Overlay in a Black Swan Event

We often get asked how our overlay strategy might behave in a black swan event.  Well, no time like the present to review our standard answer to this question and see how it’s holding up in reality.

Standard Answer:

Every market event is different, so the true, but unsatisfying answer is “it depends”.  First, we need to separate the beta and the alpha source within our funds.  The beta (essentially the index) should deliver the good, bad and ugly during any market event.  Our strategy, on a stand-alone basis is not designed to hedge the market beta exposure.  The nuance  comes in how our alpha source (the overlay) handles the event.  Most important to know (especially when thinking about a black swan event) is that our overlay is constantly hedged to ensure that any exposure outside of the beta is fully hedged to a 3% loss.  We have a host of other risk management tools that we use to hopefully prevent an incremental loss of that magnitude, but if those fail, we know we have a defined risk with that part of the portfolio.  Using our large cap strategy as an example, the beta is the S&P 500.  If an event occurs and the S&P is down 20% next Tuesday and all of our risk mitigation fails, we know we still have a max down of 23%.  In reality, it’s less than 3% because we have collected option premiums that help offset a loss.  During severe losses, our hedged positions spring to life rather quickly, so depending on how long until expiration, they could provide a greater offset the losses.

Significant drawdowns historically have been short in nature and happen relatively infrequently.  Over the last 20 years, we have been in the midst of a 10% or more drawdown only 16.25% of the time (39 out of 240 months) with the average drawdown lasting 4.3 months.  So, it is important to not look myopically on those few months, but consider the lead-up and aftermath as well.  By consistently collecting premiums during the period before a significant drawdown, we are effectively building a war chest of excess return which serves as an initial buffer to weather the early phases of a drawdown (which we would expect to briefly underperform).  Because we take a dynamic and nimble approach to employing our overlay, we are able to quickly adjust the risk profile of the portfolio to stay out of harm’s way during a significant market event and are positioned to take advantage of collecting higher premiums in the aftermath of an event.  This can provide the opportunity to recover more quickly from a drawdown.  While we would expect to initially underperform in the early stages, we believe that between the war chest we have built prior to the event and the opportunity for higher profits after the event make that episodic risk well worth the bump in the road.

How is the answer holding up in this environment?

While it is always challenging to stomach a black swan event and the troubles it brings to the markets, it has been comforting to have our investment strategy pan out nearly exactly as expected (so far). COVID-19  hit the world and the financial markets seemingly out of the blue in late February.  As we would have expected, our overlay strategy underperformed in the initial few days of this volatility event, but as risk management protocols kicked in, damage was mitigated and we were able to step aside from the overlay during the most volatile phases of the drawdown.  So, in terms of our answer above, our success in collecting premiums prior to the black swan event has proven correct and our risk management during the event has held up as expected.  The final leg that is yet to come is what the recovery will look like.  We would expect volatility to remain above average, which should offer attractive excess returns from the increased premiums collected on the overlay component of our approach.

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The assertions and statements in this blog post are based on the opinions of the author and Liquid Strategies. The examples cited in this paper are based on hypothetical situations and should only be considered as examples of potential trading strategies. They do not take into consideration the impact that certain economic or market factors have on the decision making process. Past performance is no indication of future results. Inherent in any investment is the potential for loss.