The dynamic approach to risk management being pioneered by global consulting firm Milliman is gaining traction in Australia, according to Milliman’s head of fund services, Michael Armitage. He explains the firm’s hedging strategy to Brendan Swift and how some hedge fund-style processes can be used to protect retirees, along with super fund portfolios.
The global financial crisis left its scars on investors and irrevocably hardened perceptions of risk and return. But the central conundrum remains eerily familiar: keep a portfolio weighted towards growth assets to help fund decades in retirement – raising the risk of greater volatility and capital losses – or shift the portfolio to more conservative lower-returning investments, which could raise the risk that you’ll outlive your life savings.
“It is the biggest financial wave of uncertainty – and also opportunity – going forward,” says Milliman’s Michael Armitage. “With the demographic wave of baby boomers entering retirement, historically low rates of risk-free returns and increased life expectancies, innovative ideas are crucially needed. I’m working through this right now with my parents who are 75 and 72 and coming to grips with their own longevity issues.”
It is an area that preoccupies the thoughts of Armitage, who joined global risk management specialist Milliman last year after spending over 20 years of his career in the absolute return fund sector. The culture of Milliman, which has its roots planted in the insurance and actuarial sectors, is far removed from the world of hedge funds although its services meet a similar need.
“I still think there are alternative investments and hedge funds that are worthy investments for various investors, however; they’re not a direct risk management tool for the equity exposure where the majority of portfolio risk resides – and that’s where people confuse their application,” Armitage says.
“You’re hopeful there’s a negative correlation and a big boost from alternatives in a negative equity market but that’s not guaranteed – their correlations vary and it depends on what strategies you have in there. Generally, alternatives including hedge funds offer some diversification. However, in periods of systemic risk, diversification benefits decrease and investors wear the full brunt of market exposure.”
It was a lifestyle switch which prompted Armitage to leave the hedge fund sector and his home in San Diego after long stints in London and New York. He moved to Australia in 2010, joining Standard & Poor’s as a Director of Fund Research, where he assessed globally-based alternative fund managers for a couple of years before the company closed its Australian ratings business.
“I came down here because it was a quality of life shift, coupled with opportunities around superannuation and the proximity to Asia. However, the ability to remain near the beach was ‘icing on the cake’. Since my arrival, I have been able to apply my knowledge of global best practices in several areas of investment research. I have always been keen on finding smart solutions or strategies and my global experience has been very valuable when it comes to new approaches and innovations.
“As I began working with Milliman, I quickly surmised that their global Financial Risk Management (FRM) practice and managed risk strategies place them in that top one per cent of global firms. Given the need for this type of innovation and expertise locally, Milliman’s global experience and work as a specialist in this space since the 1990’s makes my role working with asset management firms and superannuation clients easier.”
That industry now stands at $1.8 trillion and is regularly touted as one of the world’s best retirement systems. But while investment returns have rebounded strongly since the GFC, just how the industry should tackle the impact of volatility and capital losses on retiree nest-eggs remains a hot-bed of debate.
The average balanced fund may have returned an annualized 6.9 per cent over the past decade – just beating their targeted return – on SuperRatings figures but investors’ long-term risk tolerance levels rarely match the levels of volatility they experience over the short-term, leading to portfolio-destroying decisions such as shifting money into cash at the nadir of the GFC.
Common strategies include a focus on dynamic asset allocation and greater diversification. Parts of the industry are also gravitating towards lifecycle funds which shift assets from growth to conservative as an investor approached retirement. But it is a mechanical solution which relies solely on diversification, ignores market valuations, and had little impact during the GFC when almost every major asset class declined.
“That’s all great but unless you have an explicit risk management piece you could be surprised at how negative the portfolio returns can be. During the GFC, the poor US experience of target date and lifecycle funds was a reminder that balanced products can experience significant drawdowns despite their de-risking mantra. For the growing subset of those in and near retirement, explicit risk management and capital protection strategies can help manage this sequencing risk and encourage them to stay on course.”
Milliman’s answer is to manage the risk itself – including systematic risks such as economic crises or recessions which cannot be diversified away – rather than remove it from the portfolio. Its hedging strategy operates as a supplement to the investment team of its clients. Milliman’s Managed Risk Strategy (MMRS) attempts to stabilize the volatility of an investment portfolio and reduce the impact of significant market declines by dynamically managing exposure to market beta risk (using exchange-traded futures contracts). The expectation is that such a portfolio will still be exposed to the majority of the upside potential while significantly minimizing the downside.
Such risk-management strategies remain in their infancy in the Australian market, which has been largely focused on the time-honoured tenants of diversification and a long-term focus, although this is now changing.
Last month, for example, Equip launched a MyPension product which explicitly split an investor’s super savings between its cash, conservative and growth options in an attempt to ensure retirees have cash to live on while smoothing out medium-term volatility.
However, such strategies still include exposure to both market risk and systematic risk. By way of contrast, Maritime Super introduced a discretionary managed volatility overlay – managed by Milliman – for its growth and balanced investment options aimed at reducing fluctuations in investment returns, particularly during market upheavals. It is a strategy which investors can choose at the extra cost of 25 basis points, a world away from high-cost structured products and the inconsistent diversification offered by alternative assets such as hedge funds and private equity.
Fund manager Plato Investment Management also recently employed a similar risk management overlay, aimed at providing retirees with income via dividends and franking credits while managing the volatility and downside risk that has traditionally gone hand-in-hand with other equity income strategies.
It is a risk management strategy which Armitage says can be employed in a number of ways – a necessity given the evolving nature of the industry and the changing needs of investors.
“Due to the overlay nature of our services, clients can use MMRS in both explicit products targeted for near and in retirement cohorts or more implicitly as an allocation within a multi asset class portfolio. MMRS is very powerful in its impact of the risk/return profile of a portfolio. With a significant reduction in volatility and left-tail exposure, enabling the potential to have a higher allocation to growth and create greater stability and certainty for investors.”
Brendan Swift is a principal of Collaborative Media & Publishing, which consults and produces investment material for Milliman.