Overlay Strategies: A Broad Brush for Equity Risk

Topics: ,

Published on October 2, 2023

| 9 min read

Richard Yasenchak, CFA, Head of Client Portfolio Management

Share:

Investors are often faced with a paradox: the need for diversification and the desire for precision. On the one hand, we want to spread our risks across a broad range of assets and sectors. On the other hand, we want to target our investments to capture specific opportunities and manage specific risks. This paradox becomes particularly pronounced in times of frequent regime changes, where the dynamics of the market can shift rapidly and unpredictably.

In such times, one approach that can help navigate this paradox is the use of overlay strategies. Overlay strategies represent an alternative approach to managing equity risk, applying futures contracts to the entire equity mandate and providing a broader risk management framework for portfolios.

One of the primary benefits of overlay strategies is their ability to manage portfolio-wide risks effectively. By utilizing futures contracts to hedge against adverse market movements, overlay strategies serve as a robust risk management tool, akin to an insurance policy providing downside protection and mitigating the impact of market downturns on the entire portfolio.

Consider a scenario where a sudden shift in monetary policy leads to a surge in interest rates. This could trigger a sell-off in the equity markets, causing substantial losses for equity-heavy portfolios. An overlay strategy could help mitigate this risk. By holding futures contracts that are expected to increase in value during such a scenario, the losses on the equity side could be offset, protecting the portfolio’s overall value.

In addition to risk management, overlay strategies provide an effective tool for managing liquidity needs within your portfolio. The inherent leverage and ease of trading offered by futures contracts enable prompt management of cash flow requirements, providing valuable flexibility in navigating changing market conditions.

For instance, in a regime where liquidity is tight, an overlay strategy could use futures contracts to gain exposure to certain assets or sectors without having to invest additional capital. This would allow the portfolio to maintain its target asset allocations and capture potential returns, without disrupting its liquidity profile.

Overlay strategies also offer a flexible solution for efficient portfolio rebalancing. Rather than engaging in costly and time-consuming transactions involving physical securities, overlay strategies enable swift adjustment of portfolio exposures through futures contracts. This flexibility enhances the efficiency of the portfolio management process by reducing transaction costs and minimizing market impact.

Imagine a regime where certain sectors are outperforming others. An overlay strategy could adjust the portfolio’s exposures to these sectors by taking long positions in futures contracts linked to these sectors. This would allow the portfolio to capture the potential upside of these sectors, without having to buy or sell the underlying securities.

Like integrated strategies, an overlay approach may invite general risks like the speculative nature of futures and specific risks such as potential overexposure to equity markets. However, overlay strategies also present their own set of considerations and challenges. The application of futures contracts introduces an additional layer of complexity to your investment strategy. It requires specialized expertise to execute overlay strategies effectively and align them with your overall investment objectives. The mismanagement or misalignment of overlay strategies can lead to unintended risks and suboptimal performance.

Additionally, overlay strategies have the potential for higher costs. Unlike integrated strategies, where futures management and equity mandates are combined under one entity, futures overlay strategies may come with higher fees given the scope and complexities of their mandate. Furthermore, the overlay strategies potentially necessitate extra due diligence. Investors must be prepared to dedicate time and resources to continuously monitor and adjust the strategy, ensuring it remains aligned with changing market conditions and investment objectives. This additional layer of complexity requires a commitment to ongoing oversight and management, which can also contribute to higher operational and governance costs.

In conclusion, overlay strategies offer a powerful approach to managing equity risk and optimizing portfolio efficiency. They provide comprehensive risk management, efficient rebalancing, and agile liquidity management capabilities. However, they also require specialized expertise and ongoing monitoring to ensure alignment with investment objectives and adaptability to changing market dynamics.

In our next post, we’ll delve into the comparison between integrated futures strategies and overlay strategies, providing a comprehensive analysis to guide investors in today’s new market order. Stay tuned!

 


For U.S. Investors:

The views presented are for educational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. All content is presented by the date(s) published or indicated only and may be superseded by subsequent market events or other reasons. You should not rely on this information as the primary basis for your investment, financial, or tax planning decisions. While every attempt is made to ensure that all information is accurate, there is no representation or warranty, express or implied, as to the accuracy and completeness of the statements or any information contained herein. Any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed.

Past performance cannot predict future results. Investing involves risk, including possible loss of principal, fluctuation in value, and total loss of investment.

Investing in futures is speculative, involves substantial risk, and is not suitable for all investors and is for designated institutional investors who have the resources and financial expertise to understand the risks and limitations of such a strategy.

This information may be restricted by law, may not be reproduced or referred to without express written permission or used in any jurisdiction or circumstance in which its use would be unlawful. We are not responsible for any unlawful distribution of this material to any third parties, in whole or in part. The contents of this material have not been approved or endorsed by any regulatory agency.

For Europe Investors:

The views presented are as of the date published. They are for educational purposes only and should not be used or construed as investment, legal or tax advice or as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. Nothing in this material shall be deemed to be a direct or indirect provision of investment management services specific to any client requirements. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, are subject to change and may not reflect the views of others in the organization. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its use. Janus Henderson Investors is the source of data unless otherwise indicated and has reasonable belief to rely on information and data sourced from third parties.

Past performance cannot predict future results. Investing involves risk, including possible loss of principal, fluctuation in value, and total loss of investment.

Investing in futures is speculative, involves substantial risk, and is not suitable for all investors and is for designated institutional investors who have the resources and financial expertise to understand the risks and limitations of such a strategy.

Not all products or services are available in all jurisdictions. This material or information contained in it may be restricted by law, may not be reproduced or referred to without express written permission or used in any jurisdiction or circumstance in which its use would be unlawful. Janus Henderson is not responsible for any unlawful distribution of this material to any third parties, in whole or in part. The contents of this material have not been approved or endorsed by any regulatory agency.

Issued in Europe by Janus Henderson Investors. Janus Henderson Investors is the name under which investment products and services are provided by Janus Henderson Investors International Limited (reg no. 3594615), Janus Henderson Investors UK Limited (reg. no. 906355), Janus Henderson Fund Management UK Limited (reg. no. 2678531), Henderson Equity Partners Limited (reg. no.2606646), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority) and Janus Henderson Investors Europe S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier). Investment management services may be provided together with participating affiliates in other regions.

Janus Henderson and Knowledge Shared are trademarks of Janus Henderson Group plc or one of its subsidiaries. © Janus Henderson Group plc. 

For Australian Investors:

This information is issued by Intech Investment Management LLC (Intech) and is intended solely for the use of wholesale clients, as defined in section 761G of the Corporations Act 2001 (Cth) and is not for general public distribution. Intech is permitted to provide certain financial services to wholesale clients pursuant to an exemption from the need to hold an Australian financial services licence under the Corporations Act 2001. Intech is regulated by the United States Securities & Exchange Commission (SEC) under U.S. laws, which differ from Australian laws. By receiving this information you represent that you are a wholesale client.

Past performance cannot predict future results. Investing involves risk, including possible loss of principal, fluctuation in value, and total loss of investment.

Investing in futures is speculative, involves substantial risk, and is not suitable for all investors and is for designated institutional investors who have the resources and financial expertise to understand the risks and limitations of such a strategy.

This information may be restricted by law, may not be reproduced or referred to without express written permission or used in any jurisdiction or circumstance in which its use would be unlawful. We are not responsible for any unlawful distribution of this material to any third parties, in whole or in part. The contents of this material have not been approved or endorsed by any regulatory agency.