How dynamic volatility management can limit equity exposure in volatile markets

The big increase in the number of people choosing income drawdown has brought several issues for advisers to address. While some have been attracted by the ability to take cash withdrawals, many have chosen drawdown because of a dislike of annuities and are looking for a regular income. These clients need to remain invested to avoid inflation eroding their pension fund. However, the most important factor for many of these investors is to avoid having their investments fall in value. Drawdown investors do not have the luxury of time to allow their investments to recover from any market falls. This is compounded by sequence of returns risk, where a drop in value in the early years of drawdown can significantly reduce how long a fund will last.

The rise of volatility management

These changes have not been lost on the investment industry. There are already more than 125 funds in the Investment Association’s new ‘Volatility Managed’ sector. Some funds use diversification, others invest in stocks with historically low levels of volatility and other funds sell assets, hold the cash and then re-invest when markets stabilise. In addition, advisers themselves can help manage volatility by advising clients with a cash reserve to stop withdrawing income and ride out any short-term volatility.

An innovative approach to volatility management

The Scottish Widows Retirement Portfolio Funds employ a different and innovative approach to dealing with volatility. The four funds invest in a mix of equities and corporate bonds, each with a different strategic asset allocation according to its risk rating. In times of high volatility, the equity component of the funds is reduced to limit the impact of any market falls. To achieve this, the funds use a semi-automated process called Dynamic Volatility Management (DVM). DVM uses an algorithm to respond to equity market volatility. When volatility is within defined levels, the funds are invested according to their stated asset allocation. However, when volatility exceeds that level the funds reduce their allocation to equities. The DVM threshold is dynamic and moves depending on equity performance over the previous 12 months. If equity markets have been rising then the DVM threshold will be moved up (as customers can tolerate more volatility after a period of growth). In falling markets, the threshold will be revised downwards so the funds will de-risk earlier.

Once the DVM has been triggered the funds will then remain in a de-risked position until volatility falls below the threshold.

How might DVM operate in different market conditions?

As part of the funds’ development, we tested how a fund with DVM would have performed in a variety of different market conditions and used stochastic modelling to test around 5,000 potential future scenarios to see when they would be most and least effective. It is important to note there is no guarantee that these funds will prevent or reduce equity losses, nor is there any guarantee that they will ensure a pension pot lasts for a specific length of time.

A prolonged market correction

If equity markets experience a drawn-out correction, such as the drop in equity values after the global financial crisis, the increase in volatility caused by the initial sell-off would cause the funds to gradually de-risk. If markets continue to fall or if volatility increases, the funds would continue to reduce exposure to equities, possibly to zero, to mitigate the worst of any losses.

Low volatility

In periods of low market volatility, the DVM would be inactive, so the funds would remain at their strategic asset allocation and performance would be similar to that of a fund that does not use volatility management.

Extended periods of volatility 

DVM is likely to be less effective during an extended period of significant equity market volatility with periods of positive and negative return. Here, the benefit from DVM on the downside is offset by loss of gain on the upside. We have not identified a time when markets performed this way over a long period, but it is possible.

A sudden sharp fall in the value of equities 

If equity markets were to experience a sudden correction with no preceding spike in volatility, it is unlikely that DVM would be triggered in time to reduce equity exposure. Events that fit into this category include the Black Monday crash of 1987 and smaller short-lived ‘flash crashes’. In addition to these specific scenarios, it is possible that when share prices recover after market volatility, the funds may not benefit from the full increase in share values. This is because the gradual process of returning to the strategic asset allocation can delay in the funds’ achieving their full strategic asset allocation. Overall, the Retirement Portfolio Funds offer an innovative way for drawdown investors to remain invested while reducing the risk of capital losses during volatile markets.

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This is a Scottish Widows Paid Post. The news and editorial staff of the Financial Times had no role in its preparation