The PRA QIS Exercise: What does it cover and what will it mean for firms?
While the PRA stresses QIS should not be viewed as policy proposals, firms should consider the impact the exercise could have on their balance sheets.
Risk is return's gatekeeper: Investors must pass through it to reap the potential rewards.
But sometimes, the gatekeeper extracts a heavy toll.
Is it possible to redefine the relationship? There's only one true test: Compare how investment strategies stand up to a major market downturn.
There's plenty of proof to be found in the aftermath of the Global Financial Crisis (GFC) in 2008-09 and the COVID-19 downturn in 2020.
Some strategies tried to close the door on risk without affecting returns. Others successfully reshaped the risk-return spectrum.
The meaning of protection has changed over the past 15 years.
Before the GFC, the term was associated with complex structured products.
Many promised capital protection by investing the majority of funds in a fixed income product, with the rest invested in higher-risk assets such as shares. Unfortunately some of these funds had liquidity issues while others were closed after the share market collapsed in late-2008.
This is a very different strategy than downside protection, which provides a hedge against extended market downturns.
Downside protection has been successfully used for decades by insurers to manage the liabilities on their balance sheets. It uses futures contracts (or options) to dynamically adjust a portfolio's exposure to equities in response to market volatility.
This strategy has produced very different results through the last two crises. The real-world performance of Milliman's SmartShield High Growth portfolio is shown in the diagram below1.
The portfolio still fell as COVID-19 hit in March 2020, but by nowhere near as much as portfolios with a similar asset allocation. This is downside protection in action.The effectiveness of this strategy – implemented through a separately managed account (SMA) structure – was recognised at the 2020 IMAP Managed Account Awards with an Innovation award.
Redefining the relationship between risk and return is a major challenge. Unfortunately, many historical products simply replaced market risk with illiquidity risk.
This was a key lesson from the GFC and more recently, the COVID-19 downturn. Many super funds are now holding higher levels of cash after the members withdrew almost $40 billion through an early release scheme.
Downside protection offers another option: It provides a cushion against the worst market drawdowns while retaining daily liquidity.
Fund analyst Lonsec acknowledged the difference between downside protection and old-fashioned capital protection when it reviewed Milliman's Even Keel strategy in mid-2020.
“The product overcomes some of the shortcomings of earlier capital protection techniques, some of which became 'cash-locked' during severe equity market downturns and investors were unable to participate in any subsequent equity market recovery. Lonsec considers this to be a key feature of the product."
The SmartShield range of SMAs which uses Milliman’s Even Keel strategy can do this because the downside protection is applied dynamically as market conditions change using futures contracts. Capital is not locked away, and neither is capital guaranteed.
Diversification is sometimes called the only free lunch in town because of its ability to reshape the risk-return relationship at minimal cost.
While it works under most market conditions, this free lunch has historically left investors feeling unsatisfied when a major market downturn strikes.
COVID-19 is an example of systemic risk–it was pervasive, dragging down all major asset classes, just as the GFC did more than a decade earlier. When a client's overall portfolio starts to crash, many investors panic and sell at the worst possible time.
Yet, with cash rates hovering near zero, investors need to retain exposure to these assets if they want the opportunity to generate attractive returns.
The downside protection built into the Milliman SmartShield product range gives investors the confidence to remain invested.
While this protection is dynamically adjusted, advisers can also switch it on or off through the SMA structure at any time without needing to sell out of the core holdings.
The underlying assets that comprise each portfolio are built from low-cost exchange-traded funds offered by major ETF providers such as Vanguard, iShares, and BetaShares. This creates a highly liquid, low-cost way to reshape risk and return.
Investors have learned that they can't entirely avoid risk if they want the chance to generate potentially higher returns–but downside protection can soften the impact of an extended market downturn.
You can check the potential benefits of downside protection on your own client portfolios by accessing the free simulator here https://advice.milliman.com/en/insight/The-SmartShield-digital-portfolio-simulator.
For more information about Milliman’s SmartShield Managed Accounts, please email firstname.lastname@example.org
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