Convex financial instruments

Institutional investors today face a structural dilemma: rising interest rate volatility, increasing geopolitical risks, and a high level of correlation between risk and safe-haven assets have substantially eaten into the diversification efficiency of traditional 60/40 portfolios. In this environment, convex financial instruments such as options and variance swaps are gaining in importance. They facilitate a systematic reduction in tail risk, the smoothing of return profiles and, ideally, an improvement in risk-adjusted returns over the entire investment cycle. Please note: investing in securities involves both opportunities and risks.

The non-linearity of the payoff profiles of convex instruments implies limited losses on small movements but potentially unlimited gains on large market movements.

Convexity as risk architecture

In portfolio theory, convexity refers to the non-linearity of an instrument's payoff structure. It allows for a disproportionate response to large market movements – a key advantage in periods of heightened uncertainty. Unlike linear investments (e.g. equities, bonds, swaps), convex positions generate an asymmetric exposure structure, which is particularly valuable in times of stress.

For institutional portfolios, convexity can be used strategically in the following ways:

• Reduction of expected shortfall and volatility.
• Increase in geometric return (CAGR) through lower drawdowns.
• Securing reinvestment capacity after periods of market stress.

Options as asymmetric diversifier

Options are the simplest form of convex instruments. Their effect depends less on market timing than on consistent allocation and structuring. Implied volatility, which usually follows a mean reversion process, plays a particularly important role here. Therefore, buying optionality in times of low volatility should be promising in the long term.

Although the premium tends to reduce returns in periods of sideways markets, it delivers disproportionately high returns in turbulent market phases, which is exactly what is needed in a portfolio context. Options are therefore ideal as a strategic overlay component to benefit from the typically negative correlation between volatility and risk assets.

Long volatility as insurance component

A long-variance overlay acts like dynamic insurance: in periods of stress, realised variance increases disproportionately, generating positive payoffs. These cash flows can be used to rebuild risky positions in a countercyclical manner. In addition, the liquidity position improves in phases when traditional diversifiers (e.g. government bonds) fail.

Strategic integration into the institutional portfolio

Institutional investors typically implement convex strategies not as a core component of their asset allocation, but as an overlay — that is, as an additional, rule-based risk management component that operates in parallel to the core portfolio. This structure keeps the core portfolio stable while allowing targeted hedging and return optimisation mechanisms to be implemented.

Allocation and magnitude

• The overlay portion might account for approximately 5% to 10% of the total portfolio. This leaves sufficient capital in the core portfolio to maintain the strategic asset allocation (e.g. SAA targets) and benchmark roles.
• In times of crisis or when volatility levels rise sharply, this ratio may be temporarily increased, e.g. by activating a risk budget or through tactical reinsurance (tail hedge).

Convexity as strategic axis of modern asset allocation

In a macroeconomic environment in which traditional diversification effects are diminishing, convexity is gaining strategic relevance. The combined use of options and variance swaps offers institutional investors the opportunity to

• control structural risks,
• limit drawdowns,
• and still achieve stable risk-adjusted returns.

In the long term, this will give rise to a new form of portfolio construction: less linear, more resilient to regime changes, and better suited to a world in which risk absorption has become more important than pure return maximisation.

I-AM Global Macro Convexity Fund: a case study of strategic convexity

With the I-AM Global Macro Convexity fund, Erste Asset Management offers a building block for covering the topic of convexity in a resource-efficient manner with a team of experts who come with many years of experience in derivatives. The fund invests globally in equity, interest rate, currency, and credit markets, primarily through the use of tailor-made derivatives (OTC) and exchange-traded products.

The fund is particularly well-suited for investors who are looking for robust, uncorrelated sources of return in a volatile market environment and at the same time want to hedge their portfolio against extreme risks. Please note: investing in securities also involves risks.

Sample product: variance swap

Highly convex variance swaps are a frequently used instrument in the I-AM Global Macro Convexity fund. These OTC derivatives, which are particularly widespread in the equity sector, offer quadratic exposure to volatility, i.e. the variance of the underlying, in contrast to options or linear volatility swaps.

Source: Cyberfinancials Datenkommunikation GmbH, reference period 19 April 2022 to 10 October 2025, data as of 10 October 2025

Performance since fund launch. Every capital investment involves risk. Prices may rise as well as fall. The performance calculation does not allow for load or redemption fees and is based on the BVI method, which takes into account all costs incurred at fund level and assumes that any distributions are reinvested. Based on an investment amount of EUR 1,000, the maximum front-end load and a back-end load (if applicable, see master data). It does not take into account any other individual costs incurred by investors, such as depositary account management fees.