Berenberg sees overlay as a new approach to an old problem
Berenberg, Germany’s oldest bank aims to attract institutional investors in the UK market with dynamic hedging and protect overlay strategies. Its UK presence is growing, as is highlighted by the ongoing construction and expansion of at the London- office.
The team has expanded to more than 200 employees in the UK and has also recently opened a San Francisco-office. Roughly one-third of Berenberg’s clients are based in the UK, consisting mainly of local authority as well as private sector pension funds.
According to Matthew Stemp, director UK institutional at Berenberg, institutional investors in the UK are showing growing interest in Berenberg’s overlay strategies amid the challenge of securing yield in a volatile environment.
“We are finding increasing interest in risk reduction strategies and a move away from passive towards more dynamic hedging strategies.”
“UK market has always held a belief that risk bearing assets in the long term will provide a natural hedge against inflation and wage growth, therefore the volatility that you experienced through equity or currency exposure was something you could bear,” argues Stemp.
“A second aspect is that pension funds are increasingly going into deficits and the cost of passive hedging strategies has become much more detrimental to the funds. Whilst they still require downside protection, they can no longer afford the cash-flow cost of having a passive strategy,” he adds.
“For us, hedging means to transform market risk into liquidity risk by mirroring market movements in hedging instruments. Of course we are aiming this with protecting as much liquidity as possible, by carefully scaling the levels of exposure while conserving liquidity levels – we are hedging when markets are falling, ” explains Maria Heiden (pictured), product specialist Overlay strategies at Berenberg.
“The strategies we employ are very common in Germany but not very common in the UK, it’s a new approach to an old problem, but a problem which is growing in urgency, not just in the UK. What we are finding is that the German experience in managing risk, both in form of currency and equity market exposure is very relevant in Anglo Saxon countries,” adds Stemp.
Hedging requires the ability to respond timely to market changes. “The challenge, which we have mastered in the past, is to deduct a model based on market up-and downward movements in order to predict future market developments. We believe major market developments never happen overnight. Behavioural finance is key to understanding herding behaviour which triggers market changes, it takes a while for the herding behaviour to manifest itself,” says Heiden.
But what exactly is the benefit of a hedging strategy as opposed to, for example multi-asset investing? “During the last years we have seen a paradigm shift in the way in which we understand causality. This was the case in June 2013, when you suddenly saw equities and stocks falling at the same time. Even a broad multi-asset portfolio does not offer sufficient diversification for such a scenario,” argues Heiden. “Another factor is the prospect of an interest rate hike, in which case volatility in both bonds and stocks can be expected. Again, a multi-asset portfolio would provide insufficient diversification,” she adds.
Looking ahead, Stemp expresses optimism that overlay strategies will grow in importance.
“The history of European pension funds is changing. When I started most pension funds were over-funded and could accept relatively high exposure, this has changed to a position where pension funds are increasingly in deficit and need to do anything they can to protect themselves from downside volatility.”