Portfolio rebalancing, Part 3: Exposure management strategies in an overlay program

Executive summary:

  • There's more to an overlay program than just cash equitisation and systematic rebalancing. The flexibility of the program allows for several other exposure management strategies.
  • Exposure strategies that go beyond traditional rebalancing include tactical tilts, plan level leverage, completion portfolios, options contracts and LDI solutions.  

Editor’s note: This is the final in a three-part series on the topic of portfolio rebalancing.

The previous two articles in this series focused on traditional rebalancing issues and the modern portfolio challenge of illiquid alternative assets. In this article, I’ll discuss portfolio solutions that go beyond rebalancing, but that share the theme of this series: express the portfolio exposures you want and hedge the ones you don’t want.

My team is predominantly known for implementing cash equitisation and systematic rebalancing for large institutional clients. While these are the most popular solutions for an overlay program, the inherent flexibility of the platform has created several other avenues that clients find valuable. One of the most rewarding parts of my job is partnering with our clients to find the most appropriate solutions to the challenges they face. This is often a customised solution that considers each client’s unique circumstances around return expectations, risk tolerances, timelines, and operational readiness. Listed below are some of the exposure management strategies that go beyond traditional rebalancing.

Tactical tilts

Most institutional investors have some flexibility to operate within a range of the target weights specified by their Strategic Asset Allocation (SAA). When an investor has conviction in a certain asset class or strategy, they might consider contributing additional capital to their existing investment managers. This is perfectly acceptable if the investor has sufficient cash reserves to contribute, the existing mandates line up with the desired investment goal, the investment horizon is medium- to long-term (to avoid a costly roundtripping of the investment), and if there are no restrictions or timing delays (e.g., fund capacity limits, investor queues, fund opening dates). These obstacles have created an opportunity for an alternative method of expressing portfolio tilts.


The overlay platform has become increasingly popular among clients who want to express their own portfolio tilts. These tend to be temporary deviations from their SAA. Client-directed tilts can modify a total portfolio’s risk characteristics to convey their tactical view without having to alter their physical assets. These adjustments can be clearly reported back to the client in the framework of their entire portfolio or as isolated positions.

Clients find value in expressing these tilts through derivatives because they are capital efficient, inexpensive, and flexible. Derivative-based solutions cost roughly one-fourth that of trading physicals, require only about 5-20% of the capital, are easy to short, and can be implemented without the constraint of a physical settlement cycle. We can implement trade instructions directly from a client or implement signals provided from a third-party manager. When tactical tilts are deployed, we encourage systematic rules to act as guardrails to ensure the desired outcome is achieved.

Russell Investments managed – Enhanced asset allocation

Many clients want to leverage Russell Investments’ long history and track record in analysing and forecasting markets. Enhanced Asset Allocation (EAA) utilises a fundamental process informed by a robust and diversified quantitative toolkit to identify compelling market opportunities. The EAA positions take the form of high-conviction tilts that intentionally deviate from the client’s SAA and are scaled within their asset class rebalancing ranges. The tilts are expressed via liquid derivatives (through a segmented sleeve of their overlay program), using offsetting long and short positions to avoid leverage. As a largely unfunded strategy, and unlike a traditional tactical asset allocation framework, EAA is not incentivised to always have positions on. Instead, EAA deploys tilts only periodically, and typically in staged tranches, to exploit high conviction tactical opportunities. The EAA program has contributed approximately +8 basis points (bps) annualised at a total portfolio level over the last ten years and currently advises to $48 billion in total client assets.

Completion portfolios + Overlay

While derivative solutions tend to be optimal for broad, sector, or cap-based exposure adjustments, many clients also desire a solution that provides more precision within asset classes around factor and other risk exposures. With powerful portfolio analytics and a long history of managing equity and fixed income strategies, we can help clients take a targeted and informed approach to risk management. This first involves identifying which risks are present in a portfolio, and then comparing the output versus the desired positioning. Implementing physical completion portfolios provides a flexible and precise tool to trim undesired factor tilts and fill exposure gaps. Many clients view a completion portfolio as an expansion of the role played by broad index funds – reduce tracking error, provide additional sources of liquidity, and allow active managers to focus in the highest areas of conviction. Through tight coordination across derivative overlay and completion portfolios, we can seamlessly address both macro and micro portfolio risks.


Option contracts can be an excellent way to express portfolio tilts and hedges in a non-linear fashion or when there’s a known time element to the position. Utilising options allows investors the flexibility to implement a vast array of strategies that can alter the portfolio’s risk/return profile without impacting the underlying investment managers. We have worked with clients to implement a variety of option strategies, some of which are outlined below.

  • Downside protection: purchasing outright put options or implementing put-spread collars to hedge (or partially hedge) the risk of a market selloff.
  • Collars: locking in a desirable range of outcomes on a particular asset class or individual equity.
  • Equity replacement structures: replacing passive index or futures exposure with a lower delta option structure such as a risk reversal that provides an element of both downside protection and upside participation. These structures can offer an asymmetrical payoff during periods of market stress.
  • Upside participation: capturing upside return by buying calls.
  • Income generation: systematic put writing or call writing strategies to harvest the volatility premium.


Liability-driven investing (LDI)

Many of our corporate defined benefit clients view portfolio risk through an asset-liability lens versus an asset-only view. An overlay program has the flexibility to provide a holistic perspective for monitoring both asset and liability risks. We can help clients achieve their desired liability hedge ratio through both physical solutions (government bond mandates, long duration STRIPS) and derivative solutions (U.S. Treasury futures, interest rate swaps, total return swaps). Interest rate hedging derivatives are liquid and are incredibly efficient for adjusting key rate duration risks and maintaining hedge ratios.

Plan-level leverage

Some clients are permitted to utilise leverage at a total plan level and use the overlay as an implementation solution to seek enhanced returns or hedge portfolio risks. For example, we have partnered with clients to add leverage for exploiting tactical market opportunities within permitted ranges, add fixed income exposure to serve as downside protection, add interest rate or spread duration to better hedge their liabilities, and boost their equity exposure with the aim of enhancing total portfolio returns. Clients may decide to implement leverage based on a percentage of their total portfolio or direct a specific trade size to achieve their leverage targets. Our clients have found value in the overlay platform because it has enabled them to implement their leverage targets cheaply and efficiently while providing the reporting that aids in visualising the impact of those decisions in the context of the total portfolio. While leverage can enhance overall fund returns, it can also lead to increased liquidity needs in certain market environments. For this reason, we suggest putting safeguards and monitoring checks in place so that the desired leverage stays within a bounded range. Monitoring liquidity is critical when any leveraged position is established, and we work with our clients closely to make sure these concerns are addressed.

The bottom line

I love working with clients to develop solutions to complex investment challenges. Our clients often dip a toe in the water with a solution such as cash equitisation or rebalancing, and then subsequently discover other areas where the overlay can be utilised. The overlay platform has developed into an extremely flexible tool allowing our clients to manage their exposures in a highly customised fashion. Clients can use the platform to implement tactical tilts, plan level leverage, LDI solutions, adjust their exposures using options, and achieve their desired risk exposures through a completion portfolio. The dynamic nature of financial markets means that clients’ needs change over time and, consequently, there’s a persistent demand for a nimble platform that provides thoughtful, cost-effective solutions to the challenges they face.