Real World Overlay Solutions in Challenging Times

With only a few brief downturns in an otherwise upward trend in the U.S. equity market since the Global Financial Crisis, declining interest rates have pulled forward the net present value of distant earnings and propelled growth stocks (and the market as a whole) higher. Perhaps outsized gains in equity and fixed income markets over this period most likely come with a price: reduced forward-looking return expectations.

Even if we assume long term equity returns will be near recent historical levels—which involves a very strong argument on the power of innovation—Treasuries will be challenged to contribute much to portfolio expected return over the coming decade. Credit spreads of various forms have produced decent risk-adjusted returns in the past, but they bear risks highly correlated to equity markets. This alignment of portfolio risks poses several key questions:

  • Where do we turn for increased returns?
  • How much risk can we tolerate in reaching those returns?
  • Do we rely too much on equity-centric risks to generate returns?
  • How do we mitigate damage from wealth-destroying drawdowns?

An effective investment policy outlines the portfolio structure needed to generate required returns over time, and allowable ranges around asset class targets approved by the oversight body. Most notably, it is the usual benchmark for assessing relative success of an investment staff. Diligent risk control can allow for greater conviction in holding return seeking assets without creating undue risk to the investment policy.

Here are three current themes demonstrating how an overlay program can be a critical tool for success: