Anyone drawing an income from an investment portfolio faces two key risks: longevity and the sequence of returns.
For those building portfolios to serve investors in the post-retirement space, this poses a challenging conundrum:
‘We need growth assets in order to drive a growth in returns as income requirements increase,’ said Adam Bulkin, head of manager research at Sanlam Multi Manager. ‘But with that increase in growth assets comes an increase in volatility. This is the problem.
‘On the one hand, we have to have exposure to growth assets to deal with longevity and growth risk, but on the other we have to manage sequence and draw-down risk to compound wealth and ensure clients are drawing down off a higher base to meet their income needs. This is an extremely difficult problem to grapple with.’
Beyond the traditional approach
In South Africa, this has become even more acute in recent years in a low return environment. Increasingly, those building these portfolios are therefore looking to solve this problem using alternative approaches.
‘What we can see from the last decade and more importantly the last five years is that building portfolios in a traditional way is not necessarily going to get clients to where they need to be over their retirement journey,’ said Rafiq Taylor, head of implemented consulting at Glacier Invest. ‘You need to be able to mange those two risks in a more predictable and consistent manner.’
For Taylor, the ‘nirvana’ for an income portfolio is a perfectly asymmetrical pay-off profile – where there is zero downside when markets sell-off, but there is 100% participation in the up-side.
‘In reality we cannot create that perfect asymmetrical pay-off profile,’ he said. ‘But through different strategies that we utilise and portfolio construction, we can hopefully manage most of the downside, because we must have some growth assets in our portfolios.
‘If we can capture two thirds of the upside and only one third of the downside, we think we will provide a more predictable return path for investors,’ he added.
Work done by Glacier suggests that this is achievable by using a combination of alternative strategies. By iteratively analysing the effect that including different alternatives has on portfolio returns, it has found that it is possible to increase the likelihood of consistent, positive outcomes.
‘You can cut off more of the negative part of the tail without giving up too much of the upside,’ said Taylor. ‘That is a compounding philosophy. By not taking as much of the downside, you don’t have to work as hard capturing the upside, because you are starting off a much higher base.’
The first of these strategies is fixed income hedge funds.
‘Hedge funds historically have had a bad rap, but we have tried to isolate a specific category of strategies focused on being more absolute in nature,’ said Taylor. ‘These strategies are more attuned to what we are looking for.’
The second is a smoothing solution.
‘When markets are racing, the smoothing mechanism keeps some of those returns in surplus,’ said Taylor. ‘When times are tough, a smoothing portfolio can then declare bonuses that will allow for the monthly return sequence to be managed in a more predictable manner.’
The final requirement is what Taylor referred to as ‘return enhancers’, in the form of unlisted credit and private equity.
‘You particularly need return enhancers in an environment where risk assets such as listed equity and property do not deliver their traditional risk premia,’ he said.
All of these fall outside of the assets one would include in a traditional multi-asset portfolio of listed equity, property, bonds and cash. Their impact is to make the returns from a portfolio more predictable.
As the graph below illustrates, with each addition of these alternative strategies, one increasingly cuts the downside risks. At the same time, one will give up some of the higher potential upside, but range of potential returns is far narrower, and biased to the positive.
(Click to enlarge)
‘The number of positive observations increases quite significantly,’ said Taylor. ‘And that is what we are trying to do.’