The current market environment is far from calm. On the one hand, economic conditions are more favourable in Europe, the US and in emerging countries, suggesting that equity markets should be favoured. On the other hand, these same markets have, since the beginning of the year, been see-sawing much more than in 2017, and bond markets are no longer the safe haven they used to be in times of rising rates.
This means that a lot of investors want to maintain an exposure to equity markets, while looking for solutions that will adjust their risk and give them a line of defence should the markets suddenly decline. To rise to this challenge, investors can turn to overlay management.
What is overlay management?
Overlay management involves applying a second layer of asset management when constructing an equity portfolio in order to optimise its risk–return profile. There are two ways to do this: reduce risk while trying not to impinge on performance too much or maximise returns while containing the associated risk. The first method involves managing a portfolio’s hedging and is the most commonly used, as it meets many investors’ needs.
This type of strategy, which uses derivatives, has the more general advantage of being able to manage a portfolio’s equity exposure without having to change its investment lines. Simply put, it makes it possible to reduce the overall risk of a portfolio without being forced to sell equities, which can come with substantial brokerage fees or have undesirable accounting effects.
Two types of strategy: “tactical” and “permanent”
An overlay strategy can be used in the short or long term. There are “tactical” hedging strategies that can be applied over a given period, for example a few months, as well as “permanent” hedging strategies to manage a portfolio’s risk–return profile over the long term.
Tactical strategies run the risk of only being completely efficient when they are well-timed, i.e. by hedging a portfolio before a risk arises and withdrawing this protection before a rebound occurs. The unpredictability of certain events and how they develop makes it complex to optimise these strategies, although they can prove to be very useful.
In contrast, permanent hedging strategies enable the long-term volatility of a portfolio to be controlled. With dynamic management of the level of protection of a portfolio and of the optimised cost of this protection, these strategies can return more regular performances while offering lower risk than a traditional equity portfolio.
Combining several complementary models
Technically speaking, in order for an overlay management strategy to be effective, it has to simultaneously combine several complementary methods of asset management on the derivatives markets in such a way so as to benefit from optimised hedging, regardless of the timing or the extent of any market correction. This means bringing together several attractive characteristics of the options market, such as low-cost hedging strategies and the potential exposure to volatility itself (which tends to rise in times of market stress).
These strategies can be adapted to offer solutions tailored to the needs of each investor. Of course, building this type of strategy means keeping a close eye on the liquidity risk of the products being used, especially during times of high market volatility. With this in mind, not using OTC products means investors can be offered extra security. Those who cannot put together these risk-management strategies themselves can, of course, turn to UCITS, where these strategies may be applied.
Geoffroy Gridel
Senior Portfolio Manager