The last few years have certainly been fruitful for some investors in the international space, with most markets showing meaningful gains. The future, however, may hold more uncertainty, with quantitative tightening and heightened geopolitical risks anticipated as we look ahead. In years gone by the response to failing markets and economies was that of fiscal and monetary stimulus (governments spending more money and lowering interest rates). However, with interest rates at all-time lows and most governments running deficits, the ability to use these tools seems somewhat compromised.
With markets potentially facing more risks it will also not be surprising to see volatility starting to spike. A useful way of examining volatility is to look at the equity premium, which in the case of the U.S. is the difference between the monthly return on the U.S. stock market (as measured by the benchmark index) and the one month U.S. Treasury bill rate. For the period between 1963–2016 this premium has averaged around 0.51% per month. However, the standard deviation (the amount of variation from the average) of the monthly equity premium has been a far heftier 4.42%1. These long-term statistics should serve as a reminder that equity markets can be volatile and the returns we have seen over the last five to six years are, in my view, unlikely to be repeated anytime soon.
The recent low levels of volatility may have tempted some investors to over expose themselves to risk in the search for yield. This strategy may be particularly dangerous for retirees who, in conjunction with market risk, also face longevity risk (outliving savings) and sequencing risk (the risk of markets falling whilst you are drawing down on your funds). The last two risk factors tend to work in combination, as a retiree with no further capacity to work may feel obliged to invest more in equities markets (in a bid to ensure their nest egg lasts as long as possible), which increases their exposure to large falls in the market whilst they are still drawing down an income stream. One may be left wondering whether it is indeed possible to still invest in growth asset classes such as equities whilst mitigating the downside risks of doing so… the answer is yes.
The BetaShares Managed Risk suite of funds aims to provide a smoother ride through volatile markets. The BetaShares Managed Risk Australian Share Fund (managed fund) (AUST) and the BetaShares Managed Risk Global Share Fund (managed fund) (WRLD) utilise the Milliman Managed Risk Strategy, which is used by many of the world’s largest financial groups. The strategy involves monitoring the volatility of each Fund’s equities portfolio daily and if volatility rises beyond “normal” levels the Fund will apply a ‘handbrake’ and reduce market exposure by selling futures. As volatility returns to normal levels the Fund will dynamically remove the ‘handbrake’ to increase market exposure again.
These strategies aim to capture most of the upside in rising markets and defend against losses in sustained market downturns. This can be beneficial for investors who wish to remain exposed to growth assets via the equity market, but who may be concerned about uncertain and volatile financial markets.
1. Fama and French, ‘Volatility Lessons’.