Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.
Dynamic risk management strategies (risk overlays) can be very useful for institutional investors. They are a means of reconciling their two main objectives: a) capturing the risk premia of risky assets to meet their long-term strategic goals, while b) still meeting short-term risk constraints such as limits on drawdowns or requirements for regulatory capital.
Over the last two decades, we have seen a number of extreme market downturns. The latest selloff has occurred over the COVID-19 crisis. It is extremely difficult to anticipate market dislocations (especially if the underlying economic environment appears benign), and to correctly time decisions to remove or add risk to portfolios.
Large drawdowns in such selloffs often force investors to liquidate positions, causing losses. The result is that they also miss out on the following rebound. To remedy this, investors should have a protection strategy in place.
We believe investors should define a risk framework and protection overlay strategy ahead of time, that is, not in the heat of the moment. This strategy should protect the portfolio when and where required. Such an approach reduces timing risk around a decision to put protection in place.
Although this approach may involve upfront and opportunity costs, over the medium to long term we believe these costs are small relative to the reduction in drawdown and market volatility that a protection strategy brings.
It is possible to construct different protection strategies. We illustrate this using one of our funds. It implements a strategy structured around an EMU multi-factor equity portfolio with an option overlay to reduce the maximum drawdown and the SCR (for insurers).1
Our risk overlay approach using options
The protection consists of:
- Acquiring, every month, 1/12th of the full size of the portfolio via a one-year EuroSTOXX 50 index put option with an 85% strike price and then rolling it at expiry. This creates a series of 12 overlapping put options, which are closely following the European equity market.
The cost of the put is offset by:
- Selling overlapping one-year put options at a 60% strike price and
- Selling one-month call options where the strike price is such that the cost structure is zero.
Proven effective in the recent downturn
This strategy worked well between the end of February and the end of March 2020, protecting the value of the assets against the sharp 25% decline of the MSCI EMU index over that period. Investors should note that all the protective puts were in the money following the significant fall in the market.
During the market’s rebound in April, the strike price of 20% of the protective puts was reset to buy the call again. The idea was to participate in a potential market rebound while preserving the downside protection, locking in any excess performance.
To fully grasp the benefit of the strategy, let’s look at the longer-term performance.
Since 2012, when the systematic option overlay was implemented, the strategy has delivered what we were expecting: a limited opportunity cost (i.e. underperformance) compared to the equity market, a lower volatility relative to the benchmark and a lower average SCR for insurers.1, 2
Limiting the downside, leaving room for the upside
Such an overlay strategy can be shown to protect the investment, while still offering performance that is closely aligned to that of the underlying market over the long term (as mentioned above, the opportunity cost is limited). The strategy allows investors to contain losses, while they can still participate to some extent in a market recovery.
An alternative strategy is a floor protection overlay (via futures or ‘physical de-risking’). This strategy is not active all the time (so it is less costly), but, being pro-cyclical, may cause it to lag some initial extreme market moves. A future blog post will provide you with full details of this strategy.
To maximise the benefits, we believe that combining an option overlay strategy with a futures-based floor protection overlay is the most effective and cost-efficient solution.
You will find a comprehensive analysis of this combined approach in our new white paper.