Preparing for downside with upside potential

Many institutional investors, especially those with net cash outflows or weaker solvency, still face the daunting task of meeting strategic target returns within the constraints of their risk budgets. The challenge is compounded by today’s complex and ever-changing market conditions, ranging from the prolonged pandemic and growing geopolitical tensions, to the effects of climate change and inflationary expectations.

Over the last 20 years financial markets have experienced severe drawdowns, for example, during the Dotcom Bubble (2000-2001), the Global Financial Crisis (2007-2009) and the Covid-19 outbreak (2019-2020). The first two notable financial storms took a much longer time to recover from trough to peak.

Despite institutional portfolios being, on average, relatively well diversified, it is still essential for these investors to find ways to mitigate the potential for catastrophic losses. This is especially useful if they need to meet short-term liquidity needs or maintain a minimum solvency position at all times.

How can institutional investors tackle this problem?

One approach is to change a portfolio’s underlying allocation by increasing its exposure to safer asset classes, such as fixed income. Yet while that may reduce volatility, it would also be expected to drag down returns. Another route is to use options, buying puts for explicit tail-risk protection. Adding put options to the portfolio delivers risk mitigation against large equity drawdowns, however it carries a high cost that can easily erode the portfolio’s returns in the long run.

In response, risklab, a global team of risk advisory experts within Allianz Global Investors, believes there is a third way to mitigate drawdowns when a financial storm hits.

This is achieved by a “tailored” dynamic asset allocation approach that we call a Risk Management Overlay, or an RMO.

RMO solutions in practice

In essence, RMO is a non-disruptive and systematic approach, managed as an overlay and measured against a portfolio’s own Strategic Asset Allocation (SAA). In other words, it uses the investor’s existing SAA as its benchmark.

This is meaningful because it leverages the extensive work and effort that institutional investors and their consultants have typically already put into developing an optimal SAA to satisfy the required return target.

Measuring the overlay against the SAA, in turn, allows the RMO manager to observe and position the portfolio from both an absolute and relative risk standpoint. For example:

• As markets rise and the portfolio outperforms the SAA benchmark, the manager allows an overweight to return-seeking assets to build a “profit cushion” versus the benchmark.
• As the cycle matures, the manager can then “lock-in” the over-performance relative to the benchmark and reduce active risk by returning closer to the SAA.
• As markets correct, the manager reduces allocations to risker assets to minimise any potential loss.
• As the correction runs its course and, if there is room for risk-taking in the risk budget, the manager can increase exposure to return-seeking assets to capture potential upside.

An RMO may be a customisable solution to actively manage the portfolio’s risk exposures and react in a timely manner against (extreme) market movements. By design, when compared to the SAA, an RMO can help to reduce downside risk while still allowing the portfolio to fully participate in rising markets as shown in the diagram.

With proper execution, it can enhance the portfolio’s potential to deliver its return targets over the long run.

Asymmetric payoff profile of RMO
RMO can help mitigate devasting drawdowns by lowering the chance of left-tail risk.

In summary, institutional investors may consider adopting ongoing tail-risk mitigation through an RMO as an integral part of their strategic goals.

As the risk management solution is implemented through a dedicated overlay portfolio using derivatives, it does not interfere with the ongoing management of established investment mandates. Thanks to its asymmetric nature, an RMO can mitigate drawdowns amid stormy markets while preserving a carefully designed SAA to deliver its return targets over the long run.

Disclaimer
The views and opinions expressed in this document, which are subject to change without notice, are those of Allianz Global Investors Asia Pacific Limited and/or its affiliated companies at the time of publication. While we believe that the information is correct at the date of this material, no warranty of representation is given to this effect and no responsibility can be accepted by us to any intermediaries or end users for any action taken on the basis of this information. Some of the information contained herein including any expression of opinion or forecast has been obtained from or is based on sources believed by us to be reliable as at the date it is made, but is not guaranteed and we do not warrant nor do we accept liability as to adequacy, accuracy, reliability or completeness of such information.

Investment involves risks, in particular, risks associated with investment in emerging and less developed markets. Any past performance, prediction, projection or forecast is not indicative of future performance. The information is given on the understanding that any person who acts upon it or otherwise changes his or her position in reliance thereon does so entirely at his or her own risk without liability on our part.

This material has not been reviewed by the Hong Kong Securities and Futures Commission. Issuer of this material: Allianz Global Investors Asia Pacific Limited.

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