Article 5 / 8
Sourcing Income – April 2016Investors must rethink how they manage risk
Modest expected returns across a variety of asset classes, sub-par growth and a subdued outlook have presented investors with the challenge of how to maintain income when so many traditional sources of income are drying up.
Secular trends, such as an ageing demographic, public debt and increased regulation, will shape the outlook and behaviour of investors.
The pension cliff about to occur in the next 10-20 years could lead to an entire generation’s retirement needs being underfunded.
In the past, such a scenario has led investors to run more risk, yet the increase in regulation has made it harder for long-term investors to make riskier choices. Instead, investors are increasingly looking for flexibility, sophistication and active management.
By adding diversified sources of return to traditional portfolios, investors may achieve higher levels of wealth accumulation over time. Portfolios therefore should be better equipped to achieve lower correlation with traditional asset classes, lower volatility and contain drawdowns.
Today, there is obviously a need to consider a different way of investing that targets new sources of return, downside mitigation, and volatility management.
DEMOGRAPHICS Older Retirees |
The demographic issue of ageing populations around the world is driving the demand for more income, with Asia one of the key regions affected by the problem. King Fuei Lee, head of Asia equities in Singapore at Schroders, notes: “Investing in dividend-yielding stocks in a low-yield environment has become almost de rigueur for investors in search of returns in the current environment. What is perhaps less well-understood is that a high dividend-yielding strategy is often also the preferred choice for an ageing population. “The area of behavioural economics has shed light on a multitude of issues and has often been at the forefront of the most insightful observations about investor habits. According to the behavioural life-cycle theory, an individual mentally breaks down their wealth into three components: ■ Current income ■ Current assets ■ Future income “At the individual level, the temptation to spend is always greatest for current income, and least for future income. This is especially the case as people age and start to retire. They have a tendency to consume out of dividends received (or current income) rather than from capital gains (or future income). As a result, these investors generally favour high dividend-paying stocks over those that pay lower dividends, which in turn has led to outperformance from the former. “It is particularly pertinent for countries such as Australia, Hong Kong and Singapore – the traditional bastions of Asian dividend-paying stocks.” |
Absolute return funds aim to provide diversification, improve risk-adjusted returns, and may act as shock absorbers during times of market stress. They offer extra flexibility to long-only allocations as managers seek to realise opportunities from non-traditional strategies.
Meanwhile, multi-asset investments can provide different potential sources of return and a more diverse means of allocating risk than through a simple global macro strategy.
It appears that investors are considering more outcome-oriented investing and directing their allocations around specific objectives, because moving from low-risk assets to high-risk assets may not work anymore.
Investors are increasingly considering the risk they are willing to run and are more likely to sacrifice some upside in return for better downside protection.
By rethinking the function of their portfolio and what they want it to do, investors are considering the fluctuations of returns versus the reliability of income and making a reasonable and considered trade-off between these two principles.
To achieve this aim, investors could consider more flexible approaches – for example, turning the volatility of assets to their advantage by using things such as option overlay strategies that are intended to deliver stable, reliable sources of income or reducing interest rate sensitivity through investment in bank loans.
However, it will not simply be a case of granting managers more discretion to be active.
Risk needs to be managed in different ways; being less reliant on single measures such as tracking error or value-at-risk in favour of using several judgements and scenario analysis.
Most importantly, investors need to have a view on capital impairment and relate that to their windows of tolerance.
Hugh Prendergast is head of strategic product and marketing at Pioneer Investments
