Investors must be prepared to scrutinise complex equity overlay strategies as downside protection comes to the fore, according to consultancy Bfinance.
A number of pension funds have turned to such strategies over the last year to protect portfolios against falling market prices.
Toby Goodworth, managing director for 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 12 months as artificially stimulated asset prices have given way to increased market volatility, geopolitical tensions and trade war concerns.”
The prospect of severe downturns had bolstered the case for more explicit safeguards on investment portfolios, he said, in contrast to the past decade when investors had instead built up implicit downside protection through diversifying strategies.
However, changing approach in this way involved several critical choices, Goodworth said – some of which were relatively complex from a technical point of view.
Usually, equity protection strategies involve a derivative overlay designed to limit how much an equity portfolio falls in value.
“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,” Goodworth warned.
“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.”
The South Yorkshire Pensions Authority (SYPA) was among the large pension schemes to have put a strategy in place over the past year to mitigate possible falls in equity markets. In June 2018, it tasked Schroders with a £2.6bn (€3bn) equity risk management strategy.
In December, the £1.4bn London Borough of Tower Hamlets Pension Fund also hired Schroders to run a “risk management solution” protecting around half of its portfolio.
Also in December, multi-sector Dutch pension fund PGB hired BMO Global Asset Management to implement a protection strategy for its €12bn equity portfolio.