How can SMSFs better manage risk in equity investments?

The market selldown and subsequent increased volatility in early February was an unwelcome but necessary reminder for SMSF trustees and members that downturns are a fundamental part of investing.

However, for people in retirement or about to retire, such downturns can be disastrous. Those relying on a set amount of capital in their SMSF to generate enough income to live on are ill-placed to recover from market downturns.

The traditional ‘low-risk’ methods of generating income in retirement – such as term deposits or bonds – are no longer a sure bet for investors. In a low interest rate environment, the lower returns from these asset classes, combined with higher life expectancies, can perversely increase the risk that a retiree will run out of capital. The reality is retirees need exposure to both income and growth in order to address their day-to-day needs, as well as longevity risk.

Elevated exposures to equities, and hence risk, is acceptable – even desirable – in the accumulation phase. It often goes hand-in-hand with higher returns, and investors may have decades of investing ahead to harness the long-term returns of the asset class. However, in retirement, SMSF investors’ objectives have fundamentally changed as they are drawing down on their savings and no longer adding to them, and their investment horizon is much shorter.

This fundamental swap from accumulation to de-accumulation means that instead of ‘averaging down’ when markets are weak (that is, buying when prices are falling), retirees are often forced to do the opposite and sell into market troughs, precisely when it impairs their longer-term investment outcomes the most.

This is what makes market downturns so dangerous for retirees. Once in retirement, their financial course is unknown but already largely set. Their outcomes are dependent on the future returns with which they will be presented and, having completed their working lives, they get only one shot at this path. There is no – or very limited – opportunity to recover from a prolonged market downturn.

Unfortunately, these downturns are more common than most people anticipate. Tail risk refers to the tendency for financial markets to melt down far more frequently and aggressively than investors expect as fear turns to panic and everyone tries to sell at the same time. While statistically these events should be quite rare, in reality they are not and in fact happen every eight or nine years on average.

Because retirees are particularly likely to act against their own best interests at these times, managing tail risk is more critical for retirees than any other demographic.

There are a variety of strategies SMSFs can implement to manage tail risk. All come with pros and cons.

• Diversification into other asset classes such as bonds and cash can help. However, in a low interest rate environment, the low returns on these assets can increase longevity risk (the risk of retirees outliving their savings).

• Market timing is another option, which involves choosing investments based on a view of the timing of future events. In its simplest form this can be via having lots of cash in a portfolio. A more aggressive approach might include investing in negatively correlated instruments that will add value when markets fall. However, this is also very risky if you get the timing wrong.

• Specialist tail-risk managers take an insurance approach to managing meltdowns, seeking to minimise harm whenever and however it happens, and can be engaged for a small cost.

As with any form of insurance, it’s a policy you hope you never need, but a well-constructed hedge can deliver an all-weather safety blanket for SMSF members for a range of possible outcomes. These strategies can allow 100 per cent of an investor’s capital to be deployed in the pursuit of higher-growth equity returns – precisely what a retiree needs to fund their future.

Whether the next crisis is an overnight ‘gap’ event, such as Black Monday in 1987, or manifests over a far longer period, such as the global financial crisis of 2008/09, it pays to be prepared. The current bull market is now the longest in history, equity valuations are high and interest rates are rising. As we saw recently, market volatility can occur out of the blue and the timing may be closer now for some sustained market turbulence.

While we believe it’s a fool’s errand to try to predict exactly when or how market peaks and troughs will occur, at Wheelhouse we sleep a little better at night knowing we are prepared for overnight ‘gap’ events and longer-term changes in market volatility regimes. Our strategy considers factor-specific sources, as well as broader and more gradual market price realignments.

Essentially, these are opportunities for retired SMSF investors to continue their exposure to the growth of equity returns by reshaping those returns and thus reducing risk.

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