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


BNP Paribas Asset Management

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

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

Over the last two decades, we have seen a number of extreme market downturns. The latest selloff has occurred over the COVID-19 crisis. It is extremely 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 selloffs often force investors to liquidate positions, causing losses. The result is that they also miss out on the following rebound. To remedy this, investors should have a protection strategy in place.

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

Although this approach may involve upfront and opportunity costs, over the medium to long term we believe these costs are small relative to the reduction in drawdown and market volatility that a protection strategy brings.

It is possible to construct different protection strategies. We illustrate this using one of our funds.[2] It implements a strategy structured around an EMU multi-factor equity portfolio with an option overlay to reduce the maximum drawdown and the SCR (for insurers).1


Our risk overlay approach using options

The protection[3] consists of:

  • Acquiring, every month, 1/12th of the full size of the portfolio via a one-year EuroSTOXX 50 index put option with an 85% strike price and then rolling it at expiry. This creates a series of 12 overlapping put options, which are closely following the European equity market.

The cost of the put is offset by:

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


Proven 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.[4] 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 opportunity cost (i.e. underperformance) compared to the equity market, a lower volatility relative to the benchmark and a lower average SCR for insurers.1, 2


Limiting the downside, leaving room for the upside

Such an overlay strategy can be shown to protect the investment, while still offering performance that is closely aligned to that of the underlying market over the long term (as mentioned above, the opportunity cost is limited). The strategy allows investors to contain losses, while they can still participate to some extent in a market recovery.

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 initial extreme market moves. A future blog post will provide you with full details of this strategy.

To maximise the benefits, we believe that combining an option overlay strategy with a futures-based floor protection overlay is the most effective and cost-efficient solution.

You will find a comprehensive analysis of this combined approach in our new 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.

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