Enhancing strategy returns with an annuity

Thought Leadership

Enhancing strategy returns with an annuity

03 Aug, 2022

As a general philosophy, we like to think about investment solutions as opposed to investment products. An investment solution comprises of multiple underlying components, or building blocks, and has the advantage of being completely customisable to meet our clients’ investment objectives. A common solution we employ is combining an unfunded derivative exposure with a funded cash building block. Simplistically, the unfunded derivative strategy delivers an excess return, the cash investment delivers the base return, and the combination of the two is the total return for the investment solution.
Insto table Aug 22  

total return solution formula

Depending on the investment objective, “cash” can range from cash held at the custodian to a short-duration credit fund, and even extends into one of Challenger’s flagship products, a term annuity. The rate of return on the annuity can be thought of as the risk-free rate of return plus an excess return.

Return annuity forfmula

A simple example of the investment solution framework using a Challenger annuity as the cash building block is what we call Index Plus. Here, the client earns the return on an underlying index (say for example their benchmark equity index) plus an additional return. The solution effectively guarantees outperformance (by a known-in-advance amount) vs the benchmark index. The flow diagram below outlines the basic mechanics.

Enhancing index returns with an annuity cashflow diagram

Figure 1: Enhancing index returns with an annuity - cashflow diagram

As a rough guide, depending on the term of the annuity (Challenger will pay a higher rate of return for longer-term capital), the magnitude of the guaranteed alpha ranges from 50-100bp. This outperformance is delivered to the client each and every year for the term of the solution, regardless of the performance of the index.

Typically, we observe that active equity managers have a tendency to deliver ‘lumpy’ alpha. They often experience a short period of extreme outperformance, followed by a more extended period of smaller out/underperformance. The alpha from the period of large outperformance persists for several years in the long-term performance numbers, but in reality, the manager may be delivering negative alpha far more frequently than positive alpha. The Index Plus solution delivers guaranteed and consistent alpha year-in year-out, and is therefore a highly effective beta investment solution.

What if an investor wants to transform their equity exposure to reduce downside risk? A good example of this is a systematic option buying strategy. A long option position is, by definition, convex. When markets are moving in your favour your exposure increases, while when markets move against you your exposure decreases. Put differently, when you are long a call option, for example, you make more money when markets go up by 10% than you lose when markets go down by 10%.

Long convexity is obviously an appealing characteristic, however, it’s something that you have to pay for, in the form of an option premium, and the benefit is only really realised in large market moves. However, the value of the option decreases over time, so the ‘cost’ of a long option position is basically an extended period of “not much happening” such that the option loses more value in time decay than it makes from the long convexity position. Because of this, over long periods of time, systematic option strategies tend to underperform vanilla delta-one index exposures.

Including an annuity (with an embedded excess return) in the investment solution can help to overcome this. The chart on the left below shows the total return on $100 invested in the S&P500, compared to the total return on $100 invested in a systematic call buying strategy1 with excess cash earning Fed Funds flat. The call strategy outperforms during periods of market drawdowns – when the market sells off, overall index exposure of the call strategy drops below 100% – but over the long term underperforms the benchmark index slightly. The chart on the right shows the performance of the S&P500 vs the call strategy combined with an annuity. Here, instead of Fed Funds, the excess cash is deployed at Fed Funds plus 135bp, where 135bp is the current excess spread that can be earnt on a 5y Challenger annuity.

Systematic strategy buying 2x 1y 100 call and rolling every 6 months daily tranches

Figure 2: Systematic strategy buying 2x 1y 100 call and rolling every 6 months daily tranches

By combining the call strategy with an annuity earning an excess spread, an investor could conceivably benefit from convex equity exposure with no long-term performance impact. In fact, the Strategy Plus example provided actually outperforms the equity benchmark slightly during the period shown.

The above is an example of one of an infinite number of possible Strategy Plus solutions. The strategy could be tweaked to adjust overall equity exposure, the amount of convexity, the underlying index or pretty much anything else. We can also do non-options-based strategies, for example, combine an unfunded investment in our Liquid Alternatives Fund with an annuity.

More generally we consider the following use cases for annuity-as-a-building-block:

  • Index Plus – client earns the return on the underlying index plus a contractual amount of alpha.
  • Facility Plus – client earns the return on a flexible portfolio with dynamic allocations to several underlying indices with additional alpha on top.
  • Strategy Plus – client earns the return on a custom underlying investment strategy plus additional return from the annuity.
  • Fund Plus – replicate a long only equity fund exposure synthetically and earn additional contractual alpha.
  • Principal Plus – the full amount of the annuity income can be reinvested in some other strategy, and at maturity the client receives the principal plus the investment return on the reinvested income.

Importantly, the above use cases need not be mutually exclusive – an investment solution can consist of any number of underlying strategies. And indeed, not all investment solutions need to include the annuity building block. The annuity building block can be substituted out for some other cash-like investment or even any other funded investment2.

The Solutions Team

The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.

1 The delta on a at-the-money call is approximately 50%, so in order to match the index exposure, the systematic call strategy buys twice the notional of at-the-money calls.

2 For example, we have explored combining a funded investment in an unconstrained fixed income fund with a synthetic duration overlay to more closely match the YFYS fixed income benchmark.

Important notice

Financial services provided by Challenger Investment Solutions Management Pty Ltd (ABN 63 130 035 353 AFSL 487354) (CIP Asset Management, CIPAM). The material in this document is general background information about Challenger’s Investment Solutions activities and is current at the date of this document. It is information given in summary form and does not purport to be complete. It is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any particular investor. These individual circumstances should be considered with professional advice when deciding if an investment is appropriate. Nothing in this document should be considered a solicitation, offer or invitation to buy, subscribe or sell any, or a recommendation of, financial products. All reasonable care has been taken to ensure that the facts stated and opinions given in this document are fair and accurate. To the maximum extent permitted by law, the recipient releases each member of the Challenger Limited group of companies, their directors, officers, employees, representatives and advisers from any liability (including, without limitation, in respect of direct, indirect or consequential loss or damage or loss or damage arising by negligence) arising in relation to any recipient relying on anything contained in or omitted from this document. Any forward looking statements included in this presentation involve subjective judgment and analysis and are subject to significant uncertainties, risks and contingencies, many of which are outside the control of, and are unknown to, Challenger. In particular, they speak only as of the date of these materials, and they are subject to significant regulatory, business, competitive and economic uncertainties and risks. Actual future events may vary materially from forward looking statements and assumptions on which those statements are based. Given these uncertainties, recipients are cautioned not to place undue reliance on such forward looking statements. Any past performance information provided in this presentation is not a reliable indication of future performance. This document is not audited.