While the dangers of a market meltdown and continued market volatility can make many institutional investors nervous, there is now a solution that uses a fixed income overlay strategy to convert equity declines and volatility into a defensive strategy using a fixed income overlay strategy.
The fixed income overlay strategy is offered by Ryan Labs Asset Management Inc. (Ryan Labs), a Sun Life Investment Management company, in the form of its Defensive Risk Premia (DRP) strategy for corporate and public pension plans, and other institutional investors.
According to Peng Zhou, senior managing director of Sun Life Investment Management and portfolio manager for Ryan Labs DRP strategy, this approach “enhances the defensive role the fixed income allocation within the total asset allocation of an institutional investor’s portfolio and is used to further offset losses from equity market downturns.”
DRP uses a proprietary quantitative model that monitors financial and economic risk on a daily basis. The DRP strategy is launched when there is a danger of a market meltdown or extreme equity volatility. When this occurs, Peng, who been with Sun Life since 2003, said the market seeks “a flight to quality into safe haven assets.”
In this situation, participants will pay a premium for this transition. This is when DRP buys U.S. Treasury futures contracts to dynamically offset the negative equity performance caused by market volatility.
The risk premium strategy works because when markets are under stress, investors sell risky assets and buy safer and more liquid fixed income safe haven assets in crisis times.
Peng said its institutional clients use the DRP strategy to offset the macro-risk of a market meltdown instead of the traditional route of buying equity puts, which he said are often very expensive and expire worthless if the volatility dissipates. However, by exploiting the flight to quality risk premium, the DRP strategy buys Treasury futures when the market is under stress and then captures the flight to quality premium to offset the equity loss.
The strategy can be implemented quickly, and once implemented is only in position about 12% off the time and often lasts just a few days as the crisis dissipates and the market returns to normal volatility ranges, Peng said.
Ryan Labs, in conjunction with Sun Life Investment Management, developed the strategy two years ago and after an internal review, put it to work in July 2016 internally. It now has $300 million in notional funds invested from a strategic U.S. institutional partner and the strategy has also attracted the attention of some Canadian funds, he added.
DRP fees could be based on an overlay strategy or as part of a larger portfolio solution. Peng said he often encourages smaller clients to consider a packaged solution. Clients that would find the overlay strategy useful are those with assets of “a couple hundred million” up to $20 billion. Institutions with assets in excess of over $100 billion often have the capacity to manage the derivatives overlay strategy in-house, he added.