Many investors forego return opportunities because they don’t use their Master funds to their full potential. While going to great lengths when selecting specialist portfolio managers for individual asset classes, they then limit those managers’ ability to generate outperformance by imposing tight investment limits, setting value floors or defining tracking error targets. The fixed income market is a case in point: fear of rising interest rates led many investors to stick to unnecessary low duration targets.
Beyond individual segments, this overly defensive stance also affected the master fund level where investors held back, not least because of their limited risk capacity. Adept risk balancing across the entire master fund, however, can frequently increase opportunities at the exact same risk level.
Professional, specialist risk management at the master fund level gives alpha managers additional performance opportunities. Just as - and perhaps more - important than performance optimisation, particularly in times of low bond yields and overheated risk asset markets, is the ability to take swift and appropriate action in the overall portfolio context in the event of trend reversals on the interest rate front or even a significant stock market correction. Overlay management, i.e. the management of asset allocation risks (with derivatives) based on the investor’s risk capacity, provides this crucial component.
Each and every overlay starts with the client’s strategic asset allocation (SAA), more specifically with an in-depth SAA examination: which explicit and implicit risks are contained in the SAA (“risk analysis”), which diversification effects exist, can existing risks be managed via derivatives (“sensitivity to risk management”)? Must and can assets be sold in a worst-case scenario? The outcome of this exercise must then be reconciled with the investor’s wishes and requirements: what are the investor’s primary investment objectives, what is his risk capacity? How much capital is he prepared to lose or should drawdowns be limited (“risk budgeting”)? Should the allocation be adjusted accordingly (“quality controls”)?
In this exercise, the overlay manager serves as an ideal sparring partner and can point the investor to the overlay system that is best suited for his needs. All overlay approaches come with a set risk budget that is derived from the risk capacity and the portfolio allocation. The risk budget is the maximum amount of money the investor is prepared to lose in a sell-off. Broadly speaking, the different overlay models can be broken down by
– Monolithic: no risk buckets, only one risk budget for the overall allocation
– Modular: risk budgeting buckets for individual risk factors (stocks, interest rate, ethics and their separate management;
– No forecasting: purely based on NAV changes (e.g. CPPI models) or additionally based on risk measures (such as modified CPPI, VaR approach),
– Forecast-driven: forecasts for the individual asset class or risk factors determine either the size of the available risk budget (for instance in a risk overlay with “tactical risk budget management”) or use both short and long positions in the context of the available risk budget (the so-called “opportunity-driven overlay” or “tactical overlay”).
No-forecast - and often monolithic - models are frequent in the “overlay world”. Most are called “risk overlay” since they only protect the portfolio against market risk - and do so in a procyclical manner, i.e. in response to market downturns. Once spent, the risk budget must be “rebuilt” when the market recovers before there is again room to increase the exposure. As a result, investors miss out on the first stages of the next market rally, which is equivalent to paying opportunity costs. This is particularly problematic if the risk budget has been used up completely and the portfolio is fully protected: the portfolio is effectively stopped out until a fresh risk budget is provided.
These approaches are suited for very risk averse investors or investors with significant risk capacity that only want to protect themselves against tail risks.
Forecasting future market developments and risks can make portfolio protection less procyclical. This is best done via a modular approach in which each risk type is assigned a risk budget as well as the corresponding internal or external forecast. This “tactical risk budget management” delivers a forecast-driven risk budget.
As a result, the risk budget can be reduced in the event of negative projections and extended when forecasts turn positive in order to reverse protection measures in a countercyclical manner. A signal-driven transfer of risk budgets between various modules can serve as another countercyclical component. All these measures reduce the path dependence of the overlay model and typically also the opportunity costs. Since there is no active positioning based on market forecasts, this approach also provides a measure of protection against false signals.
These models are suitable for investors who have a limited risk budget, want to save opportunity costs and wish to follow through with their SAA for as long as possible. A certain risk tolerance is, however, required.
A so-called opportunity-driven overlay takes active long or short positions above and beyond the existing overall portfolio depending on a given forecast. Within the limits of the available risk budgets, these tactical positions can therefore provide an additional source of returns and generate outperformance. A modular approach can also include elements of the tactical risk budget management in order to make even better use of the risk budgets, thereby increasing the return opportunities from overlay management.
This model requires a greater risk appetite than the previous variants and investors need to implicitly trust the quality of the model signals, however it is also the least cyclical and minimises opportunity costs.
To demonstrate the effectiveness of the overlay systems, we will look at simulations with a 50/50 allocation to global equities and developed market bonds, with both components hedged back to euro. The fixed income and equity market forecasts that have been prepared under a strictly quantitative approach are provided by Vescore, our partner of many years, with whom Universal-Investment is managing several overlay mandates with a total volume of seven billion euros. The Vescore approach is used to systematically capitalise on the risk premiums in the equity and fixed income markets.
The simulations illustrate that the theory is working. All three overlay variants deliver on their protection mandate in the crisis year of 2008. However, the simple risk overlay and the overlay with tactical budget management shed some of their protection earnings as opportunity costs in the ensuing market rally, with the tactical risk budget management slightly reducing protection costs. The third variant, a combination of a tactical overlay and an overlay with tactical risk budgeting management, has the freedom to leverage a given exposure if market forecasts are positive. Negative signals are implemented exclusively via a risk budget reduction without any active positioning. The simulation shows: in rising markets, this approach can generate excess returns over the same - not overlay-managed - allocation.
In short, overlay management offers investors an opportunity to optimise their risk profile through various approaches that will depend on their risk tolerance and appetite. To be successful, however, it also requires a reliable and experienced partner with the ability to take into account such different aspects as investment objectives, regulatory environments and risk capacity.
Universal-Investment has been providing overlay management services to investors for over 15 years and is managing mandates with a total volume of approximately 12 billion euros.
Author: Dr. Marc Christian Heitzer and Manuel Stratmann
Date of issue: 7/20/2018
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