The fear of losing retirement savings sees many people move their superannuation to cash investments in preparation for this new phase of life. The experience of those who retired in 2007 and 2008 with significantly lower than expected superannuation balances seems to weigh on the collective consciousness. Fear of a similar event results in retirees eschewing growth assets for the perceived safety of cash and defensive investments.
At the time of writing, there are things afoot that could potentially destabilise markets: the current turmoil in Greece and, of greater concern for Australian investors, the slowing Chinese economy and significant falls on the Shanghai stock index. Couple this with a six-year bull run that has resulted in equities being at least fully valued, and those approaching retirement may have cause for concern.
With cash rates at all-time lows – and possibly still declining in Australia – the alternatives are not very palatable. Despite the perceived safety of cash, putting one’s retirement savings into a cash account does not help with one of the two major risks facing retirees – longevity risk.
Longevity risk
Australian retirees could face a shortfall in their retirement savings as life expectancy continues to increase thanks to improvements in living conditions, health and medical advances. According to the Australian Bureau of Statistics (ABS), male life expectancy has increased to 80.1 years and female life expectancy to 84.3 years. Assuming a retirement age of 65, that’s an average of 15 and 19 years respectively that need to be provided for.
Put simply, longevity risk is the risk of outliving your assets. Many retirees are at risk of outliving their savings if they invest too conservatively, but many fear the impact a sharp downturn in markets could have on their capital.
Sequencing risk
Another risk factor that greatly impacts requirement savings is sequencing risk, which is the risk that the order and timing of your investments is unfavourable. For example, a retiree may have made significant contributions to their superannuation during a periods of market highs, getting less for the money.
The wrong sequence of returns can have a big impact on a retirement portfolio. For example, if an investment is made toward the end of the accumulation phase, just before a market correction. If, for example, the market falls 30%, it needs to regain 43% just to get back to the same point. Someone approaching retirement may not have the time to wait for that to occur.
Volatility in markets and the order in which investment returns occur can make a big difference to the capital base once investors begin to draw on their retirement savings. If investors experience positive investment returns in the first few years of retirement, they will be better placed to ride out market downturns. However, if returns early in retirement are negative, then proportionately more capital is required to fund ongoing living expenses. This was the case for many retirees on the cusp of the GFC; they were withdrawing from an already diminished capital base, significantly reducing the possibility of being able to recoup losses over time.
How can investors, particularly those nearing retirement, mitigate these risk?
Volatility overlay
A volatility overlay is an investment strategy that uses derivatives instruments to manage the risk of a significant market downturn while allowing investors to retain an exposure to growth assets, therefore helping to manage both sequencing risk and longevity risk.
It is a systematic program of applying a portfolio of derivatives over a broad-based equity exposure with the aim to reduce draw-downs and in some cases, add alpha over time.
Volatility overlays have been used for a number of years. They were popularised after the publication of work by Black-Scholes[1] which determined how to value options. In the late 1980s many managers were using an approach termed “portfolio replication” that used futures in an attempt to mitigate risk. More recently call overwriting and tail risk hedging strategies have gained traction.
Why use a volatility overlay?
During severe market corrections, traditional relationships between assets tend to break down. The volatility of risky assets tend to rise as there is greater uncertainty and correlations across assets can increase dramatically, meaning that portfolio diversification does not always work to manage risk.
For example, Figure two shows the correlation between the S&P/ASX-200 (ASX200) and a range of other asset classes. With the exception of the CBOE VIX Index, the correlation between the ASX200 and the other asset classes tends to increase during times of market stress.
In return for forgoing some upside, investors can use a volatility overlay to get a buffer that could minimise the impact of market downturns. The downside protection potential also means that investors have less ground to make up after a market decline. Referring back to Figure one, it is clear that larger losses require significant gains just to break even. A 30% loss requires a 43% gain, a 40% loss a 67% gain and a 50% loss a 100% gain.
Volatility overlays provide the potential for investors to maintain their exposure to growth assets and minimise the drawdowns; therefore once markets start to rise, they potentially recoup their losses much more quickly and start to see positive returns before those without an overlay in place.
Types of volatility overlays
Volatility overlays are typically derivatives based, comprising either a futures or options strategy. In the latter group, strategies include covered call writing (or buy-write strategies), tail risk hedging strategies and dynamic option strategies.
Futures-based strategy
A futures-based approach was very popular in the 1980s, but the gloss wore off post the 1987 stockmarket crash. There have been a number of academic studies that suggest the use of futures overlays exacerbated the effects of the markets’ fall.
A futures-based approach manages volatility by selling stock index futures when forecast volatility rises above a target threshold; in effect is reduces the portfolio’s equity exposure.
Essentially, the manager sells futures as the market drops to help to mitigate loss. This can be an effective strategy where the market is moving steadily, however it might not provide sufficient protection against sudden and large losses, or in a prolonged period of slow market decline. A futures-based strategy cannot add alpha.
Options-based strategies
There are two commonly deployed options strategies – covered call writing and tail risk hedging. A third less commonly used strategy, is a dynamic options-based strategy based on quantitative modelling.
i. Covered call writing
Covered call writing, also known as a ‘buy-write’ strategy, is one of the most commonly used volatility management strategy. Quite simply, an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset.
This is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously has a short position via the option to generate income from the option premium.
Selling covered call options can help offset downside risk, but it also means the investor trades the cash received from the option premium for any upside gains beyond the current value of the share until option expiry.
ii. Tail risk hedging
Tail risk hedging shot to prominence post the GFC. This event highlighted the need for investors – particularly those close to or at retirement – to have some risk mitigation strategies in their portfolio.
The term ‘tail risk’ refers to the probability that a rare event will significantly and adversely affect the value of an asset or portfolio; the name originates from what is commonly known as the ‘tail’ of a distribution of asset returns — the low probability occurrences of large negative deviations. The GFC provided evidence of a ‘fat tail’, an event that can adversely affect performance for a number of years.
Tail risk hedging strategies are comprised of investments in options (generally buying put options) that are designed to mitigate large, unexpected adverse moves in the market, such as those experienced in 2008. The majority of tail risk strategies are actively managed because of the significant cost involved in purchasing options, particularly during times of market volatility.
A tail risk hedging strategy can be very expensive and often the benefits are vastly outweighed by the losses that accumulate in times of rising markets.
Source: Triple3 Partners, Yahoo Finance
As illustrated in Figure three, a tail hedge is effective during periods when the S&P500 is declining, notably 2001 – 2003 and 2008 – 2009. As the market regains its footing and commences an upward trend, the value of the dollar invested steadily declines.
iii. Dynamic volatility overlay
This is a bespoke dynamic options based strategy created by Triple3 Partners using advanced quantitative modelling and forecasting technology built over many years of proprietary research.
The strategy aims to exploit frequent mispricings in the market to generate alpha, while providing downside protection to an equity portfolio, reducing draw-downs and adding alpha over time
Unlike typical buy-write and long-put strategies, the dynamic volatility overlay does not serially sell calls or buy puts; rather it actively seeks value in option markets and has a positive expected value. This allows for greater participation in up markets and risk reduction when markets fall.
Figure four shows the value of $1 invested in the MSCI index, and demonstrates the impact of adding a dynamic options volatility overlay to that investment. As illustrated, this strategy can add value to the underlying investment in both falling and rising markets.
There are numerous volatility overlay options available to investors. It’s important to understand the characteristics of each, how it works with each investor’s objectives and how it will impact the return profile of the investor’s portfolio.
1 “The Pricing of Options and Corporate Liabilities” published in the Journal of Political Economy, 1973
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