Asymmetric returns: how they can benefit retirement fund returns

By Andrew Rumbelow, Institutional Segment Head at Sanlam Investments.

Capture most of the upside, less of the downside.

Retirement fund trustees have to meet challenging goals — above all, achieve the highest possible rate of return for their members while limiting downside risk and volatility of returns. Yet in the current climate of increased volatility and lowered return expectations across asset classes, reaching that objective has become increasingly difficult, says Andrew Rumbelow.

Previously we made a strong case for equities: for institutional investors to meet the long-term investment goals of their members, they may need a higher allocation to return-generating growth assets such as equities. The challenge is that this also exposes them to significant downside risk in the shorter term. So institutional investors face an additional hurdle: how can they meet the return objectives of their members without exposing them to substantial risk of short-term capital losses?

Many trustees have now begun to accept that they must be willing to fundamentally re-examine their investment strategies and investigate more tactical ways to achieve their investment goals. We anticipate that a key trend going forward will be a focus on investment strategies that generate a more asymmetric return payoff profile, ie, strategies that maximize upside potential while capping downside risks in volatile markets. The key to these and to achieving sustainable positive returns over time is a dynamic risk-management process that limits the probability of large investment portfolio losses.

This article helps explain how trustees can leverage these strategies to provide members with a smoother journey toward achieving their goals.

What are asymmetric returns?
An asymmetric return profile is, at its most simplistic level, higher and more positive returns, lower and fewer negative returns – achieved through active risk management.  Asymmetric returns means a return profile that is actively managed to meet the end investors’ risk preferences more efficiently.  Besides reducing volatility in returns, asymmetric returns are designed to preserve capital and offer downside protection, illustrated below:

A typical asymmetric return profile, illustrating that participation in the upside is far greater (roughly ⅔) than participation in the downside (only ⅓):

Source:  Sanlam Investments, 2016

Asymmetric returns are also extremely useful from a behavioural finance point of view. They limit the likelihood of irrational investor behavior by creating a smoother return experience. Here we make the assumption that investors prefer asymmetric returns over symmetric returns, drawing on behavioural theorists Kahneman and Tvesky (1979), who describe the relative psychological experience of gains versus losses, called ‘loss aversion’. Accordingly investors feel the pain of loss twice as much as the joy of gains, triggering emotional reactions (like fear) which may lead to poor investor decisions. Absolute return strategies are key in that they limit the likelihood of these behaviours by limiting downside volatility.

Defining risk in absolute (rather than relative) terms
Financial expert Alexander Ineichen argues that controlling downside volatility is a key element in managing retirement assets, if sustainable positive compounding of capital and financial survival are major objectives (Alexander Ineichen, ‘Asymmetric Returns: The Future of Active Asset Management, 2006). Achieving sustainable, positive absolute returns is the result of taking and managing risk wisely, that is, an active risk management process where risk is defined in absolute terms and changes in the market place are accounted for.  A properly executed active risk management process should yield an asymmetric return profile, that is, more and higher returns on the upside and fewer and lower returns on the downside.

“The essence of investment management is the management of risks, not the management of returns.” Benjamin Graham

Risk management in an absolute return context is driven by profit and loss, rather than market benchmarks. This means that risk is defined against an absolute yardstick, like capital depreciation, as the return objective is to generate a positive compounding of capital while the risk-neutral position is cash (Alexander Ineichen, 2006).  However, in a relative return context (like benchmarking and indexing), risk is defined, perceived and managed as ‘tracking risk’. In this context, the investor is exposed to both upward and downward swings in the asset class.

It seems likely that the future of active asset management will rely more on designing investment strategies where the risk/reward relationship is asymmetric and less about beating a benchmark. It is not surprising, therefore, that internationally hedge funds have started to seriously compete with traditional asset managers in recent years —especially for institutional assets.

How we achieve an asymmetric return profile at Sanlam: absolute returns
The essence of the absolute return investment strategy is to achieve inflation-beating returns at reduced levels of volatility. Tactical and dynamic asset allocation is combined with explicit downside protection on our local equity component, using derivatives and other risk protection strategies to achieve the required real return target. A high priority is given to minimising capital losses.

How we manage downside risk
Following a pragmatic value-based investment philosophy, we look at relative valuations across all asset classes to support our dynamic asset allocation decisions. Our bottom-up driven equity valuations in particular are key to determining the magnitude and timing of the protective structures we put in place. To ensure maximum certainty in outcomes, we use these fundamental equity valuations in combination with derivative overlays to put explicit downside protection in place. This combination of derivatives with a fundamental valuation underpin acts as a protective structure (or hedge) against equity market falls, aiming to achieve the highest possible rate of return (per unit of risk taken), while minimising the risk of capital losses.

We operate dynamically across all asset classes, both local and offshore, including equities, nominal bonds, inflation-linked bonds, cash, listed property and derivatives, to adapt to relative market valuations.

Absolute return strategies are designed to provide investors with an asymmetric return profile.