Sleeping securities – better than cash in a crisis

From

Alastair MacLeod

Retirees should ensure they have a well-designed market crash protection strategy in their portfolios to help reduce the impact of inevitable downturns, particularly in the current low interest rate environment, says Alastair MacLeod, managing director at Wheelhouse Partners.

Mr MacLeod believes the portfolios of many retirees are not adequately constructed to withstand the likelihood of an imminent turn in market fortunes, but said it’s not too late to position themselves appropriately.

“Crash protection is like having little sleeping securities – they are always there, ready to wake during times of crisis when investors need them.

“They mean that investors can remain fully invested in order to make the most of equity returns, but at the same time ensure a valuable layer of capital protection,” he said.

Mr MacLeod said the move into retirement introduces new risks that don’t exist when people are working, and it’s important that investment objectives can pivot.

“Most investment strategies are designed for people in the accumulation phase, but those entering retirement need to reassess their investment approach to make sure it still suits their needs,” he said.

Many retirees increase their portfolio allocation to cash as a way of minimising the impact of any downturn, an understandably cautious approach. However, while cash is the lowest risk asset available to investors, it’s also the lowest returning.

“In the current environment, with returns from cash so low – and interest rates predicted to fall further – retiree investors need to consider other options.

“For example, a crash protection strategy using derivatives or ‘put’ options can limit losses to 50 or 60 percent of the market’s fall in a correction, but only cost the investor between one and two per cent over the course of a year,” he said.

Like insurance, crash protection is bought for a certain period (such as 12 months) and is attached to a certain notional value. The premium is also significantly cheaper if the investor wears the first few percentages of declines, in the same way that house insurance is less expensive if a larger excess is taken on.

One key advantage of crash protection is that it allows the rest of the portfolio to remain fully invested in the pursuit of equity returns, Mr MacLeod said.

“This can have a meaningful impact on long-term investment outcomes.”

He warns that crash protection isn’t a quick fix solution for every investor.

“Any worthwhile crash protection strategy needs to be tailored to the underlying portfolio exposures, and match the risks present. If the strategy hasn’t been designed properly, it will not only be more expensive, but it may not provide the desired protection,” he said.

In addition, crash protection needs to be actively managed in order to maximise its effectiveness. But in a low interest rate environment, the defensive qualities of crash protection permit a retiree’s portfolio to be more fully invested, harvesting steady income streams and accessing equity rates of return, thus reducing the risk of capital erosion and critical failure.

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