More than four million Australians have reached the 50‐65 age group as the post‐war baby boomers continue their march towards retirement. Vanguards recently conducted survey of 4,000 SMSF trustees identified they want advice on pension strategies, building income streams and wealth preservation.
The question for retirees sitting on cash is how to take advantage of the recent market falls to build income streams, whilst also preserving their nest egg. Baby boomers realise that when they stop earning income, their nest egg could shrink as fast as it grew.
The ASX200 reached the 6,000 level in early March. Over the next 2 months the market had 4 attempts to breach this level and failed on all occasions. Since then, it has fallen over 13% to 5200. The Australian banks have experienced even greater losses of 25%. Following these falls, the fully franked yields available on Australian banks are around 9% pa, a significant premium to the cash rate of 2.2% pa. Yet the traditional approach of buying the stock leaves retirees exposed if the share prices continue to fall.
The theoretical knowledge on how to “insure” your portfolio dates back many decades (Black and Scholes, 1973). Indeed, the ASX offers investor education at their web‐site, noting “There is a valid alternative that allows you to continue to receive franking credits and benefit from share price appreciation but protects your portfolio from large market corrections. Purchasing protection from the options market can help” (http://www.asx.com.au/products/equity‐options.htm) A put option gives you the right to sell a stock at a pre‐defined price for a pre‐defined period of time. You don’t have to sell the stock; you can sell the protection back into the market and receive cash. It is like an insurance policy, but like all insurance it comes at a price.
The issue for investors has been how to implement this strategy in a cost effective way.
Sophisticated investors have been using the options market to protect their investments against sharp equity market downturns. Indeed, 32 per cent of the Australian Stock Exchange’s revenue now comes from derivatives and options trading (exchange traded and over the counter) – more than its combined income from listings and issuer services and cash market trading.
Online access and lower trading fees have brought this technique within the grasp of smaller investors or SMSF trustees. But it requires skill and experience to set the right amount of insurance to cover reasonable risk, and not too much to make it a silly investment. Just like all insurance. And it requires careful monitoring and adjustment, not like the “set and forget” investment strategies of the past.
As the chairman of ASX Limited, Rick Holliday, said in his most recent annual report, the new global regulatory environment creates opportunities, particularly in post‐trade and risk management services. The game has changed.
Craig Racine is Managing Director of Gyrostat Capital Management