Investors will need tactical tools to help deal with rising market volatility, says Adnann Syed, vice-president at Toronto-based TD Asset Management Inc. and head of the TDAM team that oversees the $2.5-billion TD Risk Reduction Pool.
Volatility at the "low teen levels," as had been experienced in recent years, was unsustainable, says Syed. "First, there was ample liquidity that central banks unleashed. And liquidity, which acts like a sponge, saps volatility. But that liquidity is beginning to tighten up a bit, as the Federal Reserve has signalled its intentions to raise rates."
Secondly, Syed adds, global economic growth is expected to slow below the 4% level, which is not a good environment for strong equity returns. "The new paradigm, as we call it, will likely be characterized by single-digit equity returns, and higher volatility."
A key component in funds such as TD Retirement Conservative Portfolio and TD Retirement Balanced Portfolio, which were launched in September 2013, the TD Risk Reduction Pool is aimed at investors concerned with volatility. "Higher volatility could mean that asset prices could plunge, and downside risk could be greater than what we saw over the past few years," Syed says. "Even though we launched the product when things were rosy, our view was that that could not last. TD Retirement Portfolios could find a niche in this new environment."
Not available as a stand-alone product, the risk-reduction pool is designed to help investors benefit from rising markets and protect them when markets are falling. "Two-thirds of the time, markets trend upwards. But one-third of the time, they trend down -- and relatively more violently," says Syed, a 16-year industry veteran who has a MBA with a major in finance from McGill University and joined TDAM in 2012. "This is a key part of market behaviour, so that understanding allows us to structure the (pool) in a certain way."
The pool's derivatives-based strategy relies on a combination of S&P 500 put and call options that reduce the impact of market volatility. The advantage of S&P 500 options is that they are very liquid.
In what's known as a "collar strategy," TDAM buys put options to protect against market downturns, and sells call options to collect premiums. Income from the latter are used to offset the cost of the puts. The pool can be positioned to either participate more in the potential upside, or be more protected against the downside. "It's a very dynamic decision-making process, in close collaboration with the asset-allocation team," says Syed.
While the risk-reduction pool is designed to guard against capital losses, it may be adjusted slightly when the team decides to increase its exposure to rising markets. That's what happened in August. When global markets plunged, Syed and his team adjusted their options positions slightly to ensure that, while protection remained in place, the pool would benefit if the markets recovered.
Back-testing has indicated that the strategy works in reducing volatility. For instance, between January 2005 and May 2013 the strategy's standard deviation would have been a little less than one-third of the 15% standard deviation of the underlying S&P 500 Index as measured in U.S. dollars.
The risk-reduction pool's maximum drawdown, or loss, was only one-fifth of the drawdown experienced by the market. By avoiding the large losses experienced by the market in 2008, the strategy's overall compound annual return was very close to the annual market return for 2005-2013.
During the recent market turmoil, says Syed, the pool's drawdowns were much shallower than the index drawdown. He noted that over the long haul the pool is likely to provide stability to investors because it is focused on mitigating large losses that affect market indices from time to time. The TDAM team wants the pool to be less volatile than the market, "and that's what we're achieving."
The risk-reduction pool is used to varying degrees in the TD retirement portfolios. The range within the balanced product is 25% to 55%, with current exposure around 41%. Within the conservative portfolio, current exposure is 52%, although the range is 40% to 70%. The other components in each portfolio are TD Canadian Core Plus Bond and TD Global Low Volatility.
The three portfolio components, including the risk-reduction pool, have relatively uncorrelated returns and therefore provide diversification benefits, says Syed. "These portfolios are all about stable returns," he says, adding that the goal is delivering quarterly returns that range from -3% to 5%. "There is less chance of extreme outcomes because of the way the three underlying products complement each other and reduce risk."
