One of the biggest challenges that retirees face in framing their future income streams is balancing risk and return: how to live comfortably but also sleep at night.
Veteran fund manager Denis Donohue has created and road tested a defensive Australian equities growth annuity model he calls a “Grannuity” that combines stocks that pay high franked dividends with an accompanying options or “insurance” strategy to minimise downside by taking a small amount off the top.
It has a return target of between 6 and 10 per cent a year after tax, but with a downside limited by a careful options strategy.
It will fall if the market falls, but the “insurance” strategy aims to limit all falls to no more than 10 per cent of capital irrespective of the losses sustained by the main market index. The after-tax distributions of around 6 per cent should not be negatively affected by market falls.
In essence the managers will write or sell “call” options, which allow other parties to buy some shares in the portfolio at prices above where they were when written. At the same time the managers will buy an equivalent number of “put” options, which most importantly will give the owner the guaranteed right to sell shares at prices not too far below their purchase price or alternatively, lock-in some accumulated capital gains.
That’s where the downside protection comes in.
“It’s a risk minimisation strategy,” says Mr Donohue, who spent 25 years as Head of Australian Equities at Suncorp then moved to Solaris between 2004 and 2013.
A major part of his job was using the Exchange Trade Options (ETO) market to maximise his funds’ performance. ETOs work best when traded in conjunction with a blue chip share portfolio, as will occur with the ‘Income For Life Fund’.
His co-manager is Ewan Macleod, who managed the RACQ portfolio for over 22 years after working with Mr Donohue at Suncorp.
“I looked at my own superannuation and realised I wanted to preserve what I had without giving away the benefits of dividend franking,’’ says Mr Donohue.
“Done carefully, it is possible to combine reliable income, attractive capital growth and capital preservation to create powerful compound returns at lower risk.’’
The fund utilises put and call options to implement its very risk averse strategy, aiming to smooth out market lurches to produce a rolling return of at least 6 per cent a year over five years. The option risk minimisation strategy is expected to be between zero cost and marginally earnings accretive.
The fund has a cautiously incremental approach whereby an average of 8 per cent should come from the sum of a cash and franking yield of at least 6 per cent, plus an inflation-matching capital gain of 2 per cent.
One of the innovative elements of the fund is that it puts a value on franking credits, unlike most other funds.
For instance in the fund’s test phase, over the 11.5months to the end of March 2017, the underlying strategy effected cash distributions of 5.2 per cent, plus 1.88 per cent in franking credits, plus a change in the unit price of 7.02 per cent. That totalled a return of just over 14.0 per cent all investors
The fund is open to Australian and New Zealand investors and has a minimum investment of $500,000.
It will hold between 10 and 20 blue chip, high dividend paying stocks plus keep a cash buffer to allow redemptions. The stocks will be chosen not just for their yield but for more fundamental values such as the durability of their business, the stability of their earnings and intrinsic value.
The recommended investment period is around five years as the manager will then be able to invest in opportunities that are not normally available to funds using short term, index-dominated investment guidelines. It aims to have a turnover of less than 20 per cent per year in the portfolio, thus keeping costs down.
The Income For Life fund is index agnostic, meaning that it has no benchmark other than its stated targets.
Fees and charges have been deliberately designed to be moderate at 0.7 per cent as a management fee, plus a maximum 0.3 per cent fee for trustee and administration services.
A performance fee of 10 per cent of outperformance will only be paid to the manager if the fund exceeds a 9 per cent annual return performance benchmark.
So if the fund hits 10 per cent, the fee would be 10 per cent of that extra 1 per cent, or 10 basis points.
For flexibility and ease of management, the fund will be limited to $1.2 billion.
That's all the nuts and bolts of the 'Grannuity' offering. If you have found your eyes glazing over, be assured that the Pentalpha team has tried and tested the shaping of this product.
They’re not promising to shoot the lights out but they do understand capital preservation, the benefits of dividend franking and retaining the opportunity for growth.
All of which should loom large in the minds of investors.
For further information contact Jarrod Brown.
Written by Andrew Main. Long established and objectively minded financial journalist, Andrew Main has an eye for what counts for investors.