Three ways to protect retirement portfolios and maintain returns

Investors know that managing downside risk is vital, particularly for retirement portfolios. Those in the retirement phase, especially in the early stages, typically can’t afford large and significant drawdowns.

The traditional – and simplest – way to manage downside risk has been simply to take less risk: to hold more defensive assets than volatile growth assets.

The problem is that strategy lowers your expected return, and you can encounter longevity problems: ie the lower returns may mean your funds run out before you die.

But there are ways that investors can reduce risk while at the same time not lose too much performance.

As would be expected, part of the investment strategy is to allocate less to growth assets than an accumulation portfolio would have. However, there are three other assets and tactics investors can use to protect against equity corrections.

1. Put options

The first and most direct way to protect our portfolio is to use equity ‘put’ options.

A ‘put’ option gives the holder the right to sell the underlying security, such as shares, at an agreed price on or before a specified date. (A ‘call’ option gives the holder the right to buy the underlying security).

Buying protective put options are like buying classic insurance – you pay a premium upfront and it pays a ‘claim’ (positive return) when the market declines.

We can use various option structures depending on different scenarios and valuations.

Right now, we have what’s called a ‘collar’ on Australian equities. We have bought protective puts and sold call options at the same time on our Australian equity holdings.

The collar means we have given up some upside to protect the Australian equities portfolio from falling any more than 4% if we suffer a correction between now and December.

2. Long-duration bonds

Other types of portfolio protection include long-duration bonds.

Long duration bonds, such as 10-year bonds, offer protection against equity corrections. They tend to appreciate when equity markets hit stress because people start pricing in future central bank rate cuts. (Bond prices rise when yields fall).

But that’s not always the case. Bonds are less of an attractive portfolio hedge if there is risk of inflation which results in the bond/equity correlation breakdown, or if bonds are expensive and there is less bond price upside on offer if the economy and equity markets weaken.

Right now, we believe bonds are reaching full valuations. So we have bought a ‘call’ option on long-duration bonds, which allows us to participate if equity markets hit stress and bonds rally.

We get to participate in that rally, but we’re not exposed to the expensive valuations that we believe global bonds in general are priced at.

By replacing bonds with a call option, we are also hedging the risk of a reversal in bond prices. This could happen simply because prices have rallied too far, but most likely could be triggered by either positive inflation data, central banks switching back to hawkish policy, or stronger growth numbers.

Options come at a price and if constantly in place can create a performance drag. We aim to be selective in adding options which align with our views, provide an effective hedge, and are not overpriced. In the case of US bonds, the options were trading at multi-year lows which we believed presented an opportunity to enter.

3. Non-Australian currencies

The last form of protection you can include in your portfolio -- and anyone can access this form of protection -- is to hold more non-Australian currencies.

When global equity markets fall, the $A tends to depreciate. As an Australian investor, if you hold offshore currency – particularly in safe haven currencies such as US$, Japanese yen, Swiss Franc and maybe to a lesser extent the euro – when distressed events hit, those foreign currencies will appreciate in A$ terms and support your portfolio. It’s quite simple to do in a portfolio sense. You hold foreign assets, but you choose the unhedged version rather than the hedged version.

Too much foreign currency risk however, can start to dominate the risk of your portfolio. If building a strategy, as a rough guide, foreign currency exposure of around one-third the size of your growth allocation may be a good starting point.

In our portfolio right now, we have significant exposure to the Japanese yen and US$ to help support the portfolio should we hit equity market weakness. We tactically adjust these hedges based on our outlook on each currency and overall equity market risk.

Sensible sacrifice

Retirees do need to protect their portfolios against big corrections. But in doing so they shouldn’t sacrifice returns, which they need to fund their retirement, particularly as people are living longer.

When seeking protection, retirees therefore should look beyond the traditional approach of tilting towards defensive assets.

We’ve discussed three asset types -- put options, long-duration bonds and offshore currencies – that may allow retirees to protect against big market falls without sacrificing too much of their portfolio’s expected returns.