Stay on track and continue to take advantage of opportunities during periods of market volatility. Photo: franckreporter Source: iStock

The ideal line - staying on track with overlay management

Author: Peter Flöck

Navigating the unpredictable financial markets safely with optional driver assistance: smart institutional investors can use overlay management to stay on track and continue to take advantage of opportunities during periods of market volatility.

Peter Flöck, Head of Product Management, Head of Branch, Universal-Investment-Luxembourg S.A., Niederlassung Frankfurt Photo: Manjit Jari Source: Universal-Investment

Institutional investors react differently to uncertainty: some have strong return - focused portfolios and hit the gas, while neglecting their risk-bearing capacity when the needle moves into the red zone. By contrast, others opt for a very risk-averse asset allocation – strategic asset allocation, which is tantamount to keeping the brakes on. Although this is a less risky approach, it is hard to achieve minimum levels of returns.

Overlay management can help investors to achieve their personal targets, much like a driver assistance system in a car. No matter the market environment, investors can maintain their preferred driving style and stay on track. An overlay strategy allows investors to maintain fairly aggressive allocations even in adverse market conditions, because maximum losses – with predefined probabilities – are limited to the risk budget of the investor. The strategy increases planning certainty, without overly restricting the gains from positive market developments.

Individual routes for investors

For investors with a very defensive allocation, overlay management is the method of choice to manage the existing risk budget more effectively. Transparent, rules-based overlay strategies can be used to steer market exposure by moving in and out of particular market segments. Tactical signals can be integrated to leverage segments when market expectations are positive and to short them when the outlook is negative, to improve performance.

The same advantages can be achieved by investors with a balanced strategic asset allocation, where assets are neither too defensive nor overly aggressive given the risk budget. There is a panic button to reduce the risk of excessive losses, but also the option of shifting exposure to certain segments up a gear. Overall, the overlay strategy offers investors valuable information about the risk budget utilisation of their asset allocation.

Overlay Risk/Return Profile

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Source: Universal-Investment-Luxembourg
Zoom
Source: Universal-Investment-Luxembourg

Overlay strategies are equally effective during equity market corrections and interest rate changes, and can be effective due to modular features and risk budget sponsoring during periods of market turbulence when individual markets experience a V formation. Overlays are not only helpful in difficult markets, when investors are seeking to mitigate risk. Overlay management is also an effective way to safeguard target returns via dynamic performance protection and to permanent optimise the risk-return profile through efficient use of the risk budget.

Overlay gains outweigh the costs

Despite the many advantages of overlay management, you will sometimes hear investors complaining about high opportunity costs. To be honest, a strategic instrument that creates a better balance between personal return targets and risk-bearing ability will never come at zero cost. For most investors, the higher risk-adjusted returns will far outweigh the relatively low opportunity costs.

Buffering Extreme Events

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Source: Universal-Investment-Luxembourg

How overlay management adds value:

  • Less volatility yet similar returns
  • Much smaller drawdown, expected shortfall and conditional value at risk (CVaR)

Tailored to requirements

Overlay management solutions are as unique as the profiles of individual investors. Some investors prefer to work actively with an overlay mandate to develop investments proposals for which asset classes to hedge and when is the right time to do so. Other investors prefer to hand over responsibility for those decisions to an overlay manager.

In conclusion: what can overlay management do for institutional investors?

Hedges are only executed where needed.

Separate risk budgets are defined for interest rates, credit spreads, equity and currency factors, (each risk is managed separately). In this way, performance opportunities are maintained in rising market segments, reducing the risk of a full hedge.

With the modular overlay approach, growth segments are left untouched.

Less pro-cyclical behaviour.

If internal or external signals indicate a negative expectation in a particular financial market segment, the risk budget is reduced in that segment. The budget can be transferred to other market segments with a positive outlook instead. Risk budget transfers can be used to trigger anti-cyclical hedges.

No noticeable impact on individual asset managers.

Having an overlay segment in the master fund means that individual asset managers can continue to focus all their attention on generating alpha.

Overlay management at Universal-Investment

The Portfolio Management team at Universal-Investment has kept multi-segment institutional portfolios on track using overlay concepts for more than 16 years. The total volume of assets under management with overlay mandates is in excess of 30 billion euros. As a result of our extensive expertise in interface management, third-party data can be accessed timely for overlay management purposes. So the Universal-Investment overlay management system is not limited to our own platform: it can also be used by investors to manage assets held on other platforms.

October 2019 

Author: Peter Flöck
Date of issue: 2/27/2020