Using hedge funds to combat sequence risk

Stash Martin, 36ONE Asset Management

When it comes to investing, we often get told to not time the market. In reality, timing is everything. Especially in retirement, where early market declines, particularly if they are paired with rising inflation, can have a huge effect on how long retirement savings can sustain a retiree. In this article we’ll offer examples that illustrate sequence-of-return risk in order to better understand how it can affect a retirement portfolio and how a fund such as the 36ONE Hedge Fund can help minimise sequence-of-return risk. 

The risk involved in withdrawing from a volatile portfolio – termed sequence-of-return risk – is lower when portfolio volatility is lower. The best way to think about this is if the value of your retirement sav- ings declines near the outset of drawing an income, the amount withdrawn will represent a bigger por- tion of your investment than if you had experienced growth over the same period. The effect is that the base continues to decline with each additional income withdrawal, leaving less capital to grow. This could result in retirement savings running out much sooner than if the portfolio experienced positive returns at the start of the withdrawal period. 

To better understand sequence-of-return risk, let’s examine two scenarios: 

Scenario 1: Lump Sum Scenario
Consider a hypothetical portfolio valued at R1 million, if we start investing in April 2006 (the launch date of the 36ONE SNN QI Hedge Fund) with a single lump-sum investment portfolio and neither add to it nor withdraw from it during the ~16 year period. The scenario 1 chart (below) summarises what the investment portfolio would be worth on August 31, 2022 in nominal terms. 

The investor would have been substantially better off if she/he had invested the full lump sum amount in the 36ONE SNN QI Hedge Fund, which does not come as a surprise as the hedge fund has outperformed the FTSE/JSE All Share Index by 5.2% per year (after fees) over the period April 2006 – August 2022. 

Scenario 2: Income Producing Portfolio
The outcomes look very different if you were to regularly withdraw from the portfolios. In this second scenario, scenario 2, we observe a hypothetical portfolio valued at R1 million and assume that an annual income of 4.5% per annum is withdrawn monthly (escalating annually at 6%). 

The scenario 2 chart summarises what the investment portfolio would be worth on August 31, 2022 in nominal terms. 

When we compare the end values of the income producing portfolios (scenario 2), the 36ONE SNN QI Hedge Fund outperformed the FTSE/JSE All Share Index by 6.7% p.a. In this scenario, the end portfolio value is 172% higher when investing in our hedge fund, in comparison to the FTSE/JSE All Share Index. This is substantially higher than the lump sum scenario (scenario 1) initially depicted, where the 36ONE SNN QI Hedge Fund outperformed the FTSE/JSE All Share Index by 5.2% p.a., resulting in a portfolio end value that was 112% higher. 

That’s a sizeable gap in outcomes — the difference is the very essence of sequence-of-return risk. For investors who need to draw from their investments regularly, like those with living annuities, volatility becomes crucial. 

Over the ~16 year period (April 2006 to August 2022) the volatility of the 36ONE SNN QI Hedge Fund was substantially lower than that of the FTSE/ JSE All Share Index. Furthermore, the hedge fund experienced much lower drawdowns during the period. The return profile of the hedge fund was substantially more stable than the market over the period, which resulted in a much better outcome for the portfolio invested in the hedge fund. 

Risk Measures

While the above scenarios are simplified and don’t take tax and other related investment costs into ac- count, the point is rather to illustrate just how important the consideration of volatility is for clients in income-producing portfolios. 

Withdrawing assets in a down market during the early years of retirement is one of the biggest risks to portfolio longevity. When the market recovers, the portfolio may not have as much room to grow (longevity) because it’s been depleted by ongoing withdrawals, as is evident by the above scenario. Higher volatility can act as a drag on performance in income-producing portfolios and can result in investors not meeting their income objectives over the lifespan of their retirement. 

We believe the 36ONE hedge funds are an appropriate solution — by virtue of the strategies and instruments that we use, we have the ability to participate not only in up markets, but can also protect capital during down markets. 

Hedge funds such as ours can form a very useful part of an investment portfolio, as they have the po- tential to provide investors with returns that are similar to an equity mandate but with much lower levels of volatility and much lower drawdowns, resulting in better risk-adjusted returns. We believe such hedge funds are a fantastic complement to a well-diversified portfolio: they can reduce the sequence-of-return-risk without compromising longer-term growth. 

The 36ONE SNN Retail Hedge Fund is now available on most major LISP platforms. If you aren’t already considering the benefits of this strategy within your clients’ portfolios, we suggest you get in touch. Copyright. HedgeNews Africa – October 2022.

Stash Martins joined 36ONE in August 2018 in a business development role. Prior to this she spent five years at Allan Gray. Stash was a Golden Key Honour Society member and was on the Dean’s list at UCT in 2010. She holds a B.Com (Hons) from UCT and a post-graduate diploma in Financial Planning. 

The information presented here is not intended to be relied upon for investment advice. Various assumptions were made. See our full disclaimer here. Source: Bloomberg, 36ONE Research; Performance to August 31, 2022