Risk and DAA From an ALM viewpoint, hedging is done to protect long-term liability needs. It can also reduce downside risk. The equity risk in an equity portfolio, for example, can be reduced trivially by increasing the weight of the cash component, leading to a limited downside risk but also to limited upside potential. The right approach is to limit downside risk while maintaining access to the upside potential. Dynamic portfolio theory allows us to do just that. The theory has been extended with absolute or relative constraints on asset value that can accommodate, for example, maximum drawdown and rolling performance floors. Simple insurance strategies such as constant proportion portfolio insurance (CPPI) or options-based portfolio insurance (OBPI) arise as dynamic optimal strategies for investors, subject to particular explicit or implicit floor constraints respectively. Dynamic fund separation in an ALM context suggests the allocation to the PSP and LHP building blocks is generally not constant and depends on the market state.

Thus, in a market downturn, the closer the portfolio value gets to the floor constraint, the higher the allocation to LHP becomes, limiting the potential for further losses. Conceptually, the functional separation of the building blocks provides a key insight: diversification, hedging and insurance are complementary techniques. The first two are responsible for the optimal construction of the performance and hedging building blocks, and the method of insurance guarantees that the floor constraint is satisfied through the dynamic and state-dependent allocation to these building blocks. Unlike diversification, however, insurance always comes at a cost. The cost can materialise in different ways depending on implementation: as an implicit opportunity cost, if the implementation is through dynamic trading (for example, CPPI), or explicitly as the price of a derivative overlay (for example, OBPI). The common approach to construct the PSP portfolio is to adopt a stock market index: a capitalisation-weighted portfolio that is poorly diversified and therefore highly inefficient.

This leaves substantial room for improving the performance of this building block through better portfolio construction. Research by EDHEC Risk Institute shows that optimal diversification based on a robust methodology can result in consistent and sizeable Sharpe ratio improvements over capitalisation weighting – for example, their efficient version of the S&P 500 index has a Sharpe ratio more than 50 per cent higher than the original index. In fact, improving the construction of the performance-seeking portfolio through optimal diversification can compensate for the cost of insurance by better extraction of risk premia.