Investment Road Test: State Street Retirement Lifestyle series

“Investment control” is regularly cited as the dominant reason for setting up a self-managed superannuation fund.

Typically this breaks down into a search for capital growth, franked dividends and better risk management. More than 50% of SMSF owners don’t use any managed funds, typically seeing them as not capable of consistently delivering on these goals. The search for a better alternative is hard, though – as owners of some of the blue-chip stocks (like Leighton and QBE) that have spectacularly crashed in recent years will attest.

At least direct share owners can avoid selling when markets crash – properly basing the sell-down decision on fundamentals like maintainable earnings – unlike traditional managed funds, which are forced sellers into market crashes. It’s timely to see traditional fund managers launching new wave products that use more sophisticated risk management tools, like “volatility” and “momentum”, to control internal asset allocation; including the new State Street “Retirement Lifestyle” funds.

Investors and advisers are seeking a more effective way to manage their exposure to risky assets, as well as to constructing portfolios with multiple assets (to access different sources of growth as well as to reduce overall risk). The problem with using traditional managed funds within a diversified portfolio is that even if asset allocation is based on fundamentals (e.g. broad macro factors, coupled with country and sector specific criteria), the composition of traditional managed funds is largely based on asset prices. When price is used as a signal of how much of an asset to buy/hold or sell, this exposes investors to the risk of being part of a forced sell-off, when markets crash.

Avoiding sequencing risks

The by-product of this approach leads to the “sequencing risk” problem highlighted by former Treasury secretary Dr Ken Henry. To compensate for the prospect of crystallising large capital losses during market crashes, traditional portfolio construction holds relatively high levels of risky asset exposure. The idea in the traditional approach is that large gains through high levels of sharemarket exposure will (in good years) make up for potentially big losses in bad years. Henry makes the simple observation: not everyone can afford to wait around, for what may be many years, to recover from big losses in bad times.

This is where the new State Street products may come in handy. The “Retirement Lifestyle” funds come in three styles: “Builder”, “Provider” and “Sustainer” – each targeted for a specific part of the investor’s lifetime. Wealth accumulators will use the “Builder” fund, moving into the “Provider” as they approach retirement age and are looking for better levels of capital preservation; and ultimately moving into “Sustainer” during pension phase. These new funds use a couple of layers of very interesting risk management technology – and with the low cost price tag of 0.75% per annum, they should be considered closely by potential investors.

For example, close analysis of movements in “volatility” during previous market crashes shows that volatility typically is a “leading” indicator of pending market falls. Volatility rose at least a week before the large market crashes of 1987 – well before the price of stocks started to fall.

Asset allocation tools

Under the bonnet of the “Retirement Lifecycle” funds is a blend of low-cost index funds (also manufactured by State Street, a leading ETF provider) coupled with an allocation to absolute return style funds using managed futures positions. At this level the funds use a modified “Strategic Asset Allocation” approach – the precise formula isn’t disclosed, but it seems to use a higher-than-usual allocation to cash and “cash-like” investments such as the managed futures positions than a normal SAA approach.

Within each asset class, State Street then overlays a dynamic asset allocation approach – which is controlled by State Street’s “market regime indicator” – which seems to use a variety of indicators to implement a “risk-on/risk-off” approach. State Street statements on this indicator talk about buying and selling the underlying assets as markets move between “euphoria” and “crisis,” and as a way of adding value when markets are weak.

Most investment houses now use indicators like this, with a variety of inputs, and their accuracy will vary as a result. The simplest indicator – which relies on the momentum of the asset’s price as a guide to risk – is a widely used and fairly robust tool for guiding dynamic asset allocation decisions. Momentum helps because it spots trends as they accelerate or slow down, i.e. often before the tipping point when price moves drastically.

In these types of funds, these “euphoria vs crisis” indicators are applied at the level of each individual asset. If one asset class is moving rapidly one way or the other, the level of exposure to that asset (but not necessarily others) can be dialed up or back down (with cash holdings rising commensurately in respect of that specific asset class).

The final risk management tool within these funds uses volatility as an overriding control to the level of risk within the fund. The funds use futures positions as a way of quickly reducing or increasing risk. This is a good way of avoiding the constant buying and selling of the underlying assets in response to portfolio changes. It also allows for earnings growth to drive rising dividends over the term of the investment (which is hindered when the underlying physical assets are bought and sold).

Tailored risk and return

The three State Street “Retirement Lifestyle” funds are also designed to allow individual investors to tailor their risk and return objectives to suit their specific needs. Because the funds don’t automatically reset their risk profiles over time (compared to traditional balanced funds which use a “one size fits all” approach), investors can choose when to change their asset exposure by moving between each type of fund.

For example, if the lower-risk fund uses more fixed income exposure compared to equities, the investor can time the change from one to the other in line with their own needs, as well as the returns from the different style of asset. When bond returns are low, the investor can choose to stay longer with the higher return/risk fund, or can accelerate the timing of the defensive style fund when bond returns rise compared to equities.

Each fund distributes its income to investors – the “Provider” and “Sustainer” pay out each quarter and the “Builder” pays out each six monthly period. Re-investment of distributions is permissible. Unlike some of the competitors to these new State Street “Retirement Lifestyle” funds, which do give a guide as to their potential returns (e.g. the Schroder’s “Real Return” fund, which targets a fixed return above the annual rate of inflation), the State Street funds don’t have any track record or target for their returns. It’s probably a case of “wait and see” for potential investors into these funds.

State Street has taken the very interesting step of launching these funds into the financial planning sector before it makes them directly available to retail investors. No doubt that will deprive some “planner wary” or “true DIY” investors from access to these funds – but it will make the attraction of working with a good financial adviser more relevant to investors.

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals. He provides asset consulting and financial product services but does not receive any benefit in relation to the product reviewed. Twitter: @TonyRumble.