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The zero-capital approach to portfolio enhancement and overlay management

Abstract Both active and passive portfolio enhancement can be analysed within a zero-capital framework, wherein enhancement exposures are reported as an additional or secondary portfolio requiring zero capital. This enables an identification of the economic value added by the enhancement, using two complementary approaches. The first is based on traditional beta analysis, which is useful in identifying the direction and magnitude of exposures. The second is non-parametric in nature and plots ordered mean difference schedules for the enhancement against the base portfolio. This enables risk profiling where the manager can match the likely range of his or her own risk preferences against the empirical history of the relationship, so that explicit risk premiums do not have to be utilized. The empirical illustration exhibits asymmetries in the effectiveness of currency overlay.