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Portfolio > Portfolio Construction

Managing through a volatile market

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The market recovery since 2008 has been dramatic, with the S&P 500 reaching new highs. Corporate balance sheets have been significantly improved, with bottom-line earnings continuing to beat street estimates. The Federal Reserve continues to provide liquidity into the financial system through quantitative easing. Housing is improving and jobs are slowly recovering. Yet, investors remain tepid, at best, at participating in this rally. Trillions of dollars remain on the sideline, with the memories of the market sell-off in 2001 and 2008 fresh in their minds and evaporating the savings of many approaching retirement.

In addition, the markets have demonstrated increased volatility over the last several years, with wider swings in the markets, even as the market trends upward. Furthermore, clients see what is happening around them: family and/or neighbors are unemployed, global instability is ever-present, food and gas prices continue to rise, and growth in the global economy remains slow. Investors are seeking solutions to their fears of the market and the need for lasting retirement income. One potential solution is today’s variable annuities, which allow individuals and couples to participate in the market with guaranteed minimum income that will not run out. 

Let’s take a look at how investors can manage the volatility of their investments within these annuities and how insurance companies manage risks associated with these income solutions.

What can you do for your clients?

Diversify through asset allocation. Asset allocation is an investment strategy that aims to balance risk and reward according to an individual’s goals, risk tolerance and investment horizon. As demonstrated in the below chart, asset allocation has evolved over the years, with Modern Portfolio Theory, or MPT, one of the earliest theories of diversification between asset classes. Then the Capital Asset Pricing Model, CAPM, and Black Scholes models introduced the measurement of risk to a portfolio. 

Today’s more sophisticated portfolios utilize non-traditional (or alternative) asset classes and strategies. Although newer to the retail investors, endowments, institutions and wealthier investors have been incorporating these strategies for decades. Examples of these alternative investments include real return strategies, such as REITs, TIPs, commodities and global infrastructure. In addition, absolute return strategies are utilized, such as market neutral, currency trading and diversified arbitrage. By combining alternative asset classes with traditional equities and fixed income, the portfolio’s volatility may be dampened further.

Keep in mind, however, that asset allocation does not guarantee a profit or protect against a loss. Application of diversification does not ensure safety of principal or interest. It is possible to lose money by investing in securities.

How are variable annuity companies managing risk?

Today’s variable annuities provide clients many investment choices they have traditionally purchased outside, as well as access to several portfolio management teams normally reserved for large institutions and sovereign wealth funds. These include the alternative portfolios mentioned earlier, that combine traditional stock and bond strategies with real return and absolute return strategies. These provide asset classes, other than bonds, that can help offset market risk and smooth volatility to weather through various market environments.

Insurance companies must manage their risk so they can continue to provide these income guarantees. Each company has their own risk management tools. At a minimum, most companies require a minimum allocation to fixed income to smooth volatility. More and more companies are requiring clients to choose asset allocation portfolios that are run by professional money management teams. This allows the insurance company to lower hedging costs, since they only have to place hedges on a select number of portfolio combinations.

And now several companies are only offering volatility-controlled portfolios that set target volatility to further manage downside risk. These portfolios will reallocate out of equities during heightened volatility and back into equities as volatility normalizes. These portfolios have merit in managing through more volatile markets, but may leave investors in the wrong asset classes at the wrong time, and limit potential upside in increasing income guarantees. All investors will experience the exact same ups and downs, regardless of their unique circumstances. 

Another method uses a predetermined mathematical formula to manage volatility at the individual account value. With this method, assets are still moved out of equities as market volatility increases. However, there is no emotion involved with the decisions to transfer assets. It is based on the difference between the client’s actual account value and their guaranteed income base. When the gap reaches certain trigger points, funds are transferred from variable investments to a more conservative fixed income portfolio. When that gap narrows, the transfers go back into the variable investments. This allows clients to make investment choices based upon their own unique needs and risks, while allowing for a risk control mechanism that is activated when downside volatility increases.

The markets have become more volatile, and clients are looking for a lifeline to guarantee their retirement income. Today’s variable annuities can provide these solutions that allow clients to participate in the market, while guaranteeing their lifetime income. In order to do this, clients can attempt to increase their income and manage their risk through innovative portfolio strategies, including the use of alternative asset allocation portfolios. 

Insurance companies continue to seek ways to manage their risk through various portfolio restrictions, and in some cases the use of a portfolio overlay that manages downside risk through a mathematical formula. Clients are seeking help, and they are looking for you to guide them.

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