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Schroders mimics insurance volatility cap with post-Budget DC strategy

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Schroders is to use a volatility-cap approach in its new defined contribution (DC) strategy launched to provide pre-retirement options for investors after compulsory annuitisation ends this April.

According to the UK fund manager, its ‘Flexible Retirement Fund’ is designed to cater for DC members approaching retirement who are unsure whether to pursue income drawdown, cash withdrawal or an annuity.

DC asset managers are expected to continue launching products around the shift in policy from the UK government, with old default strategies inapplicable for many savers.

Schroders said its new multi-asset fund would target returns of inflation plus 2%, while stating a maximum loss value of 8% over any given timeframe.

The manager said the multi-asset fund would invest on a “risk-aware” basis similar to risk-parity strategies seen in the defined benefit (DB) sector.

Its core portfolio would be 40% growth, 40% defensive and 20% inflation-protection assets, with further discretionary allocations based on medium-term investment views.

The remaining strategy is based on downside risk-management, with a 6% cap on volatility, helping to keep potential losses below 8%.

The volatility management strategy is akin to that seen in the insurance sector allowing insurers to hold riskier assets on their balance sheets, Schroders said.

In practice, if volatility within the multi-asset fund rises above 6%, it will divest into cash until the level falls below the cap, before fully re-investing into the asset-allocation strategy as volatility subsides to normal levels.

Schroders said the fund would also reduce the cap if the fund experienced continued losses, down to a volatility level of 1%, leaving some non-cash assets to avoid cash lock.

The cap, and cap-reduction strategy, will allow the manager to protect losses up to a maximum of 8%, but, given the 1% minimum volatility, it cannot guarantee this, Schroders said.

Back-testing over some 15 years by the manager found the largest loss figure to be 6.46% using the volatility-cap management strategy, compared with 11.84% if the core portfolio was invested without.

John McLaughlin, head of investment solutions at Schroders, said the volatility strategy had never been used for the humble DC investor.

He also said no downside management would be free, and that the strategy would sometimes hamper returns.

“When it works well is a scenario like we 2008, where the market became intrinsically stressed and volatility spiked before we had the most severe falls,” he said.

“Conversely in 2009, when the market rallied again, it would have taken us time to get back into the market because volatility was elevated as the market was rising, and this rule would tell us to leave, so it is not perfectly responsive.

“You can also sometimes get a very calm market that suddenly dislocates downwards, and if this happens, we would follow the market down.

“But that initial drop would immediately induce volatility, causing the fund to de-risk. You will lose something but not as much if you sat tight.”

The fund’s investment strategy will include highly liquid assets to minimise transaction costs, with only around 50% in synthetics to keep the fund below the upcoming 75 basis point charge cap on DC default fund investments.

The strategy was launched in reaction to changes announced in 2014 Budget, which removed compulsory annuitisation, with DC savers expected to exert freedom and move towards cash withdrawals and income drawdown.

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