Target-date strategies took a beating when the equity market lost more than half its value in the early part of the recession, but a white paper published in January by Old Mutual Asset Management offers low-volatility strategies to help mitigate some of the risk.
Target-date funds are a useful tool for unsophisticated investors, Mike Raso, head of Retirement at OMAM, wrote in the paper. However, "prepackaged target-date solutions" failed to protect retirees' and pre-retirees' assets when the market crashed.
Raso describes the "equity dilemma": the need to ensure investors don't outlive their assets and are protected against inflation while minimizing the risk of dramatic losses in a severe downturn. Low-volatility strategies are the answer to that dilemma, he wrote.
"Low-volatility, as an investment strategy, is uniquely positioned to provide increased downside protection to weather the financial storms of the future while also permitting participation in market rallies."
Raso referred to studies that have found low-volatility stocks frequently perform better than their higher-volatility counterparts. One explanation is that investors tend to favor risky investments with the potential for a huge payoff, even if the probability of that payoff is low.
Raso listed three ways for plan sponsors to lower the volatility in their equity offerings within a target-date portfolio:
- Utilize defensively oriented value managers.
- Hire managers who use a quantitative approach that looks for the lowest expected volatility for a given set of constraints.
- Use alternative investments like commodities, managed futures, real estate and hedging strategies along with traditional equity strategies to smooth returns and create a low-volatility effect.
Raso noted that alternatives are frequently used to lower volatility, but can be more expensive and have higher liquidity constraints.
Ultimately, low-volatility strategies in target-date portfolios provide downside protection and upside participation, Raso wrote. Unlike bonds, which can also provide downside protection, low-volatility equities can "keep pace and participate in longer-term equity rallies."
