The management of institutional portfolios is becoming more and more complex: on the one hand investors increasingly seek broader diversification for their investments, while on the other they are confronted with a growing range of highly specialised asset management services. Since the financial crisis, markets have been much more volatile, which has made allocation decisions more uncertain. Investors need to work on every front in order to both achieve their long-term return goals and limit the risk of short-term losses. This is exactly where overlay management can help. Just a few years ago this instrument was barely used, but it is now firmly established.

Overlay management itself is in fact interpreted in different ways throughout the market. Generally speaking, it describes a centralised approach that enables an investor’s individual risk factors and return goals to be managed systematically across the entire portfolio. A variety of overlay strategies can be employed, depending on which investment goals are the most important: risk overlays, the most widespread type, offer protection in crisis scenarios. Interest rate risks can be neutralised with overlays as part of active duration management (a duration overlay), as can inflation risks (inflation overlay) or the specific credit spread risks of a pension fund.

In addition to this hedging function, overlay management can also be used to address opportunities and to open up additional sources of income as a tactical overlay. All these variants are not mutually exclusive, but can be used flexibly on a modular basis.

Disciplined risk reduction
The overlay concept has proven to be particularly suitable for hedging market risks. Dynamic risk overlay, the version of the risk overlay concept developed by DB Advisors, provides centralised risk management for a broadly diversified portfolio, which exploits all correlation effects and therefore the risk budget as efficiently as possible. The aim is to secure a certain level of value for the portfolio: for instance a threshold of 95 percent means a risk budget of five percent. The task of the overlay manager is to ensure the total investment risk always remains below this individually determined limit. Only when the equilibrium is lost does the manager dynamically hedge the entire portfolio – mostly using simple, exchange-traded derivatives. This requires both individual risks and the risk budget to be measured on continually and managed within a purely rule-based process.

This disciplined method of direct risk reduction passed the acid test during the financial crisis, saving many investors from extreme setbacks. In “normal” markets, however, investors still participate in market upswings where continuous, market-based risk measurement allows exposure to be built up again gradually. The positive market performance in 2009 was at least partly and 2010 performance almost fully reflected in portfolios that had been completely hedged just a short time before. The important thing to note is that the fine-tuning of portfolio risks that takes place in the course of overlay management does not encroach on investors’ long-term strategic orientation or their decisions on allocation of individual asset classes.

So does risk overlay management really mean the disciplined execution of highly refined algorithms? Certainly not! Based on their knowledge of the state of the entire portfolio, the overlay manager fulfils the role of a fiduciary, who should always be consulted in matters of portfolio construction. Risk budgeting plays a key role in this regard and should be adapted to the choice of asset classes so that the overlay does not dominate the strategic allocation. For a portfolio consisting of 30 percent equities and 70 fixed-income for example, it would not make sense to allow a risk budget of just one or two per cent. Furthermore, the overlay manager can also use his or her knowledge of the entire portfolio to advise on the form the investments should take. Even though certain asset classes may appear extremely attractive at times, it is only by considering the entire portfolio that a judgement can be made on whether their purported benefits are consistent with the individual appetite for risk. Sometimes it may even make sense to reduce or increase the risk budget anti-cyclically. In this case a larger risk budget is not necessarily achieved through contributing additional funding, but can also be provided indirectly by temporarily increasing the loss tolerance. Investors who were willing to raise their risk budget in summer 2009 – when the first signs of a market recovery became apparent – were in some cases able to avoid high opportunity costs.

Looking ahead, the advisory process will continue to constitute a core element of risk overlay management. The duration of economic cycles in the 21st century will be much more condensed, and their swings will be more volatile. Risk management must continue to find an appropriate balance between protecting the investment and seizing opportunities.

Avoid losses, seize opportunities
Overlay management need not serve solely to avoid losses. A “tactical asset allocation overlay” can tap additional yield and supplement a pure risk overlay. With this approach, the asset manager uses the free risk budget and deliberately departs from the strategic allocation in order to turn short-term market opportunities into additional returns. Fundamental research can identify sources of alpha in sideways or booming markets with the lowest degree of correlation with the overall portfolio. Being able to respond rapidly and efficiently to these signals is then key to realising additional returns. Effects on the individual portfolio risk are measured directly, enabling the free risk budget to be optimally deployed.

This strategy is particularly attractive in periods of economic growth of course. In critical market phases, however, pure risk management always trumps tactical positioning in order to defend the defined risk limits consistently – as long as both value hedging and income generation are in the same hands.

Acknowledging climate change
 If overlay management represents a basic toolbox, including instruments for “beta protection” and “alpha potential”, then one might ask what other possibilities it has to offer. And though the Greek alphabet has plenty more letters, the danger of over-engineering is imminent. Rather than go for additional “engineering options”, the key is to examine other, new sources of risk and return in order to determine the extent to which they can be managed.

Environmental risks, for instance, are increasingly moving into investors’ field of focus, and modern strategic risk management needs to acknowledge the consequences of climate change. Indeed, there is a direct connection between these risks and asset management and therefore with portfolio construction.

For example, one of the EU’s most important instruments for meeting the targets of the Kyoto Protocol and cutting carbon emissions is to establish a market for trading emissions certificates. If a company emits more CO2 than it is entitled to, it must buy certificates. If the carbon market (which has now attained a significant trading volume) prices rise, the result is a direct cost for the company concerned as well as for the value of these assets within a portfolio. In addition, there are also indirect costs to be considered, such as the expense of building more efficient production facilities, higher environmental taxes, etc. Therefore, carbon markets and CO2 as a new asset class affect investment decisions, company valuations and a new way of looking at an overall portfolio. What is known as a “carbon overlay” can offset both the economic and the ecological effect by acting as a vehicle for purchasing the necessary CO2 certificates and, ceteris paribus, incentivising companies to reduce their CO2 emissions. Investors can protect themselves against the adverse consequences of climate change and contribute to protecting the environment with their investments at the same time, whether purely financial or “green” investment goals take precedence.

Alexander Preininger is Head of Overlay Management at DB Advisors

DB Advisors is the fiduciary institutional investment management business of Deutsche Bank´s Asset Management division. We offer a broad range of investment strategies – spanning the whole risk/return spectrum – to our institutional clients around the globe, including corporate, pension funds, foundations, insurance companies, central banks and supranationals. Our global network of integrated resources in combination with our product lineup provides a powerful platform, delivering superior pension solutions and consistent competitive results under all market conditions.

At DB Advisors, our institutional clients benefit not only from our own global preference, but from that of our parent firm, the Deutsche Bank group.