Global financial markets are reeling as they grapple with the prospect of rising inflation for the first time in decades.
US and Australian shares fell by around 10% in January as high-priced growth stocks, particularly in the technology sector, were quickly dumped. Bond prices also fell as the threat of rising rates off record lows undermined the traditional benefits of portfolio diversification.
Meanwhile, the ongoing impact of the coronavirus, rising oil prices and now the Russian invasion of Ukraine are all adding to the uncertainty.
While equities regained some ground by mid-February, this new investment environment is likely to signal greater volatility ahead.
The US Federal Reserve is very likely to raise rates multiple times this year to combat inflation, which has hit its highest level in 40 years at about 7%.
Central banks around the world including the Bank of England, Bank of Korea and Reserve Bank of New Zealand have already lifted rates, slowly drawing a close on the era of easy monetary policy.
The Reserve Bank of Australia ended its $350 billion bond buying program in February amid strong employment and inflation data, while flagging the possibility of rate increases later this year.1
This increasingly challenging environment can test investors after several years of strong returns—and some investors in particular are ill-suited to withstand such uncertainty.
A higher risk environment for retirees and conservative investors
One of the industry's favourite sayings is time in the market, not timing the market.
Unfortunately, it doesn't apply to retirees and conservative investors—poor timing can have an outsized impact on their returns.
They can't absorb a lengthy market downturn or extreme volatility in the same way as younger investors with 10- to 20-year investment timeframes.
The sequence of returns becomes just as important as the average return itself.
A downturn that strikes early in retirement will have a bigger impact because a retiree has fewer years to benefit from a market rebound. Meanwhile, they are usually withdrawing money rather than investing when assets are cheaper, which locks in losses.
For example, a retiree with $500,000 earning a steady benchmark return of a consumer price index (CPI) + 3.5% will run out of money in just over 30 years (assuming they draw down $26,000 each year, increasing with CPI).2
But if that same retiree suffered a 19% portfolio loss in the first year of retirement, they will run out of money almost a full decade earlier than they expected despite still earning an average 3.5% over the course of their retirement.
The lesson is simple—find a way to avoid the bad luck of having a poor year of returns just before or after retiring.
How to implement downside protection and generate smoother returns
SmartShield managed accounts offer one way to implement downside protection against market volatility and lengthy market downturns.
They dynamically hedge portfolios against these risks by allocating a small portion of the portfolio to implement a systematic futures hedging strategy. The protection varies with the forecasted market volatility and the level of market drawdowns.
The SmartShield High Growth managed account has delivered comparable paper returns to the underlying benchmark since inception. But the real payoff for retirees and conservative investors has been better risk management.
The fund's biggest fall since inception was less than half the benchmark (7.21% versus 21.09%) while volatility was about one-third less (9.95% versus 16.34%) over the same period.
It means the fund's investment return is materially higher per unit of risk taken compared to its benchmark.
Figure 1: Cumulative net performance since inception
This downside protection helps manage the sequence of return risk that can decimate actual investment returns (as opposed to the average hypothetical return).
It can also give investors the confidence to stay invested when market volatility starts to ramp up and the media run front-page stories with headlines such as "US rates rise fears send ASX tumbling."3
That type of fear plays into behavioural biases such as negativity and loss aversion, which often lead to poor decisions, such as selling out at a market low point.
SmartShield can play an important role helping investors reach their goals during uncertain times.
You can check the potential benefits of downside protection on your client portfolios at https://advice.milliman.com/en/insight/The-SmartShield-digital-portfolio-simulator.
For more information about Milliman go to https://au.milliman.com/en/
1 Transcript of Question & Answer Session on 2 February 2022 | Speeches (2 February 2022). Retrieved from https://www.rba.gov.au/speeches/2022/sp-gov-2022-02-02-q-and-a-transcript.html. RBA Governor Philip Lowe: "It's certainly a plausible scenario that rates go up later this year, but there are a lot of other scenarios as well. The point I was trying to emphasise in my prepared remarks is there are a lot of uncertainties, both on the supply side and the labour market dynamics, and because inflation's not that high at the moment, we can wait to see how those uncertainties resolve. If they resolve in one way, then we'll be raising rates. If they resolve in another way, then it's still quite plausible that the first increase in interest rates is a year or longer away."
2 Huang, V. (23 June 2021). Sequencing Risk ... Quantified. Milliman Insight. Retrieved 27 February 2022 from https://advice.milliman.com/en/insight/Sequencing-risk-quantified.
3 This was the Sydney Morning Herald front-page headline on 28 January 2021 after the S&P/ASX 200 fell 1.8%. See https://www.smh.com.au/business/markets/probably-more-to-go-in-this-sell-off-us-rate-rise-fears-trigger-asx-slump-20220127-p59rrb.html.