Do risk-control indices work? History says yes

Fixed indexed annuities (FIAs) are an increasingly popular option for retirees and others seeking both the stability of principal protection from market loss and the potential for growth linked to an underlying index. In 2022, a record year for annuity sales, FIA sales rose 25 percent from the year before.

The custom indices offered in most FIAs sold today include a risk control, giving the index the ability to respond to volatility. While relatively new (the risk control feature was introduced in the early 2000s) a study by The Index Standard^®, in partnership with Athene, looking at 122 years of data confirms the value of this rules-based approach. 

The study found that over that 122-year period, a hypothetical FIA that included a risk-controlled custom index generally would have provided higher returns than a hypothetical U.S. bond index. In fact, in many of the worst real-world market conditions between 1900 and 2022, having a risk control custom index in a FIA would have improved returns compared with similar products that don’t. This included the inflationary period of the 1970s and early 1980s.

Risk control for volatile times

Risk control mechanisms inside a custom index work by closely tracking the volatility of an index’s underlying assets. When volatility increases — say, during a period of market uncertainty — the risk-control mechanism reduces exposure to higher-risk assets and increases exposure to a lower-risk, cash-like asset. During periods of less volatility, the opposite occurs. 

To test the effectiveness of the risk control mechanism, The Index Standard created a hypothetical risk control Index made up of S&P 500^® companies and targeting 8 percent volatility. During the 122 years studied, this risk-controlled custom index had about half the average volatility of the same index without a risk-control mechanism.

According to the research, the risk control mechanism would frequently have prevented indices from suffering the worst losses in market corrections or crashes. For example, when comparing the 10 worst drawdowns (periods from a market’s peak to trough) the risk control version had less severe drawdowns than the non-risk-control index for all 10 periods.

Accounting for risk in returns

While you get a smoother return with less severe drawdowns in a risk-controlled index, you would expect to have lower returns compared with ordinary indices. And the study confirms this: The average annualized return for the hypothetical risk control index was 7.9 percent, compared with 10.1 percent for the benchmark.  

But when you consider the risk taken to achieve that higher return, the story is different. Using this measure, the long-term return for risk-controlled indices is much higher than for ordinary indices. For 10 of the 12 decades in the study—segments that are more reasonable for investors to consider than all 122 years—the hypothetical risk-controlled equity index outperformed the benchmark on a risk-adjusted basis.

So why is it important to consider risk when studying investment return potential? When you’re looking at investments for your clients, some might offer higher returns at a higher risk. You’ll want to know how much risk they’re taking for the return they’ll potentially receive. Having that information will help you understand whether an investment that appears to have high returns is too risky.

Once again, while absolute returns favored the ordinary U.S. equity index in the study, the Sharpe ratio was higher for the risk-controlled custom index (0.47 vs. 0.37).

Taking a deeper look

When clients are considering annuities you’ll be faced with waves of numbers. Keep in mind what their priorities are. Absolute returns can be important to consider, but for those nearing or in retirement who are prioritizing stability and security, the level of risk taken for that return might be even more important.

So if your clients are seeking security combined with opportunities to capture growth in markets, a FIA that employs custom, or risk-control, indices could provide the combination they’re seeking: stability and return at a reasonable risk.

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