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Marvin Labod

“Every portfolio deserves a risk overlay.”

Marvin Labod, Head of Quantitative Analysis, Lupus alpha, illustrated the subject of risk with an iconic image of legendary 1970s stuntman Evel Knievel jumping over 13 trucks on a motorbike. The message of this image? Anyone who takes risks needs to master them. In asset management, the traditional way to do this is by diversifying – across different asset classes, countries, regions and asset managers. Labod said that sometimes this works well, sometimes not so well – and in many cases not at all. Take 2022, for example, when some bonds slumped even further than equities in the wake of the historic turnaround in interest rates.

According to Labod, a risk overlay pushes the boundaries of diversification even further, complementing risk spreading instead of replacing it. It is important to note that risk overlay works perfectly without disrupting the strategic allocation of a portfolio in any way. While the investor’s assets to be hedged – consisting of various individual portfolios with different strategies – provide a foundation for this in their entirety, derivative instruments are used to build a hedge portfolio on this basis. Wondering what might prevent investors from hedging their portfolio with a risk overlay.

Labod asked “What are your reservations when it comes to overlay?” on TED. The answers were as follows: The majority of respondents – 47% – cited cost as the main factor, while a potential cash lock put a further 23% off the idea of overlay. A lack of transparency deterred 21% of those surveyed. The additional operational requirements associated with an overlay played hardly any role, featuring in only 9% of responses despite the fact that organisational and technical prerequisites usually exist.

With this in mind, Labod took the opportunity to present the array of overlay tools in Lupus alpha’s toolkit – a must-have for any institutional assets: The drawdown brake cushions heavier losses; the tail risk parachute counteracts the risk of extreme ‘black swan’ events; the hard floor specifies the loss in quantifiable terms; and the returns booster can significantly lower the cost of these hedging instruments. All of this results in better performance, as the assets are not forced to claw their way back from the lowest possible prices when the market moves upwards again after a price slump and can instead get back on track for returns from a much higher level while at the same time bolstering the long-term performance of the investment.

Does it work? What difference would it have made if the drawdown brake, tail risk parachute and returns booster had been applied to a global portfolio consisting of 60% bonds and 40% equities between December 2007 and December 2022 – a period encompassing the global financial crisis, the coronavirus pandemic and the turnaround in interest rates in 2022? The return without a risk overlay was 100.6% – not bad. The return with a risk overlay? 146.4% – considerably better, and with significantly reduced drawdowns!