Confessions of an overlay manager
- Derivatives are a marvel—you can experience the practical benefits of holding cash while minimizing long-term performance drag.
- We obsess about managing the risks of portfolio changes and cash flows.
- The role of an overlay manager often develops into a trusted advisor and an extension of staff.
- Prepare for tomorrow's challenges by flexing the power of a multi-faceted portfolio tool.
Confession #1: Cash is every portfolio's necessary evil and occasional best friend.
Among the world's most useful inventions, cash is essential to the smooth operation of most aspects of life—from purchasing daily necessities to one-off expenditures to retirement planning. It's the same with portfolio management. Cash is needed for expenses, capital calls, and paying beneficiaries, while also being the primary method for manager redemptions, private market distributions, and plan sponsor contributions.
There aren't many jobs that would consider cash as the enemy. Most jobs are in pursuit of obtaining more of it! But as an overlay manager, I look at cash in a total portfolio context, recognize its long-term drag on performance, and seek to eliminate it. The enemy here is cash drag and it's not trivial—over the last 40 years, a typical institutional portfolio would've missed out on 15.3 basis points per annum.1 To put this in dollar terms, a $5 billion portfolio is missing out on $7.7 million of gains per year. Thankfully, most institutional investors recognize the necessary evil that cash plays in a portfolio—they need it for operations but would much rather have it invested in higher-yielding assets. This is a dilemma, but there's a viable solution thanks to another invention: derivatives. An overlay manager can use derivatives to capture the market risk premium while only needing a small portion of the cash to do so. In the world of finance, this is about as close to having your cake (market risk premium) and eating it too (having cash on hand for operations). Despite over 20 years of working with derivatives, I still marvel at these simple advantages.
One ancillary benefit here is that with an overlay program in place, investors are less pressured to run thin cash balances. In times of crisis, cash is king. So, having more liquidity in the portfolio can make a crisis a bit easier to manage.
Confession #2: Risk involving portfolio changes and cash flows is underappreciated.
Historically, portfolio risk management has focused on top-down (e.g., asset allocation) or bottom-up (e.g., security or manager selection) approaches. These tend to capture most of the airtime in investment committee meetings, and perhaps rightfully so. However, in the day-to-day management of a portfolio, there are frequent opportunities to reduce risk related to portfolio changes and cash flows. While these may not garner headlines, diligence in these matters can have meaningful implications to investment returns and risk.
The challenge here is that institutions and plan sponsors are long-term investors who must live in the daily reality of managing a complicated portfolio. This is no academic exercise—modern portfolios are messy. There's the impact of daily market volatility, periodic manager valuation updates, corporate actions, capital calls, distributions, manager changes, benefit payments, and a thousand other things that impact the portfolio. Clients who are new to an overlay manager are often surprised at how far we go into the weeds on these matters. The reason is because we know that taking a lackadaisical approach to managing portfolio changes increases risk but with no expectation of reward.
In practice, our goal is to hedge the risk of unintended exposures by lining up our trades with the appropriate benchmark so that the portfolio isn't levered or exposed to excessive cash levels at any point during the day. Just one hour of misaligned portfolio exposure can be costly. For example, a $50 million cash flow involving U.S. equity exposure that is misaligned for just one hour can cost over $200,000.2 That could be enough to pay the manager's fee for the year. Uncoordinated or loosely coordinated portfolio changes result in opportunity cost. This becomes starkly apparent when a portfolio is managed under the microscope in which every minute of risk matters and every basis point of performance is measured. As a risk manager, I know that opportunity cost is often the elephant in the room and yet also the thing that's most tempting for investors to sweep under the rug when it doesn't go their way.
A common mantra on our desk is: even the best investment decisions can be offset by poor implementation. It's in our DNA to obsess about risks like these and help our clients save every possible basis point through tight coordination and diligence in trading.
Confession #3: An overlay manager is not your typical manager.
As an overlay manager, I have a unique perspective that's quite different from all other managers in a portfolio. This is particularly true for completion overlays in which we have visibility to the entire portfolio including every manager in the lineup. In those mandates, we obtain daily custodial information so that we can build the client's portfolio every day according to their asset allocation and investing parameters. The end result is a picture of portfolio exposures relative to targets. This is a valuable report for clients, and it ensures that both parties are aware of each manager in the portfolio and looking at top-level exposures through a similar lens.
One thing that's difficult to explain to a prospective client is how deep in the trenches we get with the investment staff regarding the daily management of their portfolio. Over time, this tends to create a bond between the investment staff and the overlay manager—we're treated less like a sub-advisor and more like an extension of their staff.
When clients want to modify their target asset allocation or change their manager lineup, we tend to be the first to know. When the investment staff is planning for next quarter's liquidity, we tend to have a seat at the table. When a new challenge arises, or a new risk, or an exposure to a new asset class is being contemplated, clients often reach out to get our thoughts on how best to implement those changes. By leveraging our experience with institutional investors all around the globe, along with our colleagues' deep expertise in trading, consulting, and operations, we can often help clients find the low-cost, low-risk solution that meets their objectives.
Confession #4: A little prep work can hedge the risk of regret.
Investing is hard. Consistently predicting the future is impossible. In many cases, the best an investor can do is be thoughtful and prepare in advance. This means having the right portfolio tools in place to handle both current and future challenges.
The beauty of an overlay program—and an element that can make it difficult to explain to prospective clients—is its flexibility. In perhaps its simplest form, an overlay program can be used to equitize the cash exposure in a portfolio. However, this same platform can also be used for rebalancing, implementing asset allocation changes, hedging currency risk, expressing tactical portfolio tilts, reducing liability risks, protecting against downside tail events, and a host of other objectives. Derivative instruments like futures, forwards, swaps, and options tend to do the heavy lifting here. But in other cases (e.g., LDI, transition management, factor-based completion) it's a combination of derivatives and physicals that result in the best solution for clients.
Advanced preparation can add significant value to clients when they need it most. What we seek to avoid are feelings of regret and anxiety because it takes time to open new accounts, complete legal and regulatory paperwork, or add OTC trading capabilities. Some of these actions are rather quick (a matter of days) while others can take several weeks or months. With any toolkit that is both powerful and flexible, there's a tendency to walk before running. This is perfectly understandable. The encouragement here is to get the paperwork and accounts in place because you never know when you'll need to start running.
What I love about being an overlay manager
Institutional investors face all sorts of challenges. What I love about being an overlay manager is that there are so many ways to use the platform to make those challenges less daunting. Those solutions might be focused on improving returns or reducing risk, and often it's a combination of the two. In all cases, we're endeavoring to implement solutions in a cost-effective and transparent manner—something clients have grown to expect from a trusted advisor who's with them in the trenches of their portfolio every day.
1 The impact from 12/31/82 to 12/31/22 of 1.5% US equity manager cash, 2% International equity manager cash, and 1.5% operational cash (total fund cash of 2.5%) versus a pro-rated target of 40% Russell 3000, 20% MSCI ACWI ex-US (MSCI World ex-US prior to 1998), and 40% Bloomberg Barclays US Aggregate.
2 This is the hourly opportunity cost, at one standard deviation, between holding cash and the S&P 500 Index. See Travis Bagley and Greg Nordquist: https://russellinvestments.com/ca/blog/q2-2023-update-real-time-risk-exposure-report