Are you the type that applies sunscreen before you get exposed to the summer sunshine, or do you prefer to wait a while and apply if you start to see pink?
We’ll get to why that matters later.
There’s an interesting dynamic playing out in the performance tables of Australian equity income funds. In an equity market that’s arguably overheated and at risk of correction, some equity income funds have done really well, and others have been challenged.
Performance dispersion of funds within an asset class isn’t new.
But what makes the dispersion among equity income funds so intriguing is its magnitude. To provide context, this is a group of funds that by and large, are generally pitched as ‘low risk’ for retirees.
The lower the risk of an investment, the less performance dispersion you would typically expect. Term deposit rates are an example – they are hovering around 1.6% p.a. for the major banks without much differentiation.
If we were comparing a group of accumulation-based equity funds, you could reason that the performance differential is based on things like investment style, factor exposures and stock-picking.
But when it comes to equity income, there’s a deeper significance to the performance differential. That’s because it potentially gives rise to risks that the intended low-risk audience (retirees) may not immediately perceive.
To explain this further, if a fund is performing well because stocks have run well and it has developed a high level of sensitivity or alignment to a strong performing equity market, then by the same token, that high sensitivity may work against you if markets fall in value. It’s almost as if the fund’s performance is tethered like a labrador to the market’s own performance.
Conversely, if a fund has a low-risk focus and as a result, has lower sensitivity or alignment with the market’s performance, you can expect the rollercoaster of performance to be much smoother, relative to the equity market peaks and troughs. A low-risk, low-sensitivity portfolio may lag when the market is overstretched, but on the flipside, may hold up relatively better when markets decline. It may still be tethered, but with a much longer leash.
We know from behavioural finance and past experience a retiree client is likely to remember a decline much more than a same level of increase. And that experience helps shape their perception of the value of financial advice.
The good news is there’s actually a very effective risk statistic to measure the level of sensitivity of an equity income fund to the equity market. It’s called Beta.
Why Beta is such an effective tool for retiree portfolios is that it acts just like an X-Ray cutting through the marketing spin to measure what retirees really fear most: how exposed is their retirement savings to another GFC-like event.
Beta is a simple decimal number that tells a lot. It essentially measures sensitivity. A Beta score of 1 means a fund has very high sensitivity to the equity market. If the market falls by 1%, an equity income fund with a Beta of 1 is more likely to decline by the same amount, compared to a lower Beta fund.
A Beta of 0 means zero sensitivity and the fund performs almost like it’s in different universe to the equity market. There’s no leash here.
A Beta of 0.5 implies an equity income fund has moderate sensitivity, so the level of volatility may be about half the equity market.
For financial advisers, explaining the concept of Beta to retiree clients can be tricky, but it remains crucial to be able to help quantify their risk exposure to the equity market. Very few other risk statistics are as effective in this endeavour, so it’s worth the explanation attempt.
One way to help explain Beta is to use sunscreen as an analogy. Sunscreen works by lowering sensitivity of your skin to the sun’s UV rays, and is measured by Sun Protection Factor (SPF). So SPF can work like Beta (just in the inverse).
A SPF 0 sunscreen provides no protection, so your skin is fully exposed to the sun’s rays. That’s like Beta 1 – full sensitivity.
A SPF 30 gives good block out and reduces sensitivity to almost zero. Consider that Beta 0 – no sensitivity.
A SPF 15 gives moderate block out. Let’s call that Beta 0.5.
It’s probably worth also mentioning – and you’ll see why later – Beta can go above 1. That’s hyper sensitive – probably akin to a midday sunbake while basting in coconut oil.
Now, with that in mind, the chart below compares the SPF ‘Beta’ ratings for Australian equity income funds for the longest period all funds existed – since April 2017.
Beta is based on the relative net volatility of a fund relative to the S&P / ASX 300 TR Index. Source: Morningstar
From the chart you may be surprised to see that many Australian equity income funds are recording Beta in the mid to high levels, even beyond 1.
The Vertium Equity Income Fund has recorded the lowest Beta (highest SFP rating) across the equity income fund universe, with income of 6.2% p.a. since its inception in April 2017.
This has corresponded with a period where company earnings are coming into question and equity market valuations have tested previous highs.
At this stage it’s worth revisiting two key points from earlier in this article:
1. Beta helps you measure one of the risks that retirees fear most – capital loss associated with an equity market decline.
2. Equity income funds are often pitched as low risk, so you need to determine your own comfort level with funds that are displaying high Beta – let’s say over 0.7 – and whether that is transparent to you and within the expectations of your retiree clients. Be mindful too if your SOA explicitly states to your client it’s a low risk fund.
It is important to note that Beta is often an outcome of an investment process, and is not normally an investment objective. It can also change over time, either passively or actively by the fund manager.
That said, it does measure sensitivity of a portfolio at a point in time, and if a fund is seeking to deliver a low risk sensitivity outcome, it may act as a check and proof of the process. Don’t let any fund manager tell you otherwise!
As an example of how low Beta can help preserve capital of retiree clients, in the most recent significant drawdown (decline) in the equity market, the S&P/ASX 300 Accumulation Index fell 8.4% over the December 2018 quarter, while the Vertium Equity Income Fund fell only 4.3%. The Fund was able to deliver higher capital preservation partly because its Beta is about half of the index (half the sensitivity, and roughly half the drawdown).
A higher Beta portfolio may have fallen further, and lost more of the retiree’s capital in this period.
If you have clients that are seeking greater capital preservation potential through the market cycle, then the Vertium Equity Income Fund may be worth considering.
Think of it as a high SPF equity income sunscreen that you may want to always carry in your beachbag. And it’s delivering what’s printed on the bottle.
So will you apply sunscreen now, or wait to see some red?
Past performance is not a reliable indicator of future performance. This document is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any specific reader. As such, before acting on any information contained in this document, readers should consider whether the investment is suitable for their needs. This may involve seeking advice from a qualified financial adviser.