When it comes to investment objectives, many retirees―quite understandably―want to have their cake and eat it: they want enough income to enjoy an adequate lifestyle for their remaining years, and they want to preserve enough capital so that they have some insurance against adversity.
From an investment perspective, the key to meeting these potentially conflicting demands lies in strategies that can reduce volatility in retirees’ portfolios and produce reasonably consistent total returns that would help meet both these income and capital objectives.
Financial-market turbulence or asset-price volatility work against nearly all investors, but particularly retirees, who―because they are drawing down capital to meet expenses―are less able to recoup losses when markets recover after downturns.
Broadly speaking, low-volatility strategies fall into two categories: those that use derivatives, and those that don’t. From an investment perspective, both have their advantages and disadvantages, and some investors will naturally prefer simplicity to the complexity implied by derivatives.
But how should retirees, given their special investment objectives, weigh these strategies’ relative merits? They should consider several factors, in our view, including volatility, price and performance. Just as importantly, they should also reflect on their own behavioural biases.
Avoiding Index Volatility
Let’s look, first, at how such strategies compare in terms of general characteristics. An equity-based strategy will typically rely heavily on its manager’s stock-picking ability, which will be essential to identifying shares which have relatively low correlation to the market’s ups and downs.
This is important, because it’s a well-attested fact that a portfolio of low-volatility stocks can outperform a broad index-based portfolio over time, on a risk-adjusted basis. It’s a phenomenon commonly known as the “low-volatility paradox”.
There are several types of derivatives-based low-volatility strategies, and one question that a retiree might want to ask in assessing them is: what role, if any, does stock selection play, and does it try to take advantage of the naturally-occurring low-volatility paradox?
Perhaps surprisingly, some derivative-based strategies have little if any concern about singling out low-volatility stocks for their equity portfolios. Instead, the portfolios replicate the broad market index while a derivative overlay attempts to smooth out the inherent volatility.
This need not be a bad thing, but there are two points to bear in mind. The first is that derivatives cost money, and the cost is likely to be reflected in the management fee. How does the fee charged by the derivatives-based strategy compare to its equity-based counterparts?
The second consideration is that the Australian share market, which is small and concentrated by world standards, is inherently volatile. The financials and materials sectors, which are both volatile, make up about 33% and 18% of the S&P/ASX 300 Accumulation Index respectively.
This means that some derivative overlay strategies―for example, put or call options on the S&P/ASX 300―need to offset broad market volatility to be effective.
One of the problems with this is that market volatility can take different forms―a short, sharp fall, for example, or a slow grind downwards―and some derivatives strategies are better able to deal with specific types of volatility than others.
A retiree looking at a derivatives-based strategy, therefore, needs to understand which kind of volatility the strategy is best equipped to handle. Strategies designed to offset many kinds of volatility tend to be expensive.
By contrast, an equities-based strategy using a portfolio of carefully selected low-volatility stocks starts off by being inherently less volatile than the market.
Managing the Upside and Downside
Relative performance is another point to bear in mind. The reason that low-volatility stocks can outperform the broad market over time is that they tend to lose less in a downturn but participate―not fully, but enough―in the upturn when markets recover.
Their limited exposure to downside risk means that they have less ground to make up when markets recover. This, combined with sufficient participation in the upside, explains how they can outperform over the medium to long term.
While the limitations in upside/downside behaviour of low-volatility stocks can be regarded as natural and inherent, however, the limitations on the upside and downside potential of derivatives-based strategies are essentially artificial.
For example, some derivatives-based strategies might attempt to limit downside risk by buying put options on their underlying stocks, and seek to offset the cost of this by selling a call option on the same trade.
The purchased put option would give the manager the right to sell the underlying stock at a predetermined price if the market price of the stock fell, while the sold call option would oblige the
manager to sell the stock at a pre-determined price if the stock’s market price rose.
In other words, the potential for this strategy to participate in market upside is limited by the sale of the call option. Some derivative strategies even target the income opportunity available from selling both calls and puts, thereby limiting both their upside potential and ability to limit downside risk.
Having weighed these pros and cons from a dispassionate investment perspective, what other factors should the retiree consider?
Behavioural Considerations for Retirees
Top of the list should be the retiree’s own risk appetite and financial circumstances―in respect of which there is no substitute for professional financial advice. The issue may not be “Which strategy should I choose?”, but how best to use both kinds as a form of portfolio diversification.
Either way, there are points that both the adviser and retiree may wish to consider, in our view.
One is that retirees tend to take a lot more interest in their investments than they did when they were in the accumulation phase and preoccupied with careers and raising families. Given their likely level of financial expertise, would they prefer to monitor complex or relatively simple investments?
As a general point, equities-based low-volatility strategies tend to be simpler and more transparent than their derivatives-based equivalents, and a lot easier to understand.
The other is the fact―well recognised in the literature of retirement planning―that our cognitive abilities tend to decline after the age of 75. Financially expert or not, it’s unlikely that most retirees would want to be grappling with the minutiae of derivatives strategies during their sunset years.
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