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Managing downside risks in retirement with alternative assets

Managing assets in retirement presents a significantly different challenge from the accumulation of wealth phase. Retirees generally have less capacity for risk together with a reduced ability to rebuild wealth once they’ve started depleting assets by drawing off income and selling assets for living expenses.

Unfortunately, there aren’t many retirees who’ve built the necessary wealth to live solely on investment income. Assuming a 4% yield on an Australian equity portfolio – which for retirees can be further buoyed by a generous dividend imputation credit system – nearly $700,000 is required to be invested to maintain a modest level of income (defined by ASFA as $34,687 per annum for a couple).

This figure is far above current average super fund member balances and yet still does not allow for the necessary growth required to maintain purchasing power. For a comfortable level of income in retirement (defined by ASFA as $59,808 per annum for a couple), the balance needed is $1.2 million, which is only a dream for many.

Disadvantages in the decumulation phase

In accumulation, monies are regularly invested via employee and employer contributions and investors can harness the power of ‘dollar cost averaging’. In a volatile world, if the market falls, the investor ‘averages down’ and buys more assets when prices are low, thereby enhancing overall returns. But, these advantages are reversed in the decumulation stage of retirement. On average, monies are removed when prices are low but cannot be replaced as fresh contributions are no longer applied. For markets that remain broadly static, the impact of a regular withdrawal pattern can lead to a 50% worse overall return than one without cash inflows.

Both the sequencing of returns and the withdrawal pattern matter significantly in retirement. To partly mitigate this disadvantage, retirement balances are generally invested in growth assets for as long as possible while income requirements are met separately from a pool of more liquid, low return assets.

Managing downside risk in volatile times for retirement is best approached by combining two inherent advantages of investing:

  • the investment ‘free lunch’ effect of diversification
  • a long-term investing approach utilising alternative assets.

This approach manages downside risk by opportunistically diversifying monies away from listed assets (listed equities, REITs and listed bonds) into alternative assets and strategies. If carefully managed, this switch can preserve capital, reduce volatility, and still provide reasonable returns.

Diversification is the 'free lunch' of investing

The extraordinary power of diversification is demonstrated by a simple two stock investment portfolio example: an umbrella manufacturer and a sunscreen manufacturer. Both do well in entirely different weather environments and have low correlation with each other, moving differently in price according to weather conditions.

Assume both expect to return 7% per annum, have identical risks (defined by standard deviation) of 12% per annum, and zero correlation. From an investment perspective, you can choose to own either:

  • Either stock in isolation

    Here you’ll expect an annual return of 7% and volatility of 12%. The risk adjusted return is 0.58 units of return for each unit of risk (i.e. 7/12).

  • A 50/50 portfolio of both stocks

    Here you’ll also expect an annual return of 7%, but due to the zero correlation, you’ll get the benefit of diversification on the portfolio risk.

Surprisingly, the risk of a 50/50 portfolio is lower than either company singularly. The portfolio risk for the equally-weighted blend is 8.5% and the risk-adjusted return rises to 0.82 (i.e. 7/8.5), that’s 0.82 units of return for each unit of risk. This is a more than 40% improvement in the risk-adjusted return of the portfolio.

The benefit of diversification is the proverbial ‘free lunch’ of investing – you either have the same return for less risk or match the risk number and have a higher return. Magic indeed! Providing the correlation between these two investments is less than 1.0, then combining them in your portfolio will provide a better risk-adjusted return and make your portfolio more efficient (on a risk-adjusted return basis).

When investing for retirement, taking maximum advantage of this diversification benefit will move the investing odds in your favour. Since retirement involves a long time horizon, you can adopt a long-term view and consider investing a portion of the portfolio in alternative assets, defined as anything that is not listed equities, bonds or REITS.

A diverse range of alternative investments can enhance returns and reduce risk

There are plenty of alternative asset classes as shown below, from direct lending and macro to reinsurance and infrastructure.

Source: Edgehaven Pty Ltd

These require expert navigation but there is a broad opportunity set to produce diversifying returns, taking an opportunistic approach and finding alternatives that complement existing exposures. Diversification into alternatives is certainly not a ‘fill the buckets’ task, nor should it be a simple bolt-on to an existing portfolio. Instead, it’s more akin to searching for excellent quality standalone investments in areas which are not easily accessible via listed markets.

Long term correlations between asset classes

The diagram below highlights diversification benefits of three alternative asset classes – timber, farmland and absolute return – with listed asset classes including equities, global REITs and listed infrastructure. The traffic light scheme shows the effects of diversification with green being good, red bad, etc. The ‘farmland’ row is nearly all green, demonstrating the asset’s good, long-term diversification effect. It’s also noteworthy that direct property is not shown here to be a particularly good diversifier on this measure, nor is Dow Jones infrastructure (representing listed infrastructure), which many use as an infrastructure proxy.

The challenge lies in accessing these alternatives in smaller parcels. Institutional investors and super funds have relatively easy access but they generally don’t make these available to investors except within large, diversified portfolios. Individuals and SMSF trustees struggle to invest the minimum amounts required for each investment, typically $5-$10 million.

The good news is there are possible solutions available. Super funds can create choice options containing broad alternative asset exposures, although the investment would need to be locked up for a minimum investment period. This may be a novel concept right now. But given equities are a long-term investment (minimum seven years) we should not confuse the daily pricing of asset classes with the minimum exposure time required for successful investing.

Future retirement investing will include more alternative assets

Long-term investment principles and locking up monies via minimum investment periods will allow retirees to reap the diversification ‘free lunch’. Opportunistic alternative asset investing also prevents ‘silo’ asset class thinking and the ‘fill the bucket’ style of investing which dominates accumulation schemes. Plus, it allows investors to take advantage of the longer-term horizon of retirement investing and harvest illiquid premia in assets that can be selectively chosen for explicit downside protection.

The market is changing and some more liquid forms of alternative assets are now available to 'retail' sized investors, often in listed form, although many are not best suited to a liquid version. Investors should expect to invest via a lock up structure which matches the investment to the illiquidity of these asset types.

 

Bev Durston is the Founder of Edgehaven and is one of Australia’s leading experts in alternatives investing. She works with long-term investors including pension and superannuation schemes, foundations, family offices and sovereign wealth funds. She provides alternative assets advice for asset class strategy, sourcing managers and funds, portfolio construction and risk management.

8 Comments
Bev Durston
June 07, 2017

Thanks for all your interesting conversations prompted by my article. I am overseas visiting many interesting Alternative asset managers right now and unfortunately am in a different time zone.

I strongly agree with Jerome that a "fill the buckets" approach is the antithesis to running a thoughtful Alternatives portfolio since unlisted assets require a commitment to locking up monies. This is a requirement to harness any illiquidity premia which may exist. But it also contains a very powerful advantage as it delegates the all-important market timing decision (when precisely to invest and when to harvest assets) to a skilled manager and gives them sufficient latitude (typically multiple years) to actually exercise that discretion.
As a result there is often no need for a fire-sale decision upon a market dislocation as unlisted managers should be able to take advantage of lower prices by calling investor monies as part of this delegated timing decision. We have all read about the poor track records of the average mutual fund investors (who typically invest when prices are high and the advertising budget is maximised) and so unlisted assets offer a built in antidote to this unfortunate trait.

There are other advantages to using unlisted vehicles to lock up money for a longer term approach (some of which I have discussed in prior Cuffelink articles), not the least of which is that managers also operate on a money weighted basis rather than a time weighted basis to judge their performance. This is a benefit compared to a pure time weighted performance assessment where investors may experience differential returns yet the manager's singular performance record remains.

I agree that commercial property is more of a core asset rather than the opportunistic funds that typically populate the Alternatives space, albeit it does have the significant advantage of having a long term outlook and being part of a "real asset" sub class.

A word of caution against making broad recommendations since this area requires detailed knowledge of the investor's existing portfolio and their risk, liquidity, tax and other preferences. For this reason a "one size fits all" does not make sense across the breadth and depth of Alternative offerings. The Preqin database reports that there are 18,000 separate products (mostly unlisted) raising funds in this space and so this requires careful filtering and expert navigation.

The ever changing nature of Alternative strategies and assets are indeed what makes this arena so interesting. Yes impact investing and social impact bonds are indeed new types of investments with different characteristics and functionality to the existing stock of assets. We may debate whether they are in fact sufficiently diversifying from traditional asset classes to be an Alternative asset or strategy but the empirical data will no doubt assist us over time.

Finally I disagree with Jerome's version of Alternatives that are easily accessible because they are listed. In my view this simply adds equity market volatility to the asset and makes it more correlated to equities. As Warren Buffet points out people who are relaxed about owning property for years without any activity at all succumb to the notion that once it is listed there must be regular activity involved since there is so much "advice" from the industry that deems activity a necessity. If individual house prices were quoted daily despite their significant transaction costs then their turnover would arguably be far higher with a commensurate decline in risk adjusted returns for investors, simply because owners were prompted into making decisions. Unlisted assets have in-built advantages including an asset liability profile linked to the time horizon of investing. This mitigates against this industry inclination for activity and allows skillful managers to reap the benefits.

Tortoise
June 05, 2017

"Free lunch" - really?

Investors should have realised that previous market ructions tell us that assets can all move together in one direction.

When the proverbial hits the fan, eg GFC, anything can be sold at 'crash' prices in order to offset losses somewhere else.

We don't all live in a Uni lab testing interesting theories and then selling those theories via textbooks.

Chris
June 01, 2017

alternative investments....? commercial property. Properly selected and managed you can achieve 7%-9% net return with 3% increases in rent (in simple terms). Longer leases than residential (3*3*3 as an example) with capital preservation. Factories can be simple as a "set and forget" with an effective lifespan of 20-30 years... even allowing for some devaluation in rent as the factory ages, the long term investment value is well suited to FI/retirement planning.

SMSF Trustee
June 03, 2017

Property is not an alternative asset, it's a traditional asset. Yes, you can find those sort of returns on some properties - a fund I invest with has been buying medical centres at that sort of expected return.

So as part of a diversified portfolio it's good to have some. But you should have lots of other assets as well, just in case the property you buy doesn't work out as you expect. Those returns are NOT guaranteed or locked in.

Hence this article was discussing other options that investors might like to look at.

shang
June 01, 2017

could anyone provide some info on alternative assets as an investment? names, contact number, past performances etc etc? i would much appreciate some details rather than just a written piece of article so generally comment on this alternative assets.

thanks

Warren Bird
June 01, 2017

There are 'alternative assets' and 'alternative strategies'. I think the article is about the former, but Jerome's comment is about the latter. The latter is a small subset of the former - e.g. 'relative value strategies' appears in the word diagram in the article. But most of the alternative assets listed here are not "forward looking and dynamic" approaches - they're just as long term, fill the bucket as shares are, but with a different risk and return profile.

I have a question, though. The argument seems to be that these alternative assets can protect a portfolio against asset sales having to be undertaken when values have fallen. But have the correlations that seem to support that argument been tested in situations of regular asset sales, as required by retiree portfolios that aren't generating enough income? If those assets were held in portfolios that needed liquidity, would they prove to be as uncorrelated as they are in what has until now mostly been a buy-and-hold world for such alternatives? Don't they have quite a wide bid-offer spread, in which case the analysis needs to make sure that correlations aren't measured using mid-rates?

For example, music rights. Yes, they're a great source of cash flow uncorrelated to interest rates or dividends, but if you needed to sell a security that was exposed to them at a time when equity markets had fallen sharply, would you be able to realise them without a very wide buy-sell spread that goes, of course, against the seller?


BTW I'd add to the alternative assets list the asset class of Social Impact Investments (aka social benefit bonds, but they are nothing like fixed income bonds so I don't like that word in this context). A cash flow and return stream that has nothing whatsoever to do with underlying interest rates or movements in equity markets, with the risk of returns falling short of expectations similarly having nothing to do with existing asset markets. A small asset class in Australia to be sure, but it will grow.

Gary M
June 01, 2017

Has anyone tried living on the ASFA ‘modest’ income of $34k for a couple? That’s not per month, that’s a whole year on $34k !?! And ‘comfortable’ on $59k !?
Worth noting that article assumes zero correlation is constant, standard deviation is constant, but nothing is in the real world.
Alternative assets often mask hidden problems of their own.

Jerome Lander
June 01, 2017

Importantly, there are indeed more liquid forms of alternative investments now available to retail investors (many investors prefer more liquid investments, where they can access their money if they want it). Generally, alternatives are not used as much as they should because of most people's obsession with short termism, the equity market's returns and 'peer relative returns'.

Outcome orientated or goals orientated investing is much better suited to most retirees, and can be used to greatly smooth returns and create much better risk adjusted outcomes. Some advisers have been implementing this for their clients for years. This approach is now moving into mainstream awareness as a more aligned way of managing money, rather than using traditional passive SAA approaches (which have been cheap and cheerful in recent years but offer poor risk adjusted returns and major risk of large draw downs, hardly well suited to retirees given the market environment).

Unfortunately, most well-known super funds are providing sub-optimal legacy offerings to their clients based on fairly static asset allocations and a "fill the bucket" approach. Fortunately, many of us do help deliver better products and solutions which are more forward looking, dynamic and better manage risk. Our industry is more than capable of doing this . Yes, it is harder work but it is also much more likely to produce the results that people want and need, including keeping likely losses contained.

 

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