Tail events or ‘outliers’ are happening 12 times more frequently than previously – and are “devastating” retirees in particular, says boutique asset manager Wheelhouse Partners.
A whitepaper by Wheelhouse Partners titled The retiree and the 100-year storm warned that outliers, characterised as “very rare and unpredictable events”, were likely to have a graver impact on retirees.
“Significant market falls seriously affect retirees because typically their asset balances are much larger, they have less time to recover from sharp losses, and they rely on their savings for income, often drawing down on their savings during periods of market volatility,” the paper said.
These ‘tail’ events, which typically occurred once or twice in a hundred years, are occurring at a rate of 12 times per 100 years, and managing tail risk was therefore imperative for this group of investors in particular.
“Advisers and their clients must recognise the very different objectives of retirees, and adjust their portfolios with appropriate tail risk management strategies to accommodate longevity risk,” Wheelhouse Partners managing director and whitepaper author Alastair MacLeod wrote.
“In many respects, the traditional means of managing tail risks are broken.
“The conventional solution to lowering risk in retirement has been to increase allocations to either cash or fixed income, which both serve to reduce volatility and preserve capital better in drawdowns.”
As a risk management strategy, diversification was no longer effective given many asset classes tended to collapse together in times of crisis, Mr MacLeod wrote in his paper.
Instead, investing in derivatives offered “a way to harvest higher returns from more volatile asset classes while delivering a retiree-friendly return profile”, Mr MacLeod said in a statement.
Three ways that derivative overlays could provide benefits included tail risk overlays, which meant “assets can remain fully invested in the pursuit of equity returns”; derivative overlays, which “can add convexity to a hedge, meaning capital is increasingly protected the more markets fall”; and multi-asset derivative overlays, which “exploit pricing inefficiencies of indirect hedging”.
Mr MacLeod said the financial course of people approaching retirement was “unknown but already largely set”.
“Their outcomes are dependent on the future returns with which they will be presented,” he said.
“We like to think that tail risk hedging strategies will help them sleep a little better at night.”