Australian superannuation fund members pay a high price for portfolio volatility.
It gives them a “rough ride” in the accumulation and retirement stages of their plans, and produces lower return than the same strategy would with less volatility.
The report, titled “A Wide Angle Lens View of Volatility: Managing the Journey and the Destination”, details why superannuation funds need to smooth the fund member’s journey and prevent the erosion of their retirement balances.
The report compares two hypothetical $10 million equity portfolios, one with volatility and one without, that illustrates a return drag from volatility of 61 basis points occurring over a five-year period.
Williams and Lee comment, “This is the ‘wide-angle lens’ view of volatility that superannuation funds should take. Our research argues that in addressing volatility, funds can, and should, do better than simply address the journey problem – they need to find solutions to address the destination problem as well.”
“Larger portfolios, higher returns, higher volatility or longer time periods can all increase this ‘leakage’.
This return drag from volatility is akin to other hidden leakages in implementation such as fees, taxes and transaction costs that furtively and assiduously eat away at member returns over time. Current solutions do not typically address these leakages because they are usually not measured, disclosed or well understood.”
Williams and Lee explain that superannuation funds typically have five strategic responses to volatility:
. Moving to a formal risk-adjusted returns investment approach;
. Favoring equity portfolios with innate defensive characteristics;
. Purchasing downside protection;
. Purchasing tail risk protection; and
. Adopting volatility dampening strategies.
This is the definitive conclusion of a research report by U.S. fund manager Parametric, says Raewyn Williams, Parametric Director, Research & After-Tax Solutions, and Managing Director, Investment Strategy & Research, Tom Lee, who describes volatility as “two problems, not one” that requires a strategic response from superannuation funds.
“The problem with these approaches concerns the member’s retirement balance. Either the portfolio continues to live with significant volatility (and the volatility drag to returns) or it costs so much to reduce the volatility that the member’s returns will be even lower than if the portfolio experienced the full volatility drag.
In our example comparing two hypothetical strategies, solutions that cost more than eight or nine basis points a year for downside or tail risk protection or 11 basis points a year for targeted volatility dampening could leave a member worse off in terms of retirement balance than simply maintaining a portfolio with full, unmitigated volatility.”
In these circumstances the authors argue a better “defensive equity” solution is one where superannuation funds do not have to make such difficult choices between journey and destination, or make assumptions about member preferences about journey or destination.
“We propose a defensive equity solution designed to reduce volatility in a superannuation fund’s equity portfolio as well as providing a substitute source of income to replenish account balances. Our solution can be implemented over Australian or international equity portfolios.
We confront the journey problem by de-risking a sizeable part of the portfolio from equities into defensive assets and the destination problem by introducing a put and call writing overlay that positions the fund on the generously-priced sell-side of the option protection (and speculation) other funds are buying.
We seek to avoid the costliness of buying protection by being on the sell-side, and also other issues like liquidity and counterparty risk.
The strategy substitutes some equity risk premium with a consistent volatility risk premium. The volatility spread on the ASX 200 has averaged 4.1% per year over the past 111⁄4 years (our backtest period). We use the same approach in our live U.S. and global Defensive Equity strategies.”
Williams and Lee say these results demonstrate how, with innovation, it is possible and practical to circumvent a difficult choice superannuation funds would otherwise face, and address both the journey and destination problems simultaneously created by volatility.
“Members will no doubt take a ‘wide angle lens’ view of their superannuation experience, caring equally about their journey and destination. Funds should be excited about solutions that do not ask them to choose between the two, but neatly address both.”
