2019 Hedge Fund

12 Acquisition International - Hedge Fund Awards 2019 Investor Appetite For Equity Overlay Strategies Increased Through 2018 Bfinance’swhitepaper: ‘DNAof aManager Search: EquityOverlay’ identifies that investors are increasingly turning to derivatives- based overlay strategies to hedge again equity losses, seeking more explicit forms of protection as the era of artificially-stimulated asset prices gives way to a period of rising market volatility, tighter monetary conditions, geopolitical tensions and trade war concerns. Many sophisticated investors have spent the past decade building up their “implicit” downside protection in the form of diversifying strategies and alternative investments such as unlisted infrastructure, private debt, alternative risk premia and multi-asset strategies had benefitted considerably. Those asset owners who took more aggressive measures to insulate against such losses, including running up large cash holdings, or at the most explicit end of the spectrum, applying hedges to protect against equity downturns, were largely unrewarded for such strategies in 2015- 17; even the cautious investor can sometimes find that stakeholders can run out of patience before protective measures pay off. The past year brought a turning point in this dynamic and many investors are now seeking more explicit forms of protection. On a case by case basis their motives for applying equity overlays have proved to be somewhat wide-ranging. Some maintain a low tolerance for losses at the stakeholder level regardless of the investment horizon or funding ration; some face high immediate liabilities relative to fund inflows, such that losses cannot be easily handled; others respond purely based on technical considerations, such as the need to protect committed capital for future investments. bfinance identified that the overlay strategies broadly fall into three categories: Static, Evolving Static and Dynamic. The static approach is effectively one of ‘set-and-forget’, which is transparent, simple and implemented fairly quickly. With the protection level decided at the outset, cost is driven by the implied volatility in the market at that time and the intention is to hold the option structure until maturity. This strategy is sensitive to timing – there is less flexibility if the market moves in the opposite direction. Evolving Static, which adjusts the hedge and establishes a new option position should market dynamics change over time, is less sensitive to its inception date than Static but more vulnerable to path-dependency. A Dynamic approach involves active trading and comprises a series of overlapping option positions to create a more complex solution. This strategy is less sensitive still to the inception date, with the protection levels evolving with the market, while transparency is lower in terms of Until recently investors have focused primarily on implicit protection in the form of portfolio diversification rather than explicit downside protection, with alternative investments representing the most obvious beneficiary. Last year saw a change in this dynamic with greater demand for derivative overlays as new white paper shows. F where the protection level actually lies. Given its complexity, Dynamic commands the greatest annual cost of between 8-30bps, compared with 3-6bps for a Static strategy. Whatever drives it, the decision to apply a more explicit risk control approach involves a number of critical choices, many of which are relatively complex, not just from a technical standpoint but also from the perspective of governance and stakeholder buy-in. These can include the decision to use single-period versus multi-period overlays, the degree of customisation, where to place caps in terms of both upside participation and downside losses, how to handle margining requirements and much more. Most managers offering equity overlay protection have capabilities across the whole spectrum, but their preference and aptitude for doing so varies. Given no two investors have exactly the same protection exposures, or the same equity protection levels, there are many potential points of differentiation between managers and it is critical therefore that investors are equipped to scrutinise this emerging but complex strategy. Toby Goodworth, Managing Director, Risk and Diversifying Strategies at bfinance said: “We have seen a clear trend among investors seeking more explicit forms of protection against equity losses over the past twelve months as artificially-stimulated asset prices have given way to increased market volatility, geopolitical tensions and trade war concerns. The prospect of severe downturns has strengthened the case for more explicit safeguards on investment portfolios, where equity overlay strategies are being sought, in contrast to the past decade where investors had been building up implicit downside protection through diversifying strategies. “Such a change in approach involves making number of critical choices, some of which are relatively complex from a technical point of view. They also need to be considered from the perspective of governance and stakeholder buy-in as even the most cautious investor can find that their stakeholders run out of patience before protective measures pay off. When it comes to applying overlays, simplicity is not always straightforward so investors should ensure they are well-equipped to consider the level of customisation required with the desired level of tactical adjustment and the types of instruments to be employed with an awareness of the trade-offs that are involved.” bfinance undertook a manager search on behalf of a pension fund, which sought to implement an equity overlay strategy in order to mitigate equity risk over a medium-term period. For more detail on the manager search and outcomes, please see https://www.bfinance.com/insights/ dna-of-a-manager-search-equity-overlay/

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