Bull markets always run out of road eventually, plunging equity investors into long periods of volatility. The end of the long rally that ran from 2009 to 2019 is no exception. Institutional investors are now negotiating choppy waters with unstable markets, a health crisis and a global recession.
They face two challenges.
First, they must fulfil their long-term commitments for financial growth. In a low-return environment, this means investing in risky assets to hit targets.
Second, they must keep to the risk limits imposed by their investment policies to guard against punishing losses when markets lurch unexpectedly.
This balancing act requires the ability to minimise equity risk without destroying growth. Old-fashioned hedging strategies aren’t up to the task – offering only an uneasy trade-off between price, equity risk avoidance and opportunity cost. They aren’t fully adapted to long-term objectives or the amount risk they will bear.
For more information, read our ‘Equity Risk Overlays’ whitepaper.
What are equity risk overlays?
Equity risk overlays are a more dynamic form of downside protection. They give pension funds, insurers, endowments and foundations a customised answer to equity risk avoidance.
This involves a variety of financial instruments and algorithms to manage risk. They may include a combination of any, or all of these strategies:
- Soft Floor Protection: This offers a degree of equity protection that can be breached for limited periods. The aim is to protect a set percentage of the portfolio’s initial value for an agreed time.
- Hard Floor Protection: This offers a greater degree of full protection that can be breached for limited periods, but not at maturity.
- Volatility Control Strategies: With these strategies, a maximum acceptable level of volatility is set for the entire portfolio at the start. If volatility moves above or below that, the portfolio manager reduces exposure.
The Quantamental approach
BNP Paribas Asset Management’s equity risk overlay products use a unique ‘Quantamental’ approach to ensure bespoke equity protection for clients.
Every client’s approach to equity risk avoidance is different. So our equity risk overlays are bespoke, too. They employ a mixture of proprietary quantitative expertise and fundamental research capabilities, underpinned by active risk management.
We call this the ‘Quantamental’ approach. It combines the best of algorithmic tools, backed by decades of human expertise and our proprietary ‘Quantnow’ market timing models. All of these come into play when building a dynamic equity risk overlay.
Our first step is to understand the client’s needs. Our structuring and modelling team then build algorithms that are customised to meet objectives, needs and preference. This creates a set of quantitative instructions that protect our clients’ equity portfolios without compromising growth.
Examples might include:
- An algorithm that shorts or sells more futures on a specific equity index if the volatility of the underlying portfolio or benchmark rises beyond a pre-defined level.
- Rolling the existing put option protection at the end of each calendar month at 85 per cent of an equity index’s market level.
We don’t just leave it to the algorithms. The second step in building an appropriate equity protection overlay is to understand an investor’s cost constraints and risk tolerance. That’s how we decide which control strategies to use for downside protection.
In many cases we suggest a hybrid strategy, where a combination of soft floor, hard floor and volatility control strategies improves some or all of the portfolio’s performance and risk metrics.
Portfolio managers are closely involved in decision-making and have leeway to override the algorithms if necessary.
This approach can be extended to an investor’s aggregate multi-asset portfolio, with portfolios of fixed income-index futures covering government bond and corporate credit allocations as well as proxy hedging for alternative investments.
Traditional hedging strategies vs equity risk overlays: the costs
Downside protection can be expensive in volatile times, as traditional hedging strategies come with a high upfront premium that can quickly affect returns.
Our equity risk avoidance strategies offer many more opportunities for cost control:
- Premium costs for equity put options are offset by other options.
- The risk budget can be split to mitigate opportunity costs through diversification.
A solution for our times
Our innovative equity risk overlays solve numerous problems, resulting in higher average returns, lower volatility, lower opportunity costs and better protection. They are extremely transparent, with each component contributing to overall performance. A flexible solution in times of extreme risk.
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