financial markets experience strong upward moves in share prices. Passive management is used mostly in the portfolio management of equities (Australian, Global and Emerging Markets) and fixed income (Australian and Global) and have given rise to the major ETF providers that currently dominate the market (see chart below).

FUM share of Australia’s major ETF providers (August 2019)

Source: ASX, Lonsec

The beta rally has put active managers in the shade

The post-GFC period has been characterised by strong equity market returns, but given the length of the bull market to date, investors are questioning how long this situation can last.

Given the inevitable cyclicality of financial markets, the one thing that’s certain is that strong markets will not last forever. In a low return environment, market beta may end up providing disappointing returns, making alpha a valuable contributor to portfolios.

The aim of active management is to be an additional incremental return source, above market returns. Alpha doesn’t scale well with beta, meaning it becomes a smaller percentage of returns when beta is very high. This is the environment we find ourselves in, so we would expect beta to do well and for seekers of alpha to struggle. But even taking a broader view, the case for active management does not appear great.

The hard truth is that most active fund managers underperform benchmarks constructed by index committees. One of the world’s most widely used benchmarks for assessing US equity fund performance is the S&P 500 index. The committee looks at only a handful of criteria when looking to add new stocks to the index, including: liquidity, financial viability (four consecutive quarters of positive earnings), market capitalisation (must be greater than US$6.1 billion), and sector representation (the committee tries to keep the weight of each sector in balance with sector weightings of the S&P Total Market Index of eligible companies). Changes to the index are made when needed.

The S&P committee does no macroeconomic forecasting, invests over a long-term horizon with low portfolio turnover, and is unconstrained by sector or industry limitations, position weightings, investment style, or performance pressures. Yet this straightforward strategy has generally outperformed active fund managers.

Some active managers can consistently outperform

If alpha were easy to find, it wouldn’t exist. There are three general sources to generate excess return for investment portfolios: strategic asset allocation, tactical tilts within asset classes (including opportunistic investing), and superior fund manager selection. While opportunistic investments tend to be episodic alpha generators in portfolios, the biggest long-term drivers of alpha are asset allocation and manager selection.

Even as managers have struggled to generate alpha, a significant number of managers are still generating returns in excess of market indices. The key is having the right resources and the right approach to find them. Average active fund managers tend to underperform industry benchmarks, but the best fund managers outperform over longer time frames.

There’s a deep body of research that looks at how investors can gain an edge by identifying active fund managers that are able to tap sustainable sources of alpha. Research indicates that to meaningfully outperform, it is often helpful to find active fund managers with a portfolio that looks significantly different to the benchmark they are attempting to beat (i.e. they have a high degree of ‘activeness’).

In the financial literature, there are numerous studies showing that the average active fund manager underperforms the benchmark index after fees. However, research presented in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management introduced an idea called Active Share. This is a new method of measuring the extent of active management employed by fund managers and is a useful tool for finding those that can consistently outperform. By analysing 2,650 US equity funds from 1980 to 2003, Cremers and Petajisto found that the top-ranking active funds—those with an active share of 80% or higher—beat their benchmark indices by 2.0–2.7% p.a. before fees and by 1.5–1.6% p.a. after fees.

Active share aims to measure the proportion of a manager’s holdings that are different to the benchmark. It is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager’s portfolio versus the weight of each holding in the benchmark index and dividing by two. For a long-only equity fund, the active share is between 0% and 100%. The active share for fully passive strategies that replicate an index is 0%, and more than 90% for strategies that are very different to the benchmark index.

As you might expect, the portfolios of active, high-conviction fund managers will diverge significantly from the benchmark, and will frequently incur volatility relative to benchmark returns. However, this differentiation provides investors with the opportunity to add value over the long term.

What to look for when assessing active managers

Skilled managers with high active share have shown a higher tendency to outperform the market. Investors that tilt towards active managers with high active share have a greater chance of outperforming. They tend to be smaller fund management organizations, often where the founder is an investor first and invests his or her wealth alongside external clients, bringing their investing acumen to a portfolio of funds.

Active managers with high active share tend to maintain this high level consistently over time. This proves useful when conducting analysis to help identify managers that are likely to outperform in the future as well. While some of these managers may not have beaten the index in recent periods, when there are dislocations in markets, these managers will be well positioned to generate long-term returns above the fees they charge.

Active share by itself does not indicate whether a fund will outperform an unmanaged benchmark. There are other important aspects to consider when conducting manager due diligence. Here are a few things you should consider:

  • Find out as much as you can about the fund’s culture and process. Outperformers see investing as a profession and not a business. Examine the fund’s investment philosophy to see if it is consistent and lived out through the fund’s investment decisions. Does the manager exercise patience and discipline?
  • Successful active fund managers have low portfolio turnover with long holding periods of at least four years versus roughly one year for average performing funds. This is a useful metric to look at when assessing a fund’s buy/sell discipline. Another strong indicator is for active managers to add to stock holdings when market pricing improves, rather than giving in to agency behaviour of selling into a falling market.
  • Alpha generators are high conviction stock pickers. This means their portfolios are concentrated in their best ideas, leading to a higher level of ‘activeness’ and differentiation from the benchmark.

While there are active managers that are persistently generating alpha, finding them is not a simple task. For investors that are committed to generating long-term outperformance, it’s critical to have the right resources in place to identify these managers. A world class research effort is required to be able to identify and evaluate those managers that can generate consistent outperformance from the thousands of managers out there.

Historically, high valuations in a range of asset classes including equities, sovereign bonds, credit and unlisted assets mean future beta returns are expected to be lower. This will make it a challenging environment for investors to meet their investment objectives. For those with the knowledge and capacity, finding alpha can help bridge the gap.

When accumulating savings for retirement, the investment objective is clear – to grow and maximise savings. Risk in the accumulation phase is also well-defined and focused on the loss of capital, as measured by the volatility of investment returns or related downside risk measures. Risk tolerance is then typically used to determine appropriate investment profiles, with the aim of achieving greater wealth to fund retirements.

However, the risk-return landscape becomes significantly more complex once retirement comes into the picture. The primary objective in the decumulation phase ceases to be pure growth and more about using accumulated wealth to sustain a target level of income throughout retirement. Therefore, volatility of investment returns is no longer a suitable risk measure as it does not describe the risk of failing to meet this objective.

Retirement income risk measure

Traditional measures of variance (standard deviation) focus on both upside and downside variation. However, behavioural economists commonly point out that individuals are more averse to downside variation than upside variation. A more relevant risk measure in the context of decumulation is the probability of running out of money, or a measure of income variation. This captures important dynamics such as the sequence of returns, which can be particularly damaging in decumulation.

The risk can be depicted as:

 

The importance of risk measurement in retirement products is highlighted in a Treasury consultation paper which proposes a range of standard metrics to help consumers make decisions about the most appropriate retirement income product for their own circumstances.

The discussion paper proposes that a measure of income variation be provided in respect of all retirement income products and this measure is presented on a seven-point scale.

The finance industry uses terms like longevity risk, market risk, sequencing risk and inflation risk, which are all relevant to the outcome experienced by investors in a retirement income product. However, these terms are not well understood by a lay person, so an income variation measure could help fill in some gaps.

Retirement objectives

Lonsec’s Retirement Lifestyle Portfolios are objectives-based portfolios focused on delivering a sustainable level of income in retirement, as well as generating capital growth. Specifically, the portfolios are designed to assist advisers in constructing portfolios to meet retiree essential and discretionary income needs, while generating some capital growth to meet lifestyle goals.

Differences to Lonsec’s core accumulation model portfolios are:

  • Income objective of 4% p.a. for all portfolios
  • Greater bias to AUD denominated assets – historically higher dividends, franking credits
  • Greater focus on absolute rather than relative performance
  • Constructed to manage capital drawdown risk
  • Fixed income allocations have less duration and greater credit exposure
  • Key building blocks are Yield, Capital Growth & Risk Control

In reality, risk in retirement is multi-dimensional. An individual retiree may have multiple goals, such as leaving a bequest, with a different level of importance attached to each. An individual’s risk aversion in retirement will therefore be defined by a holistic view of their retirement goals, and the risks to those goals across all scenarios that could play out during retirement. Typically, more than one risk measure is necessary, with multiple scenarios required to truly appreciate the risks inherent with each solution.

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.