In today’s low yield environment equity markets offer comparatively attractive yields and opportunities for profit. But for some investors the equity market drawdowns can be hard to swallow especially when markets get a little rough. Here derivatives based overlay strategies can help.
Risk overlays come in two main flavours: option-based, dynamic hedging with delta-one instruments, or a combination of the two. Long option positions generally suffer high cost of carry. They are often combined with short option positions in order to reduce the cost of carry but short option positions tend to increase risks. Dynamic hedging risk-based equity overlay strategies which aim to control some measure of portfolio risk, i.e. target volatility, make sense since the risk capacity of investors generally do not increase when market volatility increases but they tend to be pro-cyclical. The markets fall, risk measures go up, overlay program starts to hedge, markets recover, risk measures fall, overlay program reduces hedge often resulting in “sell low, buy back higher”. Therefore, dynamic hedging risk-based equity overlay strategies which purely aim to control some measure of portfolio risk tend to perform in long lasting bear markets but generally suffer in a market with lots of short V-shape recoveries.
We continuously harvest additional information from the derivatives markets to implement an anti-cyclical risk overlay. In this way, we can be proactive rather than reactive (to ex-post portfolio risk). The goal is to take equity risk when it is rewarded and hedge when risk/reward is unfavorable.
Overlay programs are customized to specific client needs and portfolios. Contact us to see how we can help you!