Derivative overlays have become a mainstay of modern pension fund management. Many plans use overlay strategies in order to achieve a variety of asset allocation objectives, ranging from passive currency hedging to implementation of tactical shifts or even complex hedge fund replication strategies.
The proliferation of these overlay strategies has created substantial confusion in terminology, as a multitude of approaches are offered under this term.
Complicating the matter even further, there are many practical considerations that pension plans need to consider once they identify the appropriate overlay strategy. For example, the potential for leverage exists whenever an overlay strategy is implemented, whether the program is outsourced or run in-house. When an overlay strategy is outsourced, the potential for leverage usually means that the plan sponsor and overlay manager interact and communicate much more frequently than they do in other asset management relationships. Not to do so would invite additional risk to plan assets and funded status.
Taxonomy of overlays
Overlay strategies come in a variety of forms. Some are managed passively, with formulaic objectives that can be executed inexpensively. Other strategies involve complex algorithms or sometimes even active decision-making. In trying to identify the types of overlay strategies that exist, we have included most strategies currently marketed under the name “overlay.” While overlay strategies have many divergent features, the common element among them is that they typically involve a synthetic replication of an asset class, market or factor exposure. In many cases, the exposure obtained may be greater than the actual funded amount of the mandate. This implicit financing and leverage is typically obtained either through the use of derivative instruments or forward-settling purchases.
One way overlay strategies can be broadly categorized is by the time horizon associated with changes in positioning. Some overlays transact frequently in order to adjust to market conditions while others are established as more of a strategic position. The most common strategies are shown in Figure 1.
Portable alpha overlays are used in an attempt to exceed performance of a given market exposure through investments in another, often unrelated, asset class. For example, an investment in the S&P 500 Index obtained by purchasing constituent stocks of the index will equal the performance of the S&P 500. However, if the exposure is obtained synthetically using futures or swaps, the return to the investor will be equal to the return of the S&P 500 Index, less a financing rate, plus the return on the cash collateral portfolio (as futures and swaps do not require the investor to pay for the market exposure up front, but instead only that they post initial margin and mark-to-market payments). To the extent that the collateral portfolio outperforms the financing rate (~0% in the current market environment), the investor should achieve a return that exceeds that of the S&P 500 Index. For further discussion on portable alpha strategies and risks see, for example, “Portable Alpha – Theory and Practice” published by Wiley Finance.
Currency overlays are used to hedge currency exposures of the plan, when managed passively, or to take active views in the foreign exchange market, when managed actively. Currency overlays often are complementary to both rebalancing and completion overlays because plans that invest in foreign securities usually hedge at least some part of their currency exposure back to their home currency.
Liability-driven investment (LDI) or duration overlays are generally used to hedge the interest rate risk arising from pension plan liabilities. Most overlays are implemented using swaps, futures or bond forwards. In the plain-vanilla case, plans match all or part of their liability structure based on duration, key rate duration, curve and/or convexity. Some of the more complicated strategies involve optionality, for example using swaption collars, or even active management.
Hedge fund replication or hedge fund completion overlays are strategies that intend to replicate exposures to common factors in hedge funds. Hedge fund replication is based on the premise that part of hedge fund returns can be attributed to directional, persistent exposures (such as credit risk) or to strategies (e.g. momentum-based investing) that can be systematically replicated using sophisticated statistical techniques. These replication strategies are typically offered for a fraction of the cost traditional hedge funds charge. Replication strategies are relatively new, so judging the investment merits of replacing part of the traditional hedge fund allocation in investment portfolios is still difficult to assess.
Tail-risk hedging strategies are among the more advanced recent additions to a pension manager’s toolkit. The hedges are investments in options that are designed to mitigate large, unexpected adverse moves in the market, similar to 2008. Many of these strategies are actively managed, as the cost of purchasing options can be substantial, especially during times of market turbulence. In addition, the hedges often need to be rebalanced, especially in the event of large market moves.
Completion overlays are most often used to line up the overall plan exposure with targets that cannot be achieved through the combination of the underlying investment management mandates, either because requiring managers to do so would materially hamper their ability to generate added value or because physical assets are temporarily unavailable to be deployed to achieve those targets. For example, a plan with a substantial (but temporary) cash position could employ a completion overlay to equitize the cash position by purchasing equity futures. Sometimes, hedge fund replication strategies and some dynamically-adjusted liability hedge overlays are also called “completion strategies” as they may be used to accomplish a plan’s overall target market exposures.
Rebalancing overlays are used to implement asset class rebalancing for the overall pension plan, typically using derivative instruments. The main benefit of these strategies is that they typically allow the realignment of asset class exposure with investment policy targets at a lower transaction cost than using sales of physical securities. Rebalancing overlay strategies are also potentially less disruptive to the active managers in the pension plan because there is no need to move physical assets between the managers.
Tactical Asset Allocation Overlays (TAA) or Global Tactical Asset Allocation overlays (GTAA) are actively managed strategies and may be part of a rebalancing overlay or standalone mandates. Instead of deriving the desired market exposures from the strategic asset allocation, the targets for these overlays are determined through a quantitative or qualitative investment process, resulting in intentional deviations from the strategic long-term allocation.
Interestingly, very few investment managers offer all of these various kinds of overlay strategies, either individually or as one package. Most managers have specialized either in passive overlays, active overlays or tail-risk hedging.
Key benefits of overlays
Higher capital efficiency. Most plans require some level of cash buffer in order to manage contributions and benefit payments, so they typically encounter some “cash drag” (i.e. potentially lower expected returns over time). For example, if a plan maintains 5% in cash and has an asset allocation that would generally be expected to deliver 6% to 7% returns, cash drag can be 30 to 35 basis points annually – similar in magnitude to all the investment management fees paid by the typical plan in a given year! Using overlays, this drag can be managed, as cash can be converted to equity, fixed income or some other asset class exposure without detracting significantly from the need for liquidity.
In fact, virtually all of the traditional and exotic beta exposures of a plan can be replicated using synthetic overlays. This may allow for additional efficiencies to be gained, for example, through portable alpha strategies. As described earlier, these strategies may allow us to combine the risk and factor exposures of multiple asset classes in an effort to generate excess returns.
Lower transaction costs. Transaction costs using physical securities can be substantial. Derivative instruments have therefore provided a more efficient way of executing month-to-month rebalancing activities for plans. For example, after a strong month in equity performance, a plan can have a position in equities that is larger than the exposure called for by the plan’s strategic asset allocation. Under this circumstance, the plan can sell equities outright by redeeming them from one of the underlying asset managers for cash and depositing the cash with a fixed income manager. Alternatively, they can use an overlay strategy to sell equity futures and purchase fixed income futures – potentially reducing transaction costs substantially.
Savings in transaction costs should be weighed against potential basis risk introduced by using derivatives to replicate a physical market exposure. For example, equity exposure can often be replicated with relatively low tracking error. On the other hand, replication of other asset classes, like fixed income credit, often lead to more significant tracking error. As such, rebalancing overlays may be more effective for relatively small rebalancing transactions. Larger asset allocation adjustments should usually be implemented through the physical market. Figure 2 illustrates the estimated tradeoffs between transaction costs and basis risk.
It should be noted that total return swaps can potentially provide both low basis risk and low transaction costs, but they present additional hurdles: transaction costs can be highly variable, and at times of market stress swaps may become unavailable given that they typically consume broker/dealer balance sheet capacity (unlike futures). Further, swaps require additional considerations related to rebalancing the exposure over time. Resizing a futures position is a simple buy/sell transaction, whereas resizing an OTC swap requires amending legal swap contracts, which can be both cumbersome and costly.
Lastly, whether the derivatives are traded on an exchange or over the counter, changes in the mark-to-market value of the position usually will result in the receipt of collateral or the need to post collateral on a daily basis. It follows that a plan making use of such strategies will want to ensure that a sufficient supply of liquid, eligible collateral instruments is on hand to satisfy potential margin or collateral calls and that the plan has the required operational and management capabilities to handle the complexities arising from use of derivatives.
Increased precision in risk management.Overlay strategies can also provide additional precision when attempting to reduce different risks in the pension plan. Pension liabilities are a great example: In typical LDI assignments, the portfolio manager seeks to construct a portfolio that more or less matches different drivers of liability risk. Those liability risk factors include duration, convexity (sensitivity of duration to large changes in yields), curve risk and spread exposure, among others. However, the specific targets that must be achieved by an LDI portfolio to control liability risk may be inconsistent with the latitude required by active managers to maintain the potential for value added. Indeed, trying to replicate liability risk factors using physical instruments could force fixed income managers into a fairly narrow segment of the market, as illustrated by Figure 3.
As Figure 3 shows, exclusive use of physical securities may ultimately result in increased concentration risk, forced accumulation of unattractive securities and limited potential for alpha given the narrow universe of securities that match the characteristics of the liability discount rate (e.g. Barclays U.S. Long Corporate AA Index). The ability to incorporate derivatives overlays into an LDI program allows the plan sponsor to expand the physical fixed income investment universe beyond the boundaries implied by liability discount curves while still maintaining the ability to match with liability risk factors.
In addition, these liability risk factors can be expected to fluctuate over time as inputs like discount rates or the demographic profile of the plan change. In those circumstances it may be more efficient to rebalance the LDI portfolio towards liability targets using derivatives. Otherwise, the portfolio adjustments would likely lead to relatively small sales and purchases of physical securities that could drive transaction costs up.
More efficient transition management. We estimate that an average plan changes at least one manager every year, causing 2% to 5% of the plan’s assets to experience some form of transition. During these transitions, derivative overlays can be used to maintain the desired market exposure. For example, if a given equity manager is terminated, plans may find it useful to ask the manager to liquidate and purchase futures to maintain equity exposure. As illustrated earlier, this methodology can substantially reduce transaction costs but may result in high basis risk.
Expression of tactical views. Overlays also can be used to express tactical views. One of the recent approaches that we have found to be interesting and applicable to pension plans is to purchase long duration credit securities and create an overlay that is designed to reduce the interest rate duration. This way, plans can take advantage of the new issuance and availability of long duration corporate credit but at the same time avoid taking additional interest rate risk given the low yield environment. Figure 4 illustrates the implementation of the strategy, using interest rate swap instruments to create an overlay that reduces interest rate duration. In this case, we compare the duration of the Barclays U.S. Aggregate Bond Index to the combined duration of Barclays Capital Long Credit Index plus a hypothetical interest rate swap overlay hedge.
In essence, plan sponsors are facing a dilemma when it comes to deploying money into fixed income in the current market environment. Many plan sponsors want to ultimately increase their allocation to long-dated corporate bonds to better match assets with liabilities, but also want to delay implementation until rates rise to a certain extent and make yields on these bonds more attractive.
However, long corporate bonds are in short supply relative to potential demand from pension funds and insurance companies. And if rates were to rise meaningfully, a significant number of plan sponsors who currently sit on the sidelines might try to enter the market at the same time as yields reach more attractive levels. This would magnify the supply/demand imbalance existing in the long-dated corporate bond market and could make implementation more challenging. The use of derivatives can help solve this dilemma by letting plan sponsors accumulate long duration corporate bonds without being exposed to the significant interest rate risk that is typically associated with those securities.
Hedge fund replication. Lastly, some plans are considering replacing part of their hedge fund allocations with hedge fund replication strategies, which use algorithms that mimic hedge fund performance. These strategies are relatively new, but are increasingly being offered by sell-side and buy-side firms alike. It is too early to judge whether these strategies will become a core part of pension plans’ investment roster.
Practical considerations on implementation
It is worth noting that these potential benefits also come with some degree of additional risk. For example, operational risks associated with derivatives can be significant, and the changing regulatory landscape may impose unexpected costs, especially if pension plans intend to implement the strategies using in-house resources.
- The first risk to consider is operational risk. Running derivative overlays requires expertise in execution, settlement and collateralization of derivative instruments, and very robust processes that support the potentially rapid turnaround times associated with management of the overlay. For example, collateral calls must be satisfied typically within T+0 or T+1 timeframe, or the position may end up being closed. Invariably, for most plans, outsourcing the execution of their overlays is the preferred option as they can then rely on the operational expertise of professional asset managers.
Another operational consideration is the fact that communication between parties is typically more frequent for overlay strategies than it is for traditional full-authority asset management mandates (see Figure 5). For example, when executing a mandate, a rebalancing overlay manager needs access to the client’s overall target asset allocation as well as the market values of each underlying account or mandate. It is also likely that any change in asset allocation or cash flow will need to be communicated formally in order to avoid any potential misallocations in the overlay. A lack of industry-wide communication standards makes effective communication all the more difficult.
- Counterparty and legal risks require specialist expertise to manage. A large amount of derivatives trading takes place “over the counter” using individually negotiated agreements which spell out terms such as how collateral is posted and which securities are eligible as collateral instruments. It is important that these contracts are negotiated with a great degree of care placed on securing the performance of the counterparty under all market conditions. In addition to contractual considerations, continuous credit monitoring of all transaction counterparties is important and requires substantial credit analysis resources.
- Liquidity and collateral considerations are also extremely important. As discussed earlier, collateral is typically required for transacting in all derivative instruments, as derivative counterparties require periodic exchanges of collateral in order to secure the unrealized gains or losses due to the other party. Sizing the overlay strategies in relation to available liquid assets is necessary from a risk-management perspective, as significant market moves can require raising additional liquid assets in a short period of time. The degree of liquidity that needs to be held is directly related to the size of the overlay positions, volatility of the instruments used and terms of permissible collateral. It should be noted that the types of eligible collateral for OTC transactions can be negotiated with the counterparties as part of the master agreement and could therefore include nearly any asset type. Commonly, however, only cash, Treasury bills and sometimes Treasury bonds are used as collateral. (Prior to the credit crisis, many counterparties accepted a wider range of instruments.)
- Lastly, “basis risk” refers to the risk of a given derivative experiencing performance that is deviating from the underlying target instrument. As illustrated earlier, tradeoffs exist between transaction costs and basis risk. It should be noted that over short periods of time basis risk can arise also from instruments that are considered to have virtually no basis risk over the maturity of the instrument. For example, a total return swap may perform without any basis risk if held to maturity, but if it becomes necessary to adjust the size of the position, temporary dislocations can force the value of the swap to deviate from the market price of underlying physical instruments.
- Another aspect of basis risk is related to the funding cost of the derivative instruments. For example, if overlays are used to convert S&P 500 equity exposures to Russell 2000 (small cap) exposures, and embedded funding cost in the relevant derivative instruments is higher for Russell 2000 exposure than S&P 500 exposure, the strategy will underperform a similar transaction executed through physical instruments (excluding the impact of transaction costs).
Notwithstanding some of the confusion around terminology, overlay strategies have become a mainstay of pension fund management. These strategies can be an effective tool for pension managers, both in terms of enhancing return opportunities and assisting in reduction of unwanted risks. There are multiple considerations for each strategy, however, and a careful assessment of both the potential benefits, risks and costs should be conducted prior to implementation.