As always there will be many different opinions on what might happen to markets in the coming year, but by and large most will agree it is unlikely to top the volatility and uncertainty of 2020. Amid the stimulus packages, lockdowns, PPE and politics, COVID-19 also brought to an end one long running market cycle and ushered in a new one, offering investors new opportunities with the potential for new risks and returns.

We believe understanding and navigating both will be more important than ever.

One of the main risks that still carries over from the last few years is the concentration of the index in just a few mega-capitalization companies. In fact, when considering the S&P 500, the top 10 companies still account for around 28% of the index, and as of late December 2020 the top 6 were worth more than the bottom 372 companies.

 

 

Why is this a problem?

Well if you’re buying the index you’re buying very expensive companies that have already grown substantially during 2020 such as Apple 86% and Amazon 76%. What’s riskier is Tesla (TLA) is nearly 2% of the index but only joined in late 2020, so index investors didn’t receive most of the benefit of its 700%+ growth, but bear all the downside if the stock were to fall.

Investors usually choose indices for their diversity – perhaps now they need to look again.

In addition, while global stimulus and support packages have helped economies from falling off a cliff, they have also pumped a lot more liquidity (cash) into the system. This, along with low interest rates may well support inflation for the first time in decades which even in small amounts can have a profound effect on stocks. Stocks with high valuations that are dominating the index (technology) are more susceptible to the increase in interest rates that usually accompanies inflation, meaning to get your money back you need to wait years if not decades. This is less the case with other sectors.

Is this likely?

While the potential for inflation is there, so too are signs of a rotation away from the tech stocks to those less highly valued sectors of the economy. From September to mid-December 2020, the S&P500 Value index outperformed Growth by around 8%, driven by more certainty about the real economy restarting on the back of a COVID-19 vaccine. While we can’t predict the future there is precedent here going back to the dotcom bust of 2000, where in the following 5 years Value had a resurgence to the point where it outperformed over the 10 years pre and post the bust.

 

To add to this are current data showing a significant increase in activity in the bellwether ISM New Orders Index which measures manufacturing activity, up 40% since the lows of 2020 and its highest level in over 3 years. The opportunity here lies in those sectors and regions that benefit from this new cycle economy, sectors that have been neglected, and so are cheap, but stand to benefit from the surge of global economic activity as populations slowly become vaccinated. The rewards here could be substantial.

Added benefit of options

Finally, the market is currently experiencing an unusual set of dynamics. Volatility (uncertainty) is higher than the long-term average, but so is the market. Usually the market is lower when volatility is higher.

This represents both heightened uncertainty alongside optimism, which has been fueled by some arguably unsophisticated market participants.

This creates unprecedented opportunity for professional investors, and especially for Talaria’s process of using put options to enter stock positions because:

  • There is a greater contracted rate of return on the put options we sell, which can generate 3-4% p.a. more option premium into the portfolio p.a. all else being equal.
  • The opportunity cost of not being fully invested is materially reduced given low expectations for equity market returns.
  • Heightened volatility allows us to widen our buffers against loss and maintain our risk credentials.

As we like to say, certainty empowers you.

 

 

 

 

 

 

 

 

 

 

 

 

It’s been nearly a year since the world changed as COVID-19 took hold. Of all that has been written
about and said so far, the word ‘uncertain’ seems to be the most enduring.

Uncertainty is not many people’s preferred state, but for retirees in particular, it’s even more
concerning, coming at a time when the juggle and stress of raising kids and building careers should be a
warm but more distant memory.

We spend 40+ years working to build an asset base to support us in retirement and we need that asset
base to deliver three key outcomes:

• Income generation – but not at the expense of capital loss,
• growth – of outcomes, and
• certainty – of outcomes…

…and do all this for an unknown number of years.

So how has the COVID-19 pandemic impacted these three retirement needs?

While stock markets globally have largely recovered since March, the underlying economy and outlook
for businesses hasn’t. This means dividends have been cut or reduced by many companies – impacting
income. Meanwhile, other asset classes such as Fixed Interest, Bonds, and Property are also delivering
substantially less returns.

Ranjit Das, Principal at Rahali Corporation believes this is a significant problem because of the over
reliance on income since the GFC. “Even over 10 years, traditional income sources like Banks, Telstra
have underperformed the ASX200, so non-traditional income sources are essential in client portfolios,”
Ranjit said.

At the same time, there has been a lot of volatility – a direct outcome of uncertainty – across asset
classes and currencies. This means it’s hard to predict when is a good time to either sell assets if
required or buy back into them.

“Retirees are very nervous in nature as they have no means to rebuild lost wealth. Any sharp spikes to
the downside creates a fear that capital will erode, income will reduce and they will ‘run out of money’.
Any sharp upticks don’t provide any joy as retirees are ‘buy and hold’ – much more than younger clients
who may be tempted to buy/sell and rejig allocations,” said Das.

In addition, the recovery of many markets at an index level has been driven by a few – namely
technology and consumer discretionary stocks – that have skewed the index. This means that those
following the index have a greater risk by being less diversified. If you’re starting out or still in the
accumulation phase of investing this might be ok, but not for retirees as they have additional risks
namely:

Sequencing – incurring large losses early in retirement, endangering a comfortable retirement
Longevity – ensuring your investments are there to support you for the full journey; and
Inflation – ensuring the purchasing power of your investments doesn’t erode.

The culmination of COVID-19 uncertainty, loss of business, and government stimulus that is currently at
play is creating all three of these.

There are solutions however that are genuinely uncorrelated sources of income – from shadow banking
to catastrophe insurance to selling equity insurance. However, the first two are very difficult to access as
a private investor, whereas equity insurance is more accessible and easily available.

So what is it?

In a nutshell equity insurance is really a metaphor for selling put options to enter stock positions that
you want to own rather than buying them directly. This then generates a premium which is treated as
income for the investor, regardless of whether the stock is ultimately bought or not. As a result, the
process creates:

• More consistent income;
• A diversified source of return;
• A downside buffer to first loss; and
• Reduces portfolio volatility.

This means that in periods such as now, investors have somewhere else to go for income. Further, as
option premium increases with volatility, an uncertain environment in most cases increases income
from this source.

Helping to create more certainty in an uncertain world.

www.talariacapital.com.au

With central bankers around the world committing to keep interest rates low for many years to come, this creates an issue for retirees looking for income. Traditional defensive assets such as cash and fixed income which typically form a large percentage of retiree portfolios are producing levels of income significantly below historical averages.

In Australia, the RBA is keeping the 3-year yield for government bonds at 0.25%, in what is known as yield curve control. Interest rates have been suppressed for the last decade, however what is unique about the current economic climate, is that with inflation yet to emerge and central bankers focused on generating growth and employment, their signalling to the market has moved further out. Lower for much longer!

 

SuperRatings Executive Director Kirby Rappell shares the latest performance results for superannuation funds and the future outlook for the industry.

Members should be prepared for more ups and downs. However, a patient approach has paid off for members over the long term with the median balanced style fund returning 7.0% per annum since the introduction of superannuation in 1992.

 

 

 


Any advice that SuperRatings provides is of a general nature and does not take into account an individual’s financial situation, objectives or needs. Because the information that SuperRatings receives about superannuation and pension financial products is from a number of sources, it is not guaranteed to be completely accurate. Because of this, individuals should, before acting on the information, consider its appropriateness having regard to their own financial objectives, situation and needs and if appropriate, obtain personal financial advice on the matter from a financial adviser. Before making a decision regarding any financial product, individuals should obtain and consider a copy of the relevant Product Disclosure Statement from the financial product issue.

Although the secrets of a long life remain a mystery, there are now over 300,000 centenarians across the globe and the numbers are rising. Most of us will not survive to 100 no matter how many green vegetables we eat, but there is no doubt life expectancy is increasing. In Japan, 2.5 times more adult than baby diapers are sold. Australian life expectancy from birth is among the highest in the world with the average man living to 80.7 and 84.9 for a woman. It assumes no improvement in healthcare which can increase life expectancy further.

The following lesson is one of IML’s ‘20 lessons for 20 years of quality and value investing’, which were recently published by Anton Tagliaferro and the IML investment team to mark 20 years since IML was founded.

We chose this lesson for Lonsec Retire, as it highlights the need for growth assets in retirement, particularly for early retirees who typically have investment timeframes of 20+ years.

The lesson illustrates the benefits of compounding by showing how companies that reinvest back into their businesses can reward investors with increasing dividends and appreciating share prices over the long-term. Increasing dividends is vital for retirees facing significantly lower returns from popular retirement income streams such as term deposits and traditional fixed income funds.


#6 The Power and Benefits of Compounding Over Time in Equity Portfolios

Most people are familiar with the concept of compound interest when it comes to term deposits, where one can earn interest on interest by continuing to roll over a term deposit. However, many investors do not relate the concept of compounding to their investments in the sharemarket.
Compounding occurs in the sharemarket when income from an investment is reinvested back into the business, and investors are rewarded with the benefits of increasing profits and appreciating share price growth over the long-term.
For investors in the sharemarket, there are two ways compounding can work in their favour to enhance their long-term returns.

These lessons are available both in hard copy and e-book format. For a copy of the book please register your interest here or email iml@iml.com.au

**IML and Lonsec  Investment Consulting will be holding a webinar as part of Lonsec Retire Program on Wednesday, February 12th, find out more.

Real estate offers potential diversification away from traditional stocks and bonds, stable income, the possibility of capital appreciation and has historically offered inflation protection. The average Australian retiree is likely to have exposure to domestic residential real estate – through the family home, an investment property or holiday home – but these assets are likely concentrated in geography and in the residential sector. Commercial real estate can present geographic diversification to the US, Asia and Europe, and sector diversification into offices, shopping centres and industrial parks. The following article explores the investment choices for the commercial real estate asset class across the risk/return spectrum.

  • Real estate may provide investors with the potential to generate attractive long-term returns through possible asset appreciation and current income
  • Real estate also may serve as a hedge against inflation and offer diversification versus traditional stocks and bonds

Anyone who has purchased a home is a real estate investor — but there’s a big difference between taking on a mortgage and investing in office buildings, malls or industrial parks. In this blog, we explain the basics of real estate investing, the potential benefits, and the ways that individuals can add real estate exposure to their portfolio.

To find out more about this article, please contact:

Sam Sorace

Director, Wholesale Sales

Invesco Australia

Direct   +61 3 9611 3744

Mobile  +61 413 050 909

sam.sorace@invesco.com

In our first paper: “Balancing the Needs, Challenges and Dilemmas of Retirement Investing”, we noted that Income generation isn’t as easy as it once was. The fact retirees require income needs no explanation.

How should we think about generating income in retirement? In August 1991 the Budget address, by then Treasurer John Kerin, proposed the introduction of compulsory superannuation in
1992. At the time a 90 Day Bank Term Deposit was paying 9.75% p.a.

Bank Term Deposits are one of the reasons Australia is the ‘lucky country’ as today these are guaranteed, or true ‘risk free’ investments. Unfortunately, while the ‘risk free’ aspect
remains attractive, the investment returns compared to 30 years ago are not.

While cash remains ‘risk free’ relying on it as your only source of income risks quality of life in retirement. Therefore, to generate sufficient income to sustain a comfortable retirement, we are forced to accept some level of investment risk. In simple terms, the more risk we accept, the higher income we should expect to generate. While acknowledging this,
acceptance of risk increases the probability that the asset base we’ve spent 40+ years working to build is at some risk of diminishing.

How Much is Enough?
The Australian Financial Security Authority “AFSA” advises that a comfortable retirement for a retiree with the ATO Median superannuation balance 5 eligible for the Government Pension needs to generate 7.6% per annum. Once upon a time, generating this level of income was achievable using “risk free” approaches. This is an exceedingly lofty ambition today with cash rates closer to 1%. As we’ve noted investing for the specific needs of retirement is incredibly complex, while much of the commentary proposes solutions that only work for those with adequate assets to be self-sufficient in retirement.

There are various proposals surrounding the use of draw-downs to supplement income generation, such as the concept of a constant draw-down policy in retirement, which we’re supportive of. However, we are concerned that their applicability is limited to only those with Asset Bases sufficiently adequate to provide for a self-funded retirement, therefore risking overlooking the
issues facing a majority of retirees.

The following commentary attempts to investigate the issues facing those with Asset Bases around the level of the ATO Median 2016-17, where the issue is more stark. For these retirees drawing down their asset base guarantees a retirement well below comfortable.

For Retirees with asset bases at or below the level of the ATO Median their Asset Base is sacrosanct.

 

James Syme, Portfolio Manager, Pendal Global Emerging Markets Opportunities Fund

After five tough years, we think the combination of a more benign US monetary outlook and some extremely compelling valuations makes for some powerful opportunities in the emerging market (EM) domestic demand space.
We see domestic demand — the sum of household, government and business spending in an economy including imports but not exports — as the primary area of opportunity in EM, particularly after the 2018 sell-off.
We emphasise an exciting combination of supportive top-down conditions, good quality companies and attractive valuations.

India in favour
India is currently our most favoured market, despite economic growth recently falling to a six-year low.
We like a number of domestic names there including mortgage lenders. Now that the global liquidity outlook has eased, there is the prospect of the Reserve Bank of India continuing to cut rates even as Indian credit growth recovers.
India, unusually in EM, has not had a credit cycle in the last ten years, so the current pick-up in credit could be enduring.
Alongside that, India has ongoing demand for 5-10m residential units per year that need financing.

Mexico and UAE good value
Elsewhere, Mexican equities look markedly cheap relative to history, despite growth being decent, implying some excessively negative market expectations for the political environment.
We also like property stocks in the United Arab Emirates (UAE), particularly in Dubai.
Through its currency peg, the UAE effectively imports US monetary policy. Higher US rates coincided with oversupply of development properties to push real estate prices and related stocks down significantly.
As the Fed’s more accommodative stance improves financial conditions in Dubai, and helped by rising tourist numbers, the prospects for attractively valued Dubai property stocks look good.

South Korea and China
Turning to South Korea, the ongoing corporate governance revolution there is one of the main reasons for our overweight position.
China is a slightly separate story and continues to disappoint.
It has tightened monetary policy significantly in the last two years as the strength of the US dollar has put pressure on the Chinese renminbi, which has been a constraint on the People’s Bank of China’s ability to act.
Activity indicators remain soft, and we think that more stimulus through faster credit creation remains key to a recovery in China.

We’re bullish about:
• The EM domestic demand space offers an exciting combination of supportive top-down conditions, good quality companies and attractive valuations
• A more benign US monetary policy outlook

We’re bearish about:
• Potential for escalation in the US / China trade conflict
• Chinese growth continues to disappoint

Why allocate to Emerging Markets?
As cash rates head below 1%p.a. in Australia, the need for returns from growth assets to offset lower returns from income assets becomes very important for retirees. However in terms of portfolio construction, trying to improve returns without increasing risk becomes very important, due to the increased concerns of retirees around drawdowns. ‘

We believe that a discrete allocation to Emerging Market equities can assist retiree portfolios to achieve these goals because:
• Emerging markets tend to higher GDP growth than developed markets (DM) – and higher equity market returns (+2.46% pa over 20 years^)
• Despite this, emerging market countries are under-represented in most global equity portfolios
• The different growth profiles between DM and EM bring the benefits of diversification to a global equity allocation, without the need to try and time shifts between them.

Figure 1 demonstrates that a simple 50/50 split between MSCI World and MSCI Emerging Markets would have delivered a significantly higher return, at a very small increase in risk, than a purely developed market portfolio over the last fifteen years.

  • Figure 1: Risk-return profile since 1 Jan 2001

^ Calendar year performance of MSCI World and MSCI EM indices in AUD over 20 years to 31 December 2018.

Hear more about emerging markets as London-based portfolio manager Paul Wimborne of J O Hambro Capital Management presents an update in Sydney and Melbourne in November
Sydney (Nov 14)
Melbourne (Nov 12) 

DISCLAIMER
This communication has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 for the exclusive use of advisers and the information contained within is current as at 21 October 2019. It is not to be published, or otherwise made available to any person other than the party to whom it is provided.
PFSL is the responsible entity and issuer of units in the Pendal Global Emerging Markets Opportunities Fund (Fund) ARSN: 159 605 811 (formerly BT Emerging Markets Opportunities Fund). A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1800 813 886 or visiting www.pendalgroup.com. You should obtain and consider the PDS before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund referred to in this presentation is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested.
This communication is for general information purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their or their clients’ objectives, financial situation and needs. This information is not to be regarded as a securities recommendation.
The information in this communication may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information in this communication is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information.
Where performance returns are quoted “After fees” then this assumes reinvestment of distributions and is calculated using exit prices which take into account management costs but not tax you may pay as an investor.

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.

 

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.