Strategy offers near-retirees the answer

Buy in the dips? Again, it would normally make sense, but these dips just keep coming. Diversify? That's unhelpful when markets are driven by emotion and good stocks are trashed along with the bad.

This is an age of high volatility. A recent report by CREATE-Research for Principal Global Investors surveyed 289 asset managers, pension plans, pension consultants and fund distributors from 29 countries and found 78 per cent thought markets were in for an era of prolonged turbulence.

The report, Market Volatility: Friend or Foe, found more than 60 per cent of respondents expect two or more systemic crises before the decade is out. It says price fluctuations of 4 per cent or more within a day have occurred six times more in the past four years than they did on average in the previous 40.

"Fear, greed and stress have amplified market cycles," it says. "The price-earnings ratios have no sensible anchor points for now."

But how we respond to this is what matters. The report identifies four key response types.

Adventurists, who believe it's a great time to profit through contrarian investing and market timing (5 per cent).

Pragmatists, who believe in portfolio re-balancing when momentum is working (35 per cent).

Purists, who believe in buy-and-hold investing and see volatility as a risky game (40 per cent).

Pessimists, who lost in the past decade and can't wait to exit at an opportune moment (20 per cent).

Obviously we don't all fit neatly into a category and many will blend their responses. But unless you fall into the pessimistic 20 per cent, there are opportunities to be had.

The challenge is finding and exploiting them. If that seems a big ask, you're not alone.

The report finds that while 71 per cent of asset managers believe prolonged market turbulence offers great opportunity for active managers to deliver good returns, only 13 per cent think the industry can capitalise on this.

The problem for active fund managers (and individual investors) was summed up by Standard & Poor's Fund Services in its latest global equities sector review. Risk-on risk-off, said the ratings agency, was creating merry hell for fund managers because "the degree of correlation at the stock level has major consequences" for them.

"High correlations mean less diversification between stocks. Many fund managers rely on the basic tenets of cross-sectional diversification and market recognition of company fundamentals for their investment process to work."

In English: fund managers weren't performing because the old strategies of stock picking and diversifying don't work in a market where investors simply dump stocks when they get nervous.

So what to do? The Principal survey found fund managers were thinking along four lines: diversifying across asset classes, with a focus on using the characteristics of different types of investments to reduce risk incentives to ensure investment professionals share the pain and gain in volatile times high-conviction strategies to spot opportunities and to act quickly and engaging more with investors so they know what to expect.

Another approach, dismissed as having limited appeal by the report because of costs and counter-party risks, is protection strategies that use derivatives to limit losses.

There is a growing school of thought that these strategies may play a role in protecting near-retirees. The five or so pre-retirement years are critical: a market correction can dramatically reduce the time super will last, as retirement income will be drawn from a depleted asset pool.

Some industry experts have been calling for funds to look at buying protection for investors in this period, rather than strategies such as switching them to more conservative investments that help protect capital but do little to ensure retirement income lasts.

Monarch Investment Management is one company that's working with self-managed super funds in this area. Its managing director, Matt Davis, says the strategy involves buying put options over a limited portfolio of shares to protect investors from losses. It's like a form of insurance, he says. If the share price falls, investors can exercise the options and buy more of the stock back at lower prices if it rises, they buy more options to protect their gains along the way.

He uses the example of ANZ shares, which were worth $30 in 2007 and had fallen to $15 by 2009. A buy-and-hold investor who experienced that fall would need a 100 per cent gain to get back to square one. But Davis says if such investors had bought put options at $30, they could have sold the shares for $30 in 2009 and bought twice as many for $15, thereby benefiting from any share-price recovery.

Of course, like any insurance, there is a cost, especially if markets rise and the options lose their value.

Davis says Monarch's strategy uses the dividend income from the shares to fund the options, so it is effectively a growth strategy. (Investors wanting income need to find it elsewhere.)

It requires high discipline, as its success depends on having protection constantly in place, even when prices are rising, so it's not for everyone. But if volatility is here to stay, we need to deal with it.