What it means
In a typical portfolio, different managers choose assets in different markets. Each of them may buy overseas shares or bonds, and each creates currency exposure without coordinating with the others.
An overlay manager looks at the total exposure across all portfolios and manages it in one place. The most familiar types are currency, interest rate, equity market and asset allocation overlays.
They are usually run with derivatives such as forwards, futures or swaps, which means the underlying assets do not need to be bought or sold. That keeps costs lower and avoids disrupting the main managers.
The benefits are consistency, scale and specialist skill. One team can apply a single policy, for example hedging half of all foreign currency exposure, instead of leaving each manager to decide separately.
Costs can be lower because trades are netted before they reach the market. An overlay is not free.
There are management fees, trading costs and collateral requirements, and cash must be available if contracts move against the portfolio. The overlay can also reduce gains when markets move in the favourable direction.
Pension funds, endowments and corporate treasuries are the main users. Boards should set a clear mandate: the target exposure, the permitted instruments, the limits on losses and how performance will be measured.
Boards sometimes worry that an overlay adds complexity, and that is a fair concern. The answer is clear reporting, a short written policy and regular review of whether the overlay is still earning its fee.
In practice
Real-world examples.
Example
A university endowment employs six equity managers around the world. It hires one overlay manager to hedge the total currency exposure to a set level. The managers keep choosing shares while the overlay controls the currency risk.
Example
A corporate treasurer runs an interest rate overlay on a group of floating-rate loans. Using swaps, she fixes the rate on 60% of the total debt. The loans themselves are not changed.
Example
A pension fund wants to keep its equity weight at 40% as markets move. Instead of selling shares each time, it uses futures as an asset allocation overlay. The overlay brings the exposure back to target at a lower cost.
Formula
Calculation
Overlay hedge amount = foreign currency exposure x target hedge ratio
A pension fund holds $400,000,000 of overseas assets across four managers. The board's policy is to hedge 50% of the currency exposure through an overlay. Overlay hedge amount = 400,000,000 x 0.50 = $200,000,000. If the overlay manager charges 0.04% a year on the hedged notional (the contract value), the annual fee = 200,000,000 x 0.0004 = $80,000.
Reading the result: the overlay covers $200,000,000 of the $400,000,000 exposure, so half of the currency risk is neutralised and half is left to run. The fee of $80,000 is 0.02% of the total overseas assets (80,000 / 400,000,000), which the trustees can weigh against the reduction in volatility.
The overlay can also be sized as a share of the whole fund. The $200,000,000 hedge on a fund of $900,000,000 covers 22.2% of total assets (200 / 900), and the trustees can compare this with their stated risk tolerance when they review the policy each year. The same method works for corporate treasuries, where the overlay hedge is sized from the total foreign currency cash flows forecast across every subsidiary and not from each entity in isolation.Case study
Seen in the real world.
Wexford Pension Trust is an illustrative, fictional fund with $900,000,000 in assets spread across five managers. Each manager made its own decisions on currency, and the trustees found that the fund was unintentionally exposed to 35% in foreign currency.
The trustees hired an overlay specialist to hedge half of the exposure under a written policy. The overlay cut the volatility of the fund's returns, though it also meant giving up some gains when the foreign currencies rose.
After a year the trustees compared the cost of the overlay, around $63,000, with the reduced swings in the fund's funding level. They concluded, in this illustrative case, that the clarity and control were worth the fee.
Watch out
Common mistakes.
- Assuming an overlay removes all risk, when it manages only the specific exposure it was set up for.
- Forgetting the cash needed to meet margin calls on the derivatives used in the overlay.
- Giving the overlay manager an unclear mandate, which can lead to speculation instead of risk control.
Questions
People also ask.
Is an overlay the same as hedging?
It is a way of organising hedging, with a single layer that applies a policy across all portfolios.
Who uses overlays?
Large investors with several managers, such as pension funds, endowments and insurers, use them most, along with corporate treasuries.
How is an overlay manager paid?
Usually through a fee based on the notional amount managed, sometimes with an extra fee linked to performance.
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