Why Overlays Matter Right Now

Lifting the Veil

Causey began by demystifying overlays. He explained they’re a type of portfolio mandate that primarily uses derivatives to manage exposures or hedge risks. Overlays operate alongside existing investment programs rather than replacing them. A common example is “cash equitization”—using futures to gain market exposure on cash to reduce performance drag. Other examples include tactical portfolio tilts, liability-hedging exposures or systematic rebalancing to keep asset allocations on target.

Some institutions use overlays for a single purpose, while others apply them across their entire portfolio for risk and exposure management. Overlays essentially work behind the scenes to keep portfolios aligned while reducing unwanted risk.

The Great Awakening

While Russell Investments has been implementing overlays since the mid-1980s, Causey said the demand for them today is stronger than ever seen before. He said there are three main factors driving the surge in interest:

1. Flexibility
   Institutional investors want the flexibility to act quickly to hedge portfolio risk or apply portfolio tilts. The solution needs to be liquid, capital-efficient and inexpensive, and derivatives check all of these boxes.
   
   
2. Growing Comfort Levels
   With the periodic uptick in market volatility in recent years, investors have become more comfortable using derivatives as a tool to reduce risk or enhance returns.
   
   
3. Search for Higher Returns
   There’s been an increase in institutions looking for less traditional ways to earn higher returns, or alpha. As investors increasingly venture into hedge funds, private markets or quantitative investment strategies, overlays help manage the beta side of their portfolios or provide liquid access to certain exposures.

Value Menu

Shockley outlined three key benefits of overlays:

• Risk Reduction
  Overlays can range from narrowly focused, client-directed trades to broad, rules-based total-portfolio strategies. In either case, their purpose is to align a portfolio’s actual exposures with its intended targets and eliminate unintended risks that do not contribute to expected returns.
  
  
• Return Enhancement
  One of the most common unintended exposures is cash. Derivatives let investors gain market exposure without tying up large amounts of cash. Because they’re cheaper and only partially funded, overlays can enhance returns in a cost-effective manner.
  
  
• Extension of Staff
  Russell Investments’ overlay team monitors client portfolios daily and adjusts as necessary. This ongoing engagement turns the overlay team into an extension of the client’s staff, freeing up in-house resources.

Managing Cash

Heier asked whether overlays still matter now that cash yields 4%–4.5%. Causey noted some clients are holding more uninvested cash to reduce absolute risk while earning higher short-term yields. Over longer horizons, however, he said the market risk premium—the return above the cash rate—is still higher. Case-in-point: Since cash rates peaked in 2023, global stocks have rallied about 40% and bonds about 13%, meaning holding uninvested cash has come at a cost. This “cash drag” makes it harder for a portfolio to achieve its return objectives.

Could an overlay help? Causey said over the past 45 years, a simple cash overlay mandate from Russell Investments added roughly 0.16% per year to a standard client portfolio. For equity-only overlays, that number was 0.25% a year. Even with higher cash yields, overlays tend to outperform cash in about seven out of 10 years, Causey said.

Covering the Bases

Shockley outlined common usages by client type:

• Corporate defined-benefit (DB) plans use liability-driven investing (LDI) overlays to extend duration and manage surplus risk. They may also equitize the cash they keep on hand for benefit payments.
• Public pensions likewise use overlays for liquidity and rebalancing.
• Endowments and foundations use overlays to manage private market exposures. For new private market investors, overlays allow uninvested cash to earn a market premium until capital is called. For mature programs with private market overweights, overlays can restore public-market exposure or convert passive allocations into derivatives, freeing up liquidity.

Real-World Examples

Causey shared examples of how overlays have helped solve specific client challenges, including:

• Closing an underweight to U.S. tech stocks using sector futures, NASDAQ futures or custom swaps.
• Quickly adding gold exposure through futures, then transitioning to an ETF to reduce long-term holding costs.
• Designing downside “tail hedges” with option structures or maintaining “always-on” tail hedges with low carry costs and high convexity.

Riding Shotgun

Causey said the greatest value Russell Investments’ overlay team provides to clients is being a trusted advisor. By “riding shotgun” on a client’s portfolio—monitoring exposures and upcoming cash flows daily—the team can proactively advise on manager changes, asset allocation shifts or new asset classes while weighing costs, risks and tracking error.

Portfolio Flex

Above all else, institutional investors need flexibility in today’s dynamic investing environment. Overlays provide exactly that, Causey said, characterizing them as the “Swiss Army knife” of institutional portfolios.

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Important information pertaining to the hypothetical example: Past performance does not predict future returns. Return level is proportionately scaled in line with cash level to be overlaid. Source: Russell Investments. Assumptions: Average cash level 1.0%, 10-year history from 12/31/2023, gross of fees. Opportunity cost from not securitizing cash varies by asset allocation and time period, and is represented by horizontal bars as marked within the chart legend. Target asset allocation used: 0% cash, 74% MSCI World, 26% Global Aggregate (GBP Hedged). For illustrative purposes only. Does not represent any actual investment. Indexes are unmanaged and cannot be invested in directly. Performance benefit (net) of overlaying cash by last 5 individual calendar year is as follows: 2023:20 bps, 2022:-17bps, 2021:16bps, 2020:14bps, 2019:23bps.

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