(pictured: Raewyn Williams)
by Greg Bright
For the past year or so funds and their consultants – in particular Frontier Advisors – have been looking more closely at equity protection strategies, given the questionable value of bonds to provide downside protection in the short-medium term. There are various options, including a new entrant with an established pedigree in efficiency.
Parametric Portfolio Associates, which is best known in Australia for its after-tax and CPM (centralised portfolio management) and other efficiency-driven products and services, has published a white paper analysing the most cost-effective ways for Australian funds to protect portfolios.
But, unlike Frontier, which has been publicly recommending its big clients look to the use of put options for protection from a share market slump since February 2014, Parametric has come at the subject from the angle of the increasing appetite for retirement products. Parametric points out that equity protection is all the more important in retirement, because of sequencing risk, and that its strategy is ideal for the new CIPR (Comprehensive Income Product for Retirement) offerings that are expected to mushroom in the next year or so.
Parametric’s director of research and after-tax solutions in Australia, Raewyn Williams, said the paper demonstrated an approach which combined partial de-risking with an overlay strategy which positioned funds on the sell-side of the equity protection that other funds were buying.
“Not only does this avoid the cost (income drag) and flexibility issues with buying CIPR protection, it generates option writing (premium) income and allows the fund to harvest a consistently observed ‘volatility risk premium’ in the market,” she said.
The new Parametric strategy for Australia involves de-risking a portion of an MSCI ACWI portfolio into bonds and selling options over the resulting portfolio, for which it has simulated positive excess returns as well as downside protection. For actual client experience in the US, over the S&P 500 for which the firm has a four-year track record, the annualised premium is 2.8 per cent on top of the protection element.
Perhaps the biggest investment dilemma facing funds currently is doubts over the protective qualities of bonds going forward because of their historically high prices. Rob Hogg, Frontier senior consultant, said last week: “We are just not as confident at the moment that bonds can give very much protection in the time ahead… In the recent moves [the August correction following China’s slump] bonds didn’t go up as much when share prices went down. But this was not surprising given their full pricing.”
He added that with the unwinding of quantitative easing (QE) in the US and likely interest rate rises there was a “not unsubstantial risk” that this would impact most on the bond market – which had been the main beneficiary of QE in the first place.
The other traditional protection for a fall in Australian equities is having a significant exposure to foreign currencies, which Frontier still advocates, but Hogg points out that this, too, is not going to provide as much diversification as it would have a year or more ago when the Australian dollar was closer to parity with the US dollar.
Alternatives help, he says, but many alternatives strategies are positively correlated with equities and they tend to have high fees, which Australian funds in particular don’t like (rightly or wrongly).
Frontier produced a client note in March this year where it analysed all the options for “funded” protection strategies through the use of various hedge funds and absolute returns funds. It concluded: “The strategies appropriate for investors’ portfolios will depend on the risk and return profile sought, relationship with equities and tolerance for fees and complexity.”
The note was mainly from the perspective of investing in a fund, as opposed to an overlay approach, which creates a portfolio of options that sits over a client’s portfolio or equities allocation.
Michael Sommers, Frontier consultant, says: “Our clients have mostly adopted the overlay approach, although a few are considering investing in funds, given an overlay offers a better fit to their portfolio and costs slightly less than funded allocations. He makes several worthwhile and additional points about overlay protection strategies:
- Overlays are structured with the client’s portfolio in mind whereas a funded allocation is simply an investment into a fund offered by a manager which does not have any awareness of the client’s portfolio. Instead, it is a fund that has been structured to offer a certain type of return profile in different equity scenarios (strong profits in a large equity downturn, little profits or losses in small equity rises or falls and small losses in rising markets)
- The overlay portfolios can be relatively simple (mix of put option structures with different maturities and strikes over several different equity indices – ASX, S&P, Eurostoxx, Nikkei) or have complexity to cheapen the protection cost (e.g. using other asset class instruments like put options on the Australian dollar against the US dollar which have historically been correlated in some way with equities in a downturn)
- In an overlay portfolio, the manager will construct the portfolio to offset the rest of the client’s portfolio in certain types of equity or portfolio level falls. So, this can be tailored to protect only against very large losses (e.g. 20 per cent), intermediate losses (say 10 per cent) or shallower-falls (e.g. 5 per cent). It depends very much on the client’s objectives
- Depending on the manager, it will also provide advice to the client about how and when to monetise the options in a protection portfolio during volatile equity markets
- The management fee: in an overlay offering, a client will usually pay a small fee (low to mid-single digit basis points) and is usually charged on the portion of a client’s portfolio being protected
- The other cost for the client is how much protection to purchase. We have tended to advocate a 0.5 per cent budget to be allocated to pay for the protection portfolio (it offers a suitable compromise for cost versus amount of protection) and have advised clients to think of this as essentially the cost of protection. The more a client wants to pay, the more of the portfolio that will be protected and the larger that the offset will be in market falls.
Frontier believes that its clients are better to use fund managers rather than investment banks for put option strategies unless they are very sure of the precise strategy they want. Fund managers, acting as agents, tend to have a more transparent process. To date, Frontier has recommended Australian managers QIC and Perennial and global manager PIMCO for overlays.
Chris Briant, Parametric’s chief executive, Australasia, said that fund managers acted as “fiduciaries”, unlike investment banks which could profit from various ways in a particular trade, not all of which were in the best interests of the client fund.
“Our offering is transparent, liquid and isn’t leveraged, with all fees and potential rewards received by us being fully known and disclosed up-front,” he said. “So, if we need to utilise the services of an investment bank, we do that as a true agent of the fund, getting the best deal possible for the fund. In short, we can’t profit from the other side of the trade.”
Briant said that Parametric did not set the objectives for a fund but, rather, looked to provide the most effective ways to implement them. The new offering in Australia was “a good solution for funds looking for both attack and defence in post-retirement”.