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The official blog of BNP Paribas Asset Management

How to protect an equity portfolio with an overlay strategy in a market downturn

Dynamic risk management strategies (risk overlays) can be useful for investors. They are a means of reconciling their two main objectives: capturing the risk premia of risky assets to meet their long-term strategic goals, while still meeting short-term objectives such as limits on drawdowns or requirements for regulatory capital.[1] 

Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Over the last two decades, extreme market downturns have become more frequent. The latest selloff has occurred over the COVID-19 crisis. It has become more and more difficult to anticipate market dislocations (especially if the underlying economic environment appears benign), and to correctly time decisions to remove or add risk to portfolios.

Large drawdowns in such sell-offs often force investors to liquidate positions, causing losses. The result is also that they miss out on the following rebound. To remedy this, investors should have a protection strategy in place.

Our risk overlay approach with puts and calls

We believe investors should define a framework and a risk overlay strategy ahead of time, that is, not in the heat of the moment. This strategy should protect the portfolio systematically when and where required. Such an approach removes the timing risks around a decision to put protection in place.

This approach often has a short-term cost (for example, during strong bull markets). However, over the medium to long term, we believe the cost is small relative to the drop in the drawdown and market volatility that a protection strategy brings.

Here is an illustration of an approach to protect an EMU multi-factor equity portfolio.

In the fund, the strategy consists of

  • buying, every month, 1/12 of the protection via a one-year EuroSTOXX 50 put option with a 85% strike price and then rolling it at expiry

The cost of the put is covered by

  • selling a one-year put option at a 60% strike price and
  • selling a one-month call option where the strike price is such that the cost structure is zero.

Effective in the recent downturn

This strategy worked well between the end of February and the end of March 2020, protecting the value of the assets against the sharp 25% decline of the (MSCI EMU index over that period.[2] Investors should note that all the protective puts were in the money following the significant fall in the market.

During the market’s rebound in April, the strike price of 20% of the protective puts was reset to buy the call again. The idea was to participate in a potential market rebound while preserving the downside protection, locking in any excess performance.

To fully grasp the benefit of the strategy, let’s look at the longer-term performance.

Since 2012, when the systematic option overlay was implemented), the strategy has delivered what we were expecting: a limited cost/underperformance compared to the equity market; a lower volatility relative to the benchmark; and with a lower average SCR.1, 2  

Capping the downside, leaving room for the upside

An overlay strategy can be shown to protect the investment, while still offering a performance closely aligned to that of the underlying market (i.e., the opportunity cost is limited). The strategy allows investors to contain losses, while they can still participate to some extent in a market recovery. It can offer protection at all times, but also has a structural cost.

An alternative strategy is a floor protection overlay (via futures or ‘physical de-risking’). This strategy is not active all the time (so it is less costly), but being pro-cyclical may cause it to lag some extreme market moves. A future blog post will provide you with full details of this strategy.

To optimise a protection strategy, we believe that combining the overlay strategy with a floor protection overlay is probably more effective and efficient. You will find a comprehensive analysis of this combined approach in this white paper.


[1] For insurers, for example, there is a Solvency Capital Requirement. The SCR is set at a level that ensures that insurers and reinsurers can meet their obligations to policyholders and beneficiaries over the following 12 months with a 99.5% probability. Under the European Solvency II Regulation, the base capital charge on equity investments is 39% with a dampener effect between -10% and +10% depending on the level of the market. Also see Determining a strategic asset allocation in a Solvency II framework (white paper).

[2] The fund is BNP Paribas Funds Euro Defensive. The example is purely for illustrative purposes. For information on our strategies or investment policies, please contact your dedicated client relationship manager.

[3] There is no guarantee that the performance objective will be achieved.

[4] The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialized or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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