Bank Stocks & Portfolio volatility

Lower portfolio volatility? It’s in the bank.

Most retirees want a steady income and some ability to withstand market volatility. But what should they do when some of their best income shares— banks, for example—are volatile?

Domestic bank shares are a key source of income for Australian retirees because of the relatively high dividends they pay. But there’s a downside as banks account for a large part of the Australian shares market (just over a third of the S&P/ASX 300 Index), they tend to reflect the market’s inherent volatility (which is caused by a significant exposure to the perennially volatile resources sector). So while the income that bank shares pay is attractive, their capital value can be unstable.

This is a problem for retirees, because they meet their day-to-day living expenses out of total portfolio returns. When markets fall, their cash withdrawals continue to eat into the capital component of their portfolios as well as the income component.

The result—likely to be exacerbated for investors with high exposures to bank shares—might be a decline in capital levels that will never recover, and which might be detrimental to retirees’ long-term investment goals.

Selling bank shares to reduce portfolio volatility would be like throwing the baby out with the bath water, however, as it would mean forgoing an attractive income stream. This is especially true as, contrary to many people’s perceptions, bank dividend payments are relatively robust.

Bank dividends: the safety nets

True, ANZ cut its dividend last year and even recent strength in bank shares (and the market generally) hasn’t totally dispelled concerns that dividend ratios might come under pressure from deteriorating bank fundamentals and new capital adequacy requirements.

Based on Alliance Bernstein’s research into Australian banks:

· The size of dividend cuts that might be required to create a more sustainable payout level would leave the banks still looking fairly attractive as dividend yield plays

· The boards of major banks are reluctant to cut dividends aggressively because doing so would reduce their ability to distribute valuable franking credits (they view franking credits as a key part of the value they generate for shareholders and see it as their duty to distribute them)

· Banks possess some structural limits to the rate of decline in their profitability. Helped by their profitability and cash flow, the banks are major borrowers from overseas—and this helps to finance the country’s current account deficit and significant accumulated debt. Consequently, governments understand that any appreciable adjustment to the banks’ profitability must be made gradually for fear of the economic consequence

· Following an increase in their capital levels in recent years, banks are in a better position to withstand downturns than they were in the past.

In light of this, the challenge for retirees is to hang on to their bank shares but somehow dampen their volatility.

The solution lies in addressing the problem at the portfolio level, rather than at the level of individual share holdings.

Winning more by losing less

One way to do this is to incorporate into the portfolio an allocation to a low-volatility shares fund or strategy that can help to offset volatility from bank shares. Ideally such a strategy should “win more by losing less”—that is, lose less than the market when the market falls and participate as much as possible in the upside when the market recovers.

In this way a retiree’s portfolio can recover relatively quickly from a market drawdown, because it has lost less ground to begin with and can recapture a significant proportion on the rebound. Research shows that, over time, this strategy should generate returns comparable to the market, but with a smoother ride.

A portfolio of Australian shares constructed according to these principles would naturally be underweight financials and resources, thus reducing volatility.

And so it should be possible for a retiree to continue to enjoy relatively high bank dividends with the shares’ volatility offset to some degree at the portfolio level.

Speak to your financial planner to discuss how you can minimise volatility in your portfolio.

Source: AB

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