Overlays Wake Up From Long Slumber

Here’s a piece of little-known trivia:  When this website was being conceived, the leading candidate for a name was “ActiveOverlay.com”, not AllAboutAlpha.com.  But the term “overlay” was generally used to describe active currency management, not active equity management.  Besides, “ActiveOverlay.com” elicited a lot of blank looks among those not familiar with institutional portfolio management techniques.   So we eventually settled on the more mainstream name in use today.

Since that time, active overlay has also come to refer to the process of tax management in unified managed accounts (see posting).  But it never seemed to catch on as a term used to describe alpha-centric investing techniques such as 130/30 (which can be alternatively described as a beta portfolio with an active overlay).  In fact, a Google search of “active overlay” returns precious few citations referring to equity overlay management (a.k.a. beta overlays or long/short overlays).

AllAboutAlpha contains only one posting (out of 300+) on the topic.  In 2004, the Canada Pension Plan began using an active overlay strategy that amounted to synthetically shorting against their $80 billion passive portfolio.  The CPP awarded four $500m “notional mandates” to manage in a market neutral (read: all alpha) strategy.  But that was three years ago.  Since then, no one seems to have seen much of the term “overlay”.

However, after several years asleep in the woods, “Overlay-Van-Winkle” seems to have stumbled into town by way of this Hedgeworld piece (free registration required).  It’s a little thinner, hasn’t showered in years and has a long “mountain man” beard.  But most alarmingly, it seems to also have amnesia.  And no one is sure exactly who it is, or what it’s supposed to do now…

Says Hedgeworld:

“Separation of alpha and beta is the mantra du jour in portfolio management, though the concept is hardly a new one. Portable alpha and hedge fund replication indexes are some common applications of the idea. One investment tool at the heart of those variable applications is the overlay. Known mostly for its protection against downside risk, the overlay is also used to actively manage a portfolio and can be applied to portable alpha portfolios or asset allocation rebalancing.”

The article goes on to support our theory that “overlay” is the wildcard of the hedging lexicon – it can mean just about anything.  For example, Hedgeworld says it can apply to risk management:

“(A) manager with a market exposure to the Standard and Poor’s 500 stock index will need to protect his portfolio against a stock market decline. One way to do that is by buying a put option on the index…”

…it can mitigate liquidity concerns:

“An overlay may be used to avoid redemptions. If the market turns the wrong way, a manager can protect himself from redemptions by limiting market exposure and hedging the risk.”

…and it can provide a method of normalizing manager returns for apples-to-apples comparisons:

“…an overlay is useful as a tool to compare two managers.”

Hedgeworld asks Robert Kulperger of Northwater Capital to define overlay.  His response:

“Portable alpha typically combines an alpha exposure obtained through an alternative investment such as a fund of hedge funds, direct hedge funds, private equity or real estate and beta exposure through a derivative instrument, such as a futures contract or swap. People often refer to the beta exposure as a type of overlay.”

So while the Canada Pension Plan calls their active management an “overlay”, their fellow Canuck says its actually the passive (beta) element that constitutes the “overlay”.  Kulperger adds that his beta overlay can also be used as a portfolio rebalancing tool to move institutional mandates back to their policy allocation quickly.

Okay, so there seems to be some debate about the definition of “overlay”.  But thankfully, a lack of definitions has never stopped people from measuring things.  In fact, Pensions & Investments ran a recent story about overlay managers (“Overlay managers see 48% increase“) as part of their ranking of the largest US institutional money managers.  (ed: hedge funds only grew 37% according to the same survey.)

P&I says the “notional value” of overlays has increased 172% over the past 3 years (see full ranking).  However, the definition of overlay used in this survey includes everything but the kitchen sink: “derivative, currency, dollar duration, options overwriting, market-neutral or global tactical asset allocation strategies.”  In addition, its not clear how “notional value” compares to asset value (for example, the #1 ranked manager reported $127b of “notional value” to P&I, but only reports around $35b of actual assets under management).

According to some of the managers on P&I’s list, the overlay market could reach “$1 trillion” in a few years.  If that does happen, it will likely involve the model used by the Massachusetts Pension Reserves Investment Management Board.  Apparently PRIM hired Russell for “beta overlay exposure” on a $2 billion portable alpha strategy last August.

Why the growth?  According to P&I’s research, more pension executives “accepted and understood the use of such strategies”.  But alas, the majority of this growth has come from overlays of the old-fashioned currency variety, not the equity beta variety, and certainly not the active variety (a la Canada Pension Plan).

The bottom line is that something – no one is sure exactly what – is growing like crazy.  And as soon as we figure out what it is, then fasten your seatbelts.

So I guess we’ll hold onto the URL ActiveOverlay.com a bit longer.  Who knows?  Maybe it will be worth something someday.

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  1. Tris Lett
    June 13, 2007 at 4:37 am

    From my point of view, active overlay and portable alpha are one and the same class of stratgeies that incorporate one necessary ingredient; alpha/beta separation. In its typical form it involves a cash investment and a derivative. The overlay(notional)can be the beta portion or the alpha portion as can the cash portion, but not usually at the same time.

  2. Bob Kulperger
    June 25, 2007 at 2:51 pm

    Not to quibble (because I hate to be a quibbler) but the quote attributed to me was actually supposed to be an example of overlay (as found in the last sentence in the quote: “a type of overlay”), not my or Northwater’s definition of overlay. I don’t think my view is in contrast to that of CPP or any other Canuck. In fact, my earlier quote in the Hedgeworld article was more in agreement with your point on the P&I numbers and the CPP use of overlay (“the uses of overlay are almost endless”).

  3. Alpha Male
    June 25, 2007 at 4:01 pm

    Bob, Thanks for the clarification…not a quibble at all.

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