5 Ways an Overlay Can Smooth Out a Rocky Market
Key takeaways:
- During volatile markets, an overlay can make for a more comfortable investing experience
- Key benefits of an overlay include liquidity management, dynamic allocation, risk management, cost efficiency and oversight and discipline
- An overlay specialist that’s also an OCIO can provide additional value because they’ll have total visibility into your portfolio
When volatility ripped through markets last month, many investors scrambled to respond. Some wanted to quickly adjust specific security exposures. Others wanted to flee to cash or build in protection against additional downside moves. And some rushed to buy the dip.
At Russell Investments, we didn’t freak out—and neither did our overlay clients. Why? Because our comprehensive overlay services program made these types of requests easily achievable.
While the worst of the short-term volatility has faded, markets could easily turn on a dime again. Having an overlay in place the next time things sour could make for a much more comfortable investing experience. Here are five reasons to consider partnering with an overlay specialist before volatility strikes again.
1. Liquidity Management
In times of crisis, liquidity becomes paramount. In other words, cash is king. An overlay program allows investors to maintain full market exposure (beta) while holding a higher percentage of their portfolio in cash or highly liquid assets. Since derivatives are capital efficient instruments, only a small portion of cash is needed to obtain market exposure, making it one of the quickest ways to boost a portfolio’s liquidity profile. Furthermore, when volatility spikes, trading volumes tend to increase but liquidity (how much you can execute quickly) gets worse. This phenomenon is much more pronounced for physical assets, making derivatives the preferred instrument during market turbulence.
Key Benefits:
- Hold more cash for liquidity purposes without experiencing cash drag.
- Capital efficient derivatives are unfunded instruments that require less cash.
- Derivatives tend to be more liquid than physicals, especially in stressed market conditions.
Example:
Redeeming from an overweight fixed income passive manager and replacing exposure synthetically via a total return swap to free up cash without altering the portfolio’s risk/return profile.
2. Dynamic Allocation
Overlay programs provide a fast and flexible mechanism to implement tactical views or adjust portfolio targets. This is crucial when market dislocations create short-term opportunities. Derivatives can be used to express these tilts immediately, without waiting on slower-moving physical asset trading.
Key Benefits:
- Take advantage of tactical opportunities quickly and efficiently.
- Execute trades outside normal market hours with liquid futures contracts.
- Avoid coordination delays across multiple managers.
Example:
A client sees equities as oversold and wants to increase exposure intraday. An overlay can buy equity index futures within minutes.
3. Risk Management
Even though risk tolerance levels vary for each client, an overlay program tends to be the go-to tool for expressing it. As markets sold off in April, investors who were more risk averse used the overlay program to place hedges to protect their portfolio against further declines. At the same time, investors who were less worried about falling equity prices and more concerned about not fully capturing the upside potential of a recovery, used the overlay to mitigate that risk.
Another type of risk is asset drift relative to the strategic asset allocation (SAA). Policy implementation overlays help ensure portfolios stay aligned with the SAA and reduce unintended drift, especially when physical asset values move quickly or unpredictably. Historically, this kind of discipline has added value during times of crisis when emotions are running high. For overlay mandates that are more client-directed in nature, using derivatives is the quickest way to rebalance a portfolio.
Key Benefits:
- Keep the portfolio close to target allocations, reducing tracking error.
- Avoid unintentional risk from exposure drifts during volatile periods.
- Add downside protection via options, short futures, or Treasury exposure.
Example:
During a sharp equity market decline, the overlay can immediately reduce the portfolio’s equity risk using short equity futures or option hedges.
4. Cost Efficiency
Compared to trading physical securities, derivatives are significantly cheaper in terms of transaction costs and operational friction. These differences become even more pronounced when volatility increases and bid/ask spreads widen. Overlay programs can reduce portfolio turnover by handling exposure adjustments synthetically rather than through manager redemptions or reallocations.
Key Benefits:
- Estimated to cost roughly one-eighth of what it takes to trade physical assets.
- Minimize portfolio turnover and disruption on physical managers.
- Use derivatives to “top up” or “trim” exposures rather than adjusting physical portfolios.
Example:
As a portfolio became underweight equities, instead of allocating cash to a physical equity manager, a client uses the overlay program to increase equity exposure via futures. This is cheaper, faster and less disruptive.
5. Oversight and Discipline
An overlay provides a centralized and transparent view of total portfolio exposures—including physical and synthetic components. Typically, this includes daily oversight and monitoring of all portfolio account values and known cash flows. This helps investment committees and boards make timely and informed decisions, particularly during periods of stress when emotions can cloud judgment.
Key Benefits:
- Real-time exposure tracking relative to targets.
- Clear governance structure with predefined rebalancing rules.
- Supports decision-making with data and structure, reducing behavioral bias.
Example:
During a crisis, an institutional investor can avoid panic selling by relying on clear guidelines implemented via an overlay program to methodically rebalance and maintain discipline.
One more thing
From my standpoint, there’s additional value in partnering with an overlay provider that’s also an OCIO (outsourced chief investment officer). This is because the best OCIO providers act as an extension of your staff, meaning they’ll already be working closely with your team. During times of crisis, these providers will have a total view of your portfolio, visibility to upcoming cash flows and portfolio changes, implementation expertise, and insight into your overall liquidity/spending needs. With visibility to daily portfolio changes, they can provide the reporting needed to allow you to make quick and informed decisions.
Consider reaching out to an investment solutions firm with overlay expertise so that you’re better equipped for the next round of volatility. Because when the going gets rough, the overlay gets going.