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The retirement wave - Dynamic volatility management

We explain Dynamic Volatility Management – a different and innovative approach to managing volatility for income drawdown investment funds.

7 minute read

Since the pension freedoms of April 2015, the number of people opting for drawdown instead of buying an annuity has increased sharply.

According to the latest figures from the Financial Conduct Authority, a total of £22.4 billion moved into drawdown in 2017/18. This compares to annuity sales of £4.3 billion.

Between April 2017 and March 2018 more than 188,000 pension pots were moved into drawdown, and the average size for a fund had increased to £123,000 by the end of this period.

The retirement movement into drawdown

The big increase in the number of people choosing income drawdown has brought several new issues for advisers to address. While a percentage of these new drawdown clients have been attracted by the ability to take ad hoc cash withdrawals, many have chosen drawdown because of a dislike of annuities and are looking for a regular income.

To sustain their standard of living, 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. This is particularly important for clients who have no other sources of income or savings.

While clients in the accumulation phase have time to allow their investments to recover from any market falls, many of the new drawdown clients do not have this luxury. 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, which has been innovating to meet this new demand. In April 2017, the Investment Association introduced a new Volatility Managed sector to cater for funds targeting a specific outcome for investors.

There are already more than 125 different funds in the sector. Many of these funds use diversification to reduce the impact of volatility on one asset class, while others invest in stocks with historically low levels of volatility.

Outside this sector there are many other investment options designed to deal with volatility, including with-profits funds, investments with guaranteed returns and funds that sell assets, hold the cash and then re-invest when markets stabilise.

In addition, advisers can take a more hands-on approach to managing 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

We believe a different and innovative approach to dealing with volatility is also possible by investing in funds that use a semi-automated process called Dynamic Volatility Management (DVM).

How does dynamic volatility management work?

DVM uses an automated algorithm to respond to recent equity market volatility. When volatility is within defined levels, the funds are invested according to their stated asset allocation. However, when market volatility exceeds that level, the funds de-risk by reducing their allocation to equities.

The DVM algorithm responds to equity market volatility exceeding an adjustable or ‘dynamic’ threshold.

The DVM threshold is initially set to reduce equity exposure, or ‘de-risk’, when volatility exceeds the 60th percentile of average historic market volatility. This average is based on market volatility over the last 20 years. That means that, on average, 60% of the time it will not trigger a reduction in equity exposure, while 40% of the time exposure will be de-risked to some extent.

An important aspect of the threshold is that it responds dynamically to market conditions depending on equity performance over the last 52 weeks on a rolling basis. If equity markets have been rising in the last 12 months, then the DVM threshold will be moved up (as customers can tolerate more volatility after a period of growth) and if equity markets have been falling in the months preceding the increase in volatility, the threshold will be revised downwards so the funds will de-risk earlier.

The retirement volatility measurement graph

The measure of volatility compared with the long term level is based on volatility over the previous 180 weeks, with volatility in recent weeks given more weight.

The funds will then remain in a de-risked position, albeit the extent of de-risking will vary over time, until volatility falls below the threshold, at which point they will move back to their stated strategic asset allocation.

Use of equity derivatives

Even when the DVM has not been triggered, the funds make some use of equity derivatives, known as futures, as an efficient and cost-effective way to get some their equity exposure. When DVM triggers the funds to de-risk, they will not use the conventional strategy of selling shares and switching into cash or bonds. Instead, the funds move gradually from a ‘long’ position in equity futures to a ‘short’ position. This allows the funds to reduce equity market exposure quickly and more cost-effectively than selling equities.

Indeed, when markets are extremely volatile, the funds’ equity exposure can be reduced to as low as zero without having to sell underlying equities. The funds use large and liquid equity index futures to adjust exposure and do not require a fund to hold large cash reserves for trading purposes.

This strategy helps a fund avoid becoming ‘cash-locked’ as it reduces equity exposure. It also avoids costs associated with portfolio rebalancing or selling equities in a falling market only to buy them back in a rising market to regain exposure.

The retirement volatility quote

How might DVM operate in different conditions?

Developing this type of fund involves testing how a fund with DVM would have performed in different market conditions over, say, the last 20 years. In addition, stochastic modelling is used, to test around 5,000 potential future scenarios to see when the funds would be most and least effective.

However, it is important to be aware that 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 that followed the bursting of the bubble or 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. Testing has 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 the funds’ achieving their full strategic asset allocation.

In summary

DVM uses a low cost, fast acting and innovative derivatives based approach (using equity futures) as its main method to reduce equity exposure in times of significant equity volatility, and therefore lower the funds’ overall volatility.

DVM employs a fully automated algorithm which responds to market conditions, measured against a defined threshold. If volatility becomes significant and exceeds the threshold, DVM triggers a reduction in equity exposure, with the aim of avoiding losses.

When volatility is within acceptable limits the DVM process effectively remains dormant, allowing equity market participation and the potential growth this can deliver.

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This information is for UK financial adviser use only and should not be distributed to or relied upon by any other person.