SMSFundamentals | May 16 2012
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
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Please note: This article was first published for subscribers on April 11, 2012. It has now been unlocked for general access.
By Greg Peel
SMSF trustees, or smurfs as we call them, can be divided into two categories: accumulators and retirees. Accumulators are still working and that income provides for day to day living, allowing super to be accumulated ahead of retirement. Retirees no longer have that income so they must rely on their super portfolios to provide income for day to day living.
The accumulation phase of super is thus one of leaning towards growth, seeking higher returns at the expense of yield. Accumulators can afford to take more risk, and as such a very simplified portfolio allocation benchmark for the accumulator might be 70% equity and 30% cash/fixed income.
The retirement phase is one of leaning towards income, seeking higher yields at the expense of growth. Retirees are reluctant to take too much risk, and the equivalent portfolio allocation might be 70% cash/fixed income and 30% equity.
Whether or not such an allocation is representative of your own retiree portfolio is not important. Either way it is likely your own retiree allocation is closer to the latter than the former. Merlon Capital Partners has been conducting some research to compare the performance of accumulation and retirement portfolios over time, using these two ratios as their benchmarks, with the purpose of comparing risk/return.
SMSF portfolios, whether accumulator or retiree, were heavily weighted towards equity between 2004 and 2008 when it seemed the bull market would never end. Bull markets always end, of course, and 2008's crash was one of the more spectacular. While prices have since improved, the few smurfs who reentered the stock market in the interim have again been burnt in between, this time by the European crisis. It is little wonder therefore that today's smurf is content just to take up attractive term deposit offers from Australia's banks.
The bank deposit war has proven a brief boon for smurfs, but the days of above-market interest rates are numbered. The banks are now happy with their deposit ratios, meaning premiums are being removed, and economists believe the RBA will be cutting its cash rate again soon, which will immediately bring down deposit rates. RBA cuts will also bring down yields on fixed income.
While inflation in Australia remains low (the TD Securities measure for March came in at 1.8%), the real return on any interest rate investment is net of inflation and of taxation. This is also true for equities, but where equities differ is in their potential for capital growth to beat inflation and their potential for no tax, that is fully franked dividends.
Merlon Capital calculates that the accumulator's 70/30 equities/interest rates portfolio would have provided an average 9% per annum return over 1994-2011, beating inflation by around 6%. Clearly Merlon is assuming “passive” portfolio management and adopting index benchmarks. Over the same period, a retiree's 30/70 equities/interest rates portfolio would have provided 6% per annum in yield but only 1% capital growth, or about minus 2% return in real terms. Says Merlon:
“This shortfall [against inflation] would have seen income growth from such a strategy fall short of the rising cost of living. Over long time periods a shortfall of this magnitude would see a material reduction in retirees' standard of living.”
Of course the self-managed retiree (and accumulator) has the opportunity to eschew a passive index-based equity portfolio and actively seek better yield and the potential for higher returns by weighting towards stocks offering both earnings and dividend growth and weighting away from low-yielding but influential large caps such as those in the dominant resource sector. But if the bulk of a retiree's investment is sitting in no-growth assets such as cash and fixed income then the benefits of a well allocated equity portfolio diminish.
To provide for a comfortable retirement right through to the inevitable, a retiree really needs to bite the bullet and introduce more return potential into his or her portfolio. This means looking at equities a little harder once more, but thus also means increasing risk. Post GFC, retirees have been a lot more inclined to suffer lower returns for the comfort of being able to sleep at night.
Merlon Capital entreats retirees to rethink equities, because it is possible to improve portfolio returns while still keeping risk at bay. That sounds like magic, doesn't it Merlon? (Oh sorry, wrong spelling).
No it's not magic. But it does involve the use of that which many retail investors dare not speak its name. It means using “derivatives”.
As an old options market-maker from way back, this writer has often been at pains to point out in FNArena articles over the years that “derivative” need not be a dirty word. It has become a dirty word because of those greedy among us who see derivatives as providing opportunity for leveraged and thus enhanced returns (with concurrent enhanced risk). But used the right way, derivatives can much reduce risk without sacrificing too much in the way of return.
The 30/70 weighting described above certainly reduces risk, but at the expense of return. Were a retiree to revert to the accumulator's 70/30 weighting, return potential is increased but risk is again reintroduced. By using ASX-listed stock options, known as exchange-traded options (ETO), investors can reduce risk while only sacrificing a lesser amount of potential return.
Australia is a very poor user of ETOs, to the point that visiting Americans are astounded that ETOs are not more popular in this small but sophisticated nation, just as they are at the retail level in the US. One of the reasons, apart from general “derivative” fear, is that up until last year the standard ETO contract represented 1000 underlying shares. It didn't matter whether those shares were priced at $1 or $100, the smallest option unit was still 1000 shares.
So back when Rio was trading at around the $100 mark, for example, to be able to use a listed Rio ETO as a hedge an investor would need to have held a minimum $100,000 worth of Rio alone. This is not retail level stuff. Fortunately someone at the ASX woke up last year (actually there has been a long and pitched battle between fund managers, brokers and the ASX itself over pros and cons) and dropped the minimum parcel level to only 100 shares. Today to use a Rio ETO as a hedge one only need have a minimum $6,600 invested in Rio shares.
Of course, one doesn't need to own Rio shares to buy or write (sell short) Rio options. One way to reduce risk in a portfolio is to invest in shares only by buying call options. This way the same returns can be gained for a much smaller investment and downside risk is known and limited. The problem here for retirees is that while ETO pricing takes dividends into account, options themselves don't pay dividends.
Another simple way to reduce risk in a portfolio is to buy the shares you want and then buy put options on those shares. This is just the same as buying a house and then buying fire insurance. Put options provide the right to sell at a pre-determined price, and that price is usually set at some level below the current share price. But buying put options requires forking out for the options as well as the shares, which increases the investment cost. Although by buying put options an investor can sleep soundly at night.
One of the most popular use of options is not to buy call options but to buy shares and then write (sell) calls in the same stock at a higher exercise price. The option writer receives the premium value of that option as enhanced return in exchange for potentially being “called” – having to give up the shares at a higher price. A successful implementer of this popular “buy-write” strategy can enhance returns every quarter and if shares are occasionally called, they're called at a higher price, so it's just like choosing to sell at a higher price.
If one writes call options “naked”, the required margin cover can be very costly, particularly for the small investor. And don't even think about writing put options unless you really know what you're doing. But if one writes calls over one's own stock position, one-for-one, then the risk is negligible and your broker/clearer will require little or no margin cover.
The sorts of strategies I've just explained are fine for some but not really that helpful for retirees needing to improve returns while not increasing risk too much, I hear you think. Buying put options to protect shares is fine, but costly, while enhancing returns through call option writing is nice, but I would still have the downside stock risk.
The trick for the retiree, however, is to put the two together.
Rather than shift funds out of no-growth and increasing lower return term deposits and the like and back into higher return, higher risk shares with eyes closed and fingers crossed, do so with the addition of put option protection funded by call writing. You buy the shares and you buy a put option over those shares at an exercise price below the traded price. This locks in a known downside risk. You simultaneously write a call option at an exercise price above the traded price, with that exercise price determined by the premium received being equivalent to the premium paid on the put option.
You pay for the shares, but your long put/short call combination costs you zero, your margin requirement is zero, and all you pay is brokerage (which is not that steep on options given we're only looking at premiums). Sounds complicated, but such a transaction is water off a duck's back for most stock brokers.
In so doing you have established your sleep-at-night factor with your puts and while the potential return on your shares is diminished by the risk of being called (at a higher price), your overall return potential is still improved by holding equities rather than cash.
Merlon Capital is an advocate of such a strategy. The benchmark 30/70 equities/interest rates portfolio introduced above assumes that equities are represented by the index. Index investment reduces yield potential given the high capital weighting of low-yielding stocks in the Australian market. The self-manager can first choose a particular portfolio weighted towards higher yield growth stocks, but can also adopt the options strategy described above to tilt that equity investment more towards the retiree's needs than the accumulator's needs.
Merlon has again conducted some calculations. Assuming a $300,000 starting value in 1994, Merlon calculates that the index-based 30/70 portfolio would have seen income grow from $18,000 in 1995 to $25,000 in 2011, or 3% per annum. The portfolio would have been worth $360,000 in 2011.
By selecting high yield growth stocks and adopting the options hedge strategy, Merlon calculates the $300,000 starting portfolio would have returned $21,000 in 1995 growing to $41,000 in 2011, or 4% per annum. In 2011 the portfolio would have been worth $580,000.
Now Merlon's report does not name those stocks, so readers should take the example as a general one. The point is that by shifting from a 30/70 index portfolio to a higher yield but hedged portfolio the retiree can win on both the swings and the roundabout as a comparison. It is also important to note that there are only around 80 stocks offering listed ETOs on the ASX, so not every one of your preferred high yield choices can be hedged in such a fashion.
Also note that put options are always more expensive than call options for the same spread away from the price of underlying shares due to the stairs and elevators principal.
To wrap up, I am reminded, in my capacity as an old options market-maker, of the 1980s bull market and the 1987 crash. Back then, as in 2006, the herd assumed stock prices would just keep going up. Fund managers were making excellent returns although one – the old BT – decided to sacrifice a bit of that return to lock in a bit of protection. The steeper the index rally became, the more BT implemented such a strategy. Oh how BT's competitors chortled when the quarterly return results were published.
They weren't chortling, however, when at the end of 1987 they posted returns of some minus 25% for the year and BT's return was 0%. BT's hedge strategy was to buy put options below the money (using SPI futures in this case) and fund them by selling call options above the money.
Readers considering looking into option strategies are strongly advised by FNArena to first seek advice from your broker or financial advisor.
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