A customized overlay strategy can help keep an institutional portfolio aligned with investor objectives. Utilizing various components of an overlay strategy can result in greater returns, reduced tracking error, and lower costs.
For seeking to streamline policy objectives, implementing a customizable solution like an overlay program can help achieve overall portfolio goals more effectively and consistently. Overlay strategies provide the tools to achieve policy objectives, increase expected returns, minimize tracking error, and reduce portfolio costs. There are four common applications of an overlay program: cash overlay, rebalancing overlay, transition overlay, and currency overlay.
Let’s begin with cash overlay, the most commonly used application and perhaps the easiest to understand. To achieve both long-term return and risk objectives, many institutional investors begin by selecting asset-allocation targets. Because of the assumption that, over the long run, risk assets are expected to earn a premium above cash returns, investors typically give cash no weight as an asset class. However, institutions often hold cash for operational purposes such as benefit payments and capital calls. This results in increased tracking error and a long-term expected performance drag.
As a potential solution, overlay instruments can provide a market return, removing the effect of cash drag while still maintaining daily liquidity on cash balances. A cash overlay strategy can increase expected return while allowing the investor to continue to benefit from the operational advantages of cash. Importantly, since the overlay removes the performance drag of cash, the investor can structure a portfolio that increases overall liquidity and results in a simplified, more efficient cash management workflow.
Simply put, rebalancing a portfolio helps investors keep portfolio exposures in line with asset-allocation targets. A rebalancing overlay strategy can be used to automatically rebalance the portfolio when predetermined thresholds are exceeded. Monitoring total allocations across the portfolio daily is central to a rebalancing overlay program and ensures any exposure imbalances are promptly identified and corrected.
Rebalancing through an overlay strategy helps to better manage portfolio exposures through daily monitoring and more timely execution of rebalancing adjustments, reducing transaction costs in the process. The overlay strategy can be set up to rebalance exposures back to policy targets automatically, avoiding the pitfalls of behavioral biases that sometimes come with manual rebalancing. A customized, systematic rebalancing overlay strategy is responsive, quickly reacting to market volatility in real time and potentially taking advantage of rebalancing opportunities without the substantial staff resources of physical rebalancing.
A transition overlay can help institutional investors with episodic events that result in disruptions to portfolio exposures. The most common application of a transition overlay is to bridge exposure gaps during manager changes. When institutional investors terminate and subsequently hire a new manager, there is often a gap where market exposure is lost as cash is moved from the legacy manager to the new manager. Applying a transition overlay when cash is in transit allows the portfolio to remain fully invested at all times, thus removing performance risk during the transition of assets.
Other situations when a transition overlay can be useful include a portfolio undergoing asset-allocation changes or receipt of a significant inflow of cash, such as a sponsor contribution. A transition overlay helps to keep the portfolio in line with intended asset-allocation targets and removes any exposure gaps until the physical portfolio can be adjusted accordingly. With a transition overlay, investors should expect both lower tracking error and increased expected returns.
Investors are increasingly allocating their assets globally. As a result, foreign currency risk is becoming a larger share of an investor’s total risk exposure. While many investors are comfortable with this increased risk, others may find it beneficial to hedge currency risk with a currency overlay. Hedging is simply using an overlay to remove unwanted foreign currency exposure, effectively eliminating that portion of the portfolio’s currency return but leaving the specific asset exposure. Through a currency overlay strategy, investors can efficiently maintain desired currency exposure at all times. By explicitly determining how much foreign currency is desired and hedging away unwanted risk, investors can better manage their overall portfolio risk exposures.
The bottom line
A customized overlay strategy provides a framework to help institutional investors manage their portfolios more efficiently and effectively in accordance with guidelines and objectives. Investors can use any combination of overlay components that best fits that specific portfolio structure. Our overlay solutions help investors achieve closer alignment with policy objectives while increasing expected return, reducing tracking error, and lowering transaction costs.