Diversification is a powerful tool but far from a perfect one. Its shortcomings have been seared into investors’ collective memories thanks to the global financial crisis (GFC), when nearly every major asset class declined in value.

The presence of systemic risk presented by crises such as the GFC is a major issue for advisers and their clients, who are increasingly required to maintain a heavy weighting to volatile growth assets if they are to have any hope of funding an increasingly long retirement.

This has been further exacerbated as interest rates have continued to fall to historic lows. Naturally, the industry has responded through the development of a range of strategies and product choices promising a smoother ride for investors.

Among them are hedge funds, low-volatility funds, absolute return funds, dynamic asset allocation strategies, guaranteed products, annuities, tail-hedging and managed risk solutions.

The challenge

However, as the range of strategies and approaches has grown, sifting out the effective approaches against those heavily reliant on marketing spin is far from simple.

For example, hedge funds were designed to outperform when markets fall but the overall performance of the sector has been unpredictable. The sector declined by 18.8 per cent during the GFC in 2008, according to the CS Tremont Broad HF Index.

Even when the correct strategies and managers are selected, they rarely account for a large enough portion of a portfolio to protect against a broad market downturn.

A major issue has been the subtle shift towards strategies designed to manage risk in a world where managers still seek to impress with their ability to make intelligent decisions and generate “alpha”.

In reality, these new “managed risk” approaches should be viewed in the same light as an insurance policy designed to pay out when markets experience a severe downturn. The skills required to deliver a predictable risk management solution are anathema to the traditional approaches adopted by many fund managers who live and die on making the right bet.

However, at the opposite end of the spectrum, guaranteed products, including lifetime annuities and capital protected solutions –which offer absolute certainty – have remained unpopular with investors.

Long-term commitments, a lack of flexibility and the associated fees (not to mention the counterparty and credit risk) have seen many of these offerings struggle to rise above niche status.

Such “set-and-forget” strategies also tend to ignore the dramatic changes that retirees face as they age. Further, an adviser operating in a fee-for-service world, needs the flexibility to adapt their clients’ investment strategies to suit the inevitable changes in their lifestyle during a lengthy retirement.

Investors and advisers are increasingly recognising these problems and are starting to explore new ways to solve them and a middle ground is beginning to emerge.

Assessing the options

Dealer groups are increasingly implementing more risk-aware model portfolios – in some cases extending to the use of risk management overlays at an individual client level. These processes are being more tightly integrated into the advice process to meet the needs of clients, and create tailored solutions.

For example, a client approaching retirement may benefit from a managed risk overlay to soften the impact of systemic risk while maintaining more aggressive satellite strategies aimed at generating growth, income or helping to meet other client objectives.

Whatever path you choose to manage systemic risk, there are four basic principles that can help an adviser unravel the complexity and opaqueness behind the marketing spin.

1. The performance of the strategy should be generally predictable under a range of market conditions (although that doesn’t necessarily equate to a guaranteed return). Look at the track record – has it delivered when you expected it to?

2. It needs to employ a robust framework. Consider the size of the investment team and the systems they have in place: will they underpin consistently replicable results over time? Do they have experience in dealing with market crises?

3. It should be reasonably priced, reflecting its nature as an insurance policy. Fees all too often erode any benefit an investor will receive, even as hedge funds have slowly given up ground on the popular ‘2 and 20’ model.

4. Financial planning integration. Products cannot be placed ahead of the advice process. Risk management strategies must be easy to implement and incorporated into current workflows and approved product lists, rather than forcing advisers to create time-consuming one-off portfolios.

These are simple areas where too many products and strategies fail. But finding the appropriate one is worthwhile and can prove a powerful corollary to the well-known benefits of portfolio diversification.

Wade Matterson is a principal and senior consultant for Milliman.
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