New market conditions are challenging investors but there are ways to manage the risks

Investors needn’t look far to know market conditions have radically changed as economic data not seen for decades becomes commonplace.

Inflation over the year to June soared at the fastest pace in more than 20 years (6.1%),¹ prompting the Reserve Bank of Australia (RBA) to hike rates at five consecutive meetings.²

Investors are bracing themselves for more rate rises, which have already sent Sydney house prices tumbling at their fastest rate in almost four decades (down 5.9% over the quarter ended August).³

This new paradigm has prompted a wild ride for investors.

Australian shares fell 8.8% in June while global equities, aided by the fall in the Aussie dollar, lost 4.6% (both were down 6.5% over 12 months).⁴ Bond returns also fell deeply into the red as their traditional diversification benefits failed when confronted with sharply rising interest rates.

The impact on investor portfolios

The average balanced super fund posted its first negative financial year of returns (-3.1%⁵) since the wake of the global financial crisis (although July provided some much-needed respite as most markets bounced back).

Some investors predictably buckle under the pressure and de-risk their portfolios. However, the long-term impact of shifting from a typical growth to balanced portfolio is expected to reduce average returns by 1.1% per annum and can approximately halve the average amount left in super as a bequest (from $245,000 to $120,000) under the same withdrawal strategy.⁶

Investors who stay the course are still facing an entirely different set of market conditions than the one that powered markets over the past decade.

Risk is higher and potential returns lower, given that the decades-long structural decline of interest rates is effectively over. However, risk is needed to generate the returns at a level needed to fund a comfortable retirement.

Markets are expected to stay volatile as a result of inflation, central bank tightening, recession fears and geopolitical instability.

While inflation is expected to peak in Australia at almost 8%,⁷ there is some light at the end of the tunnel with long-term inflation expectations⁸ reverting back to 2.34%.

Fixed income markets are adjusting, already pricing in substantial long-term rate rises. Further pain in bond markets will only come if rate rises move beyond these expectations.

Consistent downside protection counters volatility

Investors need confidence to stick with their investment strategies if they are to reach their long-term goals. Volatility and unexpected sharp market downturns threaten that stability and can lead to poor decisions.

Behavioural biases such as loss aversion predictably prompt investors to withdraw their investments at the worst possible time. Sequencing risk also comes into play, exacerbating the impact when investors nearing retirement draw down on their super at the most inopportune time during market downturns.

Managing that volatility and providing a cushion in market downturns is a crucial way to manage investor behaviour.

The SmartShield series of managed accounts aim to do exactly this. It is one of the few solutions offering an explicit built-in risk management strategy that has consistently performed through both strong and weak markets. It was launched in early 2020 as COVID-19 initially ravaged markets before they quickly bounced back to new record levels.

SmartShield’s consistency stems from its rules-based approach, which dynamically hedges the portfolio by trading futures. It creates a smoother ride for investors, applying more protection during difficult markets and allowing full participation when volatility subsides.

In fact, in benign bull markets such as last year, SmartShield’s rules-based system can rapidly remove its hedges to give investors the opportunity to fully participate and even outperform its benchmarks in the market upswing.

When central banks began quickly raising rates in June 2022, prompting a sharp market selldown, SmartShield’s risk management strategies kicked in and helped the portfolios outperform the benchmark by up to 2%. Over the 12-month period, it outperformed by up to 2.8%.

The best of both worlds

Contrarian Group Financial Planning Certified Financial Planner, Damian Liddell, has included SmartShield Managed Accounts within his client offering for more than two years now.

“Whilst investors know the best thing they can do is sit tight and ride things out—it’s easier said than done. As humans, we’re not wired that way. Most people are willing to accept modest declines but they genuinely fear a deep and protracted market decline. That’s what SmartShield is designed for—the longer a market declines, the more the brakes are applied.

“Having a systematic, rules-based process that makes dynamic changes provides investors with comfort that something is being done. As a result, they’re less likely to let their emotions take over and thus better equipped to stick to the long-term strategy. It also makes my job as an adviser a lot easier, because I don’t have to crystal-ball gaze or alternatively be that guy that always just says ‘ride it out, ride it out.’ At least with SmartShield, I can reassure my clients that measures are in place and we can then focus on other matters that we can control.

“The SmartShield portfolios have performed really well during the time I’ve been using them. They’ve allowed my clients to have the best of both worlds—exposure to growth and peace of mind.”

With central banks preoccupied with battling high inflation and unwinding a decade’s worth of monetary stimulus, market conditions are expected to remain volatile. As this new investment paradigm takes shape, portfolio protection is set to play an even more crucial role in helping investors achieve their goals.

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/.

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¹ Australian Bureau of Statistics (June 2022). Consumer Price Index, Australia. Retrieved 7 September 2022 from https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/consumer-price-index-australia/latest-release.

² Reserve Bank of Australia. Cash Rate Target. Retrieved 7 September 2022 from https://www.rba.gov.au/statistics/cash-rate.

³ Home Value Index: Housing downturn accelerates as falling values become more widespread. Retrieved 7 September 2022 from https://www.corelogic.com.au/news-research/news/2022/home-value-index-housing-downturn-accelerates-as-falling-values-become-more-widespread.

⁴ S&P/ASX 200 TR and MSCI World Ex Australia NR AUD indices.

⁵ Lonsec. Media Release: Best performing balanced super funds for 2022 financial year. Retrieved 7 September 2022 from https://www.lonsec.com.au/super-fund/2022/07/15/best-performing-balanced-super-funds-for-2022-financial-year.

⁶ Bequest at age 90 for a person aged 67 with a starting balance of $500,000 and $25,000 per annum withdrawals indexed to inflation. Detailed assumptions can be found at https://smartshield.millimandigital.com.

⁷ Reserve Bank of Australia (2 August 2022). Statement by Philip Lowe, Governor: Monetary Policy Decision. Media Release. Retrieved 7 September 2022 from https://www.rba.gov.au/media-releases/2022/mr-22-21.html.

⁸ As measured by 5-year forward, 5-year tenor AUD zero-coupon inflation swap rate on 16th August, 2022.

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