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Is swapping volatility risk for longevity risk the right investment strategy?

Many Australian investors steer clear of investing in shares of companies listed in emerging, or frontier markets, because they think they are too volatile. Generally, investor psychology leads to considering these investments in isolation rather than considering the role they play in a portfolio, because investors mistakenly perceive risk as volatility. As Warren Buffett once noted, “an asset that has dropped very sharply becomes “riskier” at the lower price paid than it was at the higher price”. In our view, volatility is more a proxy for fear which often leads to irrational investor behaviour because higher volatility and short-term monitoring due to a loss aversion bias can lead investors to sell at the wrong time.

Risk management in investor portfolios should consider the risk of:

  • Not meeting investor goals (e.g. generating real wealth, managing liabilities etc.);
  • Outliving retirement savings; and,
  • Permanent loss of capital (as opposed to capital losses on paper).

Sequencing risk is topical given its impact on retiree portfolios. However, concerns around sequencing risk tend to drive portfolio construction towards risk minimisation strategies, giving potentially a more stable portfolio, but perhaps unknowingly increasing longevity risk (out living savings). Investment strategies aligned to capital growth should not be ignored. Doing so exposes investors to the risk of falling short of their investment objectives and, in particular for retirees, outliving their savings.

Drew, Walk & West (2015) looked at longevity risk and its impact on retiree portfolios. The authors note that there is around a 50% chance that a 65-year-old Australian male will live to the age of 85, a 30% chance he will live to age 90 and a 12% chance he will live to age 95. Similarly, there is a 50% chance a 65-year-old Australian female will live to age 87, a 41% chance she will live to the age 90 and a 21% chance she will live to age 95. Remarkably, for a couple both aged 65, there is a 50% chance that at least one will live until age 91 and a 31% chance at least one will live to age 95. It is worth noting that these statistics do not take account of future longevity gains. If future longevity gains are similar to those observed for the past century or so, retirement planning based on the probabilities listed here could significantly underestimate longevity risk. Imagine an average life expectancy of 100 in 20 years’ time.

Source: The Role of Asset Allocation in Navigating the Retirement Risk Zone, FINSIA, 2015

Longevity risk presents a major challenge for those developing asset allocation strategies. Can wealth be sustained for longer periods? This risk can have a major impact, especially when retirees face the prospect of running out of savings when it’s too late to take any action. The Association of Superannuation Funds of Australia (ASFA) estimates that an Australian retiree needs an income of A$40,297 per year to provide a comfortable standard of living in retirement¹. Given the full rate age pension is currently just over $18,000 per year for a single pensioner, the risk of shortfall is meaningful.

Therefore, it is important retirees not ignore investment strategies that can generate sustainable, long-term capital growth over ever increasing investment horizons.

Are Australian equities the answer? Interestingly, many investors have been using equities as a proxy yield play. This seems to work fine until valuations on these stocks are bid up and the risk of capital loss increases. However, a company that is paying out a significant component of its profit as dividends is doing so because of Australia’s favourable taxation laws (franking) and a dearth of growth opportunities in which to invest capital. Perhaps companies should increase their focus on capex and generate investment and productivity, rather than focus on rewarding shareholders through income.

It seems we have forgotten that investing in equities is about generating capital growth through exposure to businesses that can grow their revenue and therefore create strong profitability. Can broad emerging markets give you that capital growth? “Emerging markets” is an eclectic group of countries bucketed together by an index but which share very little in common. The term embraces countries that are big and small, developed and under-developed, industrialised and agrarian, manufacturing and commodity-based, rich and poor, deficit and surplus – the diversity goes on.

Hence, it pays to be selective when identifying capital growth opportunities. Companies operating within India’s economic ecosystem are experiencing strong revenue growth, with payout ratios of only 26% and dividend yields of 1.4%. This is because the opportunity for companies to generate strong returns from reinvesting their capital is significant, given an abundance of growth opportunities. In fact, Indian companies have grown their return on equity rather consistently compared to other developed and emerging countries, as shown in Figure 2.

Figure 2:  Volatility of Earnings Growth and ROE

MSCI Index

Std Dev of EPS growth since 2002

Avg ROE growth
since 1996

India

13%

18%

China

19%

13%

Brazil

44%

13%

Russia

45%

13%

Emerging markets

27%

13%

All Country World Index

34%

12%

US

33%

15%

Developed markets

35%

12%

Source:  Morgan Stanley research

Investors need to re-examine the role of equities in their portfolio. The focus should not always be on short-term volatility of each asset, but rather the growth and diversification offered to the portfolio. An allocation towards growth/developing economies like India is likely to help address longevity risk and complement high yielding strategies.

Endnotes

1. ASFA Retirement Standard, March quarter 2012