Rate cuts are coming. Does your OCIO or risk management provider have the right overlay capabilities?

Executive summary:

• With the Fed poised to lower interest rates, we believe it's critical to partner with an OCIO provider with robust overlay capabilities in order to effectively manage portfolio risk. 
• We believe OCIO providers with internal overlay capabilities are in the best position to reduce risk and control costs, as opposed to providers that outsource their overlay services to a third party.
• Because overlays are often used to complement and complete other portfolio exposures, coordination is a must. This is most effectively achieved when overlays are handled by one single cohesive team rather than a third-party provider in another location. With one team responsible for a portfolio’s overall success, there’s also greater accountability—and no passing the buck.

If overlays haven’t been on your radar so far this year, it’s high time to start thinking about them.

That’s because the U.S. Federal Reserve (Fed) is all but guaranteed to lower borrowing costs at its policy meeting next week, making a robust overlay program critical to managing the risks of fluctuating rates in your portfolio. High short-term interest rates have led many investors to accumulate cash in their portfolios rather than holding longer-dated bonds. A change in strategy can be quickly implemented with a strong overlay program.

So, here’s a question: Does your OCIO provider have in-house overlay capabilities in its exposure management toolbox?

If not, why don’t they?

As stewards of others’ investments, an OCIO (outsourced chief investment officer) provider’s charge is a weighty one: Help organisations achieve their financial goals by effectively managing all dimensions of their investment programs. Those same OCIO organisations may also work with other asset owners to augment their internal staff’s capabilities—a partial notion of outsourcing. No matter the degree of delegation, an outsourcing partner needs a complete set of tools. 

At Russell Investments, we believe that an integrated overlay capability is critical to serving clients’ needs. To mitigate risk and manage cost in today’s uncertain economic and market environment, the internal ability to view and manage client exposures via a comprehensive overlay should be a must-have for all OCIO providers. 

Let’s dive in and explain why.

An OCIO with an in-house overlay program manages risk and reduces costs

Because large institutional investors often have several separately managed portfolios, the use of overlays is critical in keeping their total portfolio in alignment with their desired/preferred positioning. Without an overlay in place, assets can become unbalanced and undesired positioning can quickly arise as different managers buy and sell without awareness of the impact on the total portfolio—the classic the left hand doesn’t know what the right hand is doing situation.

But if the goal of an overlay is to manage exposures, does it really make sense for an OCIO provider to outsource that critical function to another party? Doesn’t that further complicate the process of keeping a portfolio on track? Isn’t adding another group of decision-makers into the fold inefficient both from a risk management and cost perspective?

In most cases, it’s the simple truth that the more a service provider sub-contracts for capabilities it does not have, the more money it’s going to cost—and the higher the chances that these costs will be passed on to the client. This is true in just about all walks of life, from home remodels to building renovations to investment services. Wouldn’t you rather get more bang for your buck by selecting an investment solutions provider that already has all the capabilities you’ll need—especially something as critical to the success of your investment program as overlays?  A best-in-breed OCIO provider should be able to do everything under the sun when it comes to implementation—whether it involves cash, rebalancing, transitions or currencies. A completion portfolio can also be a particularly useful tool in managing unintended exposure gaps while keeping your investments in alignment with your strategic beliefs.

The benefit of coordination within one team

This ties in with another benefit of partnering with an OCIO with internal overlay capabilities that can’t be overstated: the coordination among team members. Simply put, when overlays are handled by a single cohesive team, the resulting services are likely to be much more coordinated—with far less surprises.

Why? Overlays are often used to complement and complete other portfolio exposures. When assets are in motion, broad risks become more about precision and timing. Coordination is key to ensure portfolios are correctly positioned, particularly during volatile markets. The best laid plans can change due to market conditions. Having all risk exposures managed on one common trading desk ensures that a change in plans for one side can be seamlessly synced with the other, and risks remain properly managed. For instance, the ability of the transition manager to work with the overlay manager in real-time—on the same systems, with precisely synchronised execution of derivative and physical transactions—provides the most seamless implementation of large asset allocation shifts. This harmonised implementation structure affords investors confidence that exposures are intentional and aligned for success.

Contrast this with a third-party overlay services provider, which is often in another location. In cases like these, a change of plans might take a meaningful amount of time, particularly if it’s outside of local business hours. The net result of this is that exposure gaps can occur, and no single individual is fully accountable for all of the risk management. Governance becomes sloppy. And when things go wrong, no one takes responsibility.

The bottom line

There are a myriad of factors to weigh when selecting the right OCIO provider, but we firmly believe that the ability to effectively manage risks and costs should be at the top. Consider working with an OCIO provider that prioritises both by running its own overlay services program. You wouldn’t hire a contractor without a hammer in their toolbox right? With changes in rates just around the corner, the time to act is now.