Protected Index Portfolio:
About the protection
The Protected Index Portfolio (PIP) fund is exclusive to The Retirement Account and
features a protection mechanism that we believe is unique in the UK.
This document looks at two specific aspects of the fund:
1. Volatility control mechanism – in volatile markets, the fund reduces its exposure to
volatile assets like equities and moves into more stable assets like cash.
2. The put option which is provided by Morgan Stanley* and is used to ensure that the
fund’s unit price can never fall below 80% of the highest price ever attained.
* Morgan Stanley & Co. International plc. Neither Morgan Stanley & Co. International plc nor FundLogic Alternatives plc have
prepared this document and each party disclaims all liability in relation to same.
NOT FOR RETAIL DISTRIBUTION: This document has been prepared
exclusively for qualified financial advisers.
1. Volatility control at 8%
What is volatility and why is it important?
Volatility measures how much the price of an asset varies from the mean (average) over
time. It is an important factor in understanding risk within a portfolio.
A fund that gained 5% one month, 20% the next and then lost 9% the next would have a
high volatility when compared to a fund that gained 1% steadily every month.
For clients taking a regular income during retirement, high market volatility can reduce
returns and erode capital, for 3 reasons:
• The effect of ‘pound cost ravaging’ (when unit prices fall, more must be sold to achieve
the same income, leaving fewer units to benefit from a recovery)
• High volatility increases the probability of extreme outcomes, both positive and
negative, including the outcome that the client will run out of money
• Some research suggests that reducing exposure to equities, commodities and bonds
in periods of high market volatility can generate higher returns1.
How does the volatility control work in PIP?
The Protected Index Portfolio (PIP) aims to cap volatility at 8%, so clients should see
smoother returns and reduced risk. As a comparison, projected volatility of global equities
is 14%, with UK equities a little lower at 13.5%2.
PIP’s control mechanism is based on the ratio of recent volatility against the target
volatility of 8%. It works by decreasing the exposure to the investment portfolio (the risk
asset) and increasing the amount allocated to cash in volatile markets, and vice versa. The
basic principle is shown in the diagram below.
Risk Asset
Cash
LOW
Recent Market Volatility
HIGH
1 Ribeiro and di Pietro, “Volatility signals for asset allocation” (JP Morgan, 2008).
2
2017 Long-Term Capital Market Assumptions. Source: J.P. Morgan Asset Management, data at September 30, 2016.
2
This process is fully automated. On each trading day Morgan Stanley measures recent
annualised volatility against the 8% volatility control target. The actual calculation applied
is complex, but the principle is that more recent volatility is given a higher weighting than
less recent volatility.
If the calculated volatility is below 8% no additional cash buffer is held in the fund, although
it is worth noting that, regardless of volatility, around 10% of the “risk asset” is held in cash
at all times for diversification.
If the calculated volatility rises above 8% then some of the risk asset is converted into
additional cash to dampen the effect of volatility. While volatility remains above 8%, the
cash buffer will be maintained (the higher the volatility the bigger the cash buffer) and
when volatility falls again the cash will be converted back into the risk asset.
Volatility control does not guarantee that the fund volatility will always be below the 8%
target. By definition, volatility control is backward looking as the cash allocation is based
on recent experience. Therefore the actual volatility of the fund will tend to be slightly
above target in a period of rising volatility and below target in a period of falling volatility.
The chart below shows backtested volatility of an unprotected balanced index portfolio
similar to the risk asset within PIP, compared with modelled volatility of PIP over a 10 year
period to Dec 2016, showing how PIP’s volatility would have been stable and typically
below 8%, even in extreme market conditions.
Chart 1: Backtested volatility of PIP vs balanced index portfolio
25.00%
Unprotected
balanced index
portfolio volatility
20.00%
PIP modelled volatility
15.00%
10.00%
5.00%
01
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-0
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8
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0.00%
Graph source: Retirement Advantage 2017. Unprotected balanced portfolio index proportions: UK equities 41%, Govt bonds 16%, Investment grade bonds
16%, US equities 11%, Cash 10%, European equities 4%, Japan equities 2%.
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2. Protection via the put option
A ‘put’ option provided by Morgan Stanley is used to ensure that the fund’s unit price can
never fall below 80% of the highest ever price attained.
Put options allow a fund manager to sell an asset for a fixed price (the ‘strike price’) at an
agreed date in the future. A premium is paid to purchase the put option, and the option
itself has a market value.
The put option acts like an insurance policy. If the asset price rises above the strike price,
then the put option falls in value because the fund manager is less likely to need it. On the
other hand, if the asset price falls below the strike price, then the put option rises in value
because it ensures that the asset can be sold in future for a higher price.
Chart 2: How a put option rises and falls in value relative to the asset price
Market price
2. The price of the risk
asset varies over time
4. When risk asset
is below the ‘strike’
price, the value of
the put increases
Strike price
Time
X
1. A ‘put’ option
is purchased that
allows the risk asset
to be sold at date X
(“Maturity date”) for
the same price as at
the start (“strike price”)
3. When risk asset is
above the ‘strike’ price,
the value of the put
declines
Put option value
5. Maturity date: In this
example, the value of
the put has risen to
compensate for the fall
in the risk asset price
Risk asset price
The above diagram is a simplified representation of how a put option works in order to illustrate the general principle. To understand specifically how the put option works within PIP, see p5-6 of this document.
Managing the risk asset and put option in PIP
The risk asset within PIP is made up of a balanced portfolio of passive tracker funds,
suitable for investors in retirement. The asset allocation (the % proportion of equities,
bonds etc) is strategic and long term, based closely on the Retirement Advantage
Balanced Index Portfolio, and determined by leading City research consultancy, Square
Mile. Asset allocations are held stable within 1% of the initial agreed percentages.
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The put option in PIP is provided and managed by Morgan Stanley, and is an Over the
Counter (OTC) option. This means that it is a bespoke contract, arranged specifically to
protect the asset mix held within PIP.
The initial term of the put option in PIP is five years, which is sufficient time to mitigate the
risk of a market disaster early on, and also reduces cost, as longer term options typically
have a higher price.
When PIP was launched in February 2016, an initial put option was set up with a 5 year
term, with sufficient value to protect the initial investment in the fund. Each day, as the
assets grow in value or as funds are invested or withdrawn from PIP, an additional amount
of the put option is bought or sold so that the current value of the fund is always protected.
For example, if a million pounds is invested today, a proportion of that will be used to buy
more put, and if a million is withdrawn, some put will be sold.
The amount of put option held in the fund will always be such that the sum of its market
value, plus the value of the other assets held within PIP, will be at least 80% of the highest
ever net asset value of the fund. That is the essence of PIP’s 80% protection mechanism.
The value of the put option is calculated daily by Morgan Stanley. Market metrics are
independently monitored to ensure that Morgan Stanley’s valuation is fair, and that clients
are not overpaying for their protection.
The five year term of the put option will be extended by Morgan Stanley periodically
so that the fund is open ended and suitable as a long term investment. Under normal
circumstances extensions will be annual, but timing is at the discretion of the fund manger,
and is dependent on market conditions.
How the put option works within PIP
The put option protects the fund at 80% of the highest ever NAV (net asset value)
achieved. The NAV of the PIP fund is made up of the volatility control (cash component),
the value of the put option, and the value of the risk asset.
If the risk asset falls in value, the value of the put rises. Importantly, if the risk asset plus
cash value falls to less than 80% of the highest ever NAV, the put expands in value to fill
the gap, so the total NAV can never drop below the 80% protection threshold.
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Chart 3: How the put option works within PIP
150.0%
100.0%
50.0%
00.0%
1
2
3
4
Risk Asset
5
6
7
8
Cash
9
10
11
Put
12
13
14 15
16
17
18
19
Protection Level
This chart is for illustrative purposes only. The value of each component is not meant to indicate the precise relationship between the risk asset and the put in any given
circumstance.
Why PIP won’t cash-lock
Most other protected funds work by reallocating investments into cash with a small
insurance element when markets fall. This is called CPPI (constant proportion portfolio
insurance). If markets fall too far, the bulk of the fund has to be switched into cash, making
it impossible to recover when markets improve. This is known as cash-locking.
Because PIP uses a put option for protection rather than converting most of its assets
into cash, it will not cash-lock3.
PIP is also designed to recover from a downturn more successfully than a CPPI protected
fund. Firstly, it doesn’t convert most assets in cash when markets fall, so it is not as
‘deleveraged’. Secondly, it is not forced to ‘buy high’ and ‘sell low’ like a CPPI fund.
However, PIP’s performance will still lag similar funds without protection when markets
are rising or in times of market recovery.
Without the volatility control, the put option in PIP would not be economical, as the price
of options increases with higher volatility. The combination of volatility control and the
put option is the key to achieving a smoother investment performance for clients, with
reliable protection over the long term.
For further details on the Protected Index Portfolio please visit
www.retirementadvantage.com/adviser/funds/retirement-account-funds
Or call our sales team on 0800 912 9945
3 In the event of continued poor investment returns over several years, the cost of providing the protection may become unsustainable.
In the worst case scenario, keeping the fund open may not be in the client’s best interest and it may close. However even in this extreme
eventuality the client would still benefit from 80% protection.
Telephone calls may be recorded for training and quality monitoring purposes. Retirement Advantage™ is a trading name of MGM Advantage
Life Limited. Registered no. 08395855. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and
the Prudential Regulation Authority. Retirement Advantage™ and the Retirement Advantage™ logo are trademarks of MGM Advantage Holdings
Limited. Registered in England and Wales. Registered office 110 Cannon Street, London EC4N 6EU.
40-328 02/17
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