Confessions of an Overlay Manager

Executive summary:

  • Derivatives are a marvel—you can experience the practical benefits of holding cash while minimizing long-term performance drag.
  • We obsess about managing the risks of portfolio changes and cash flows.
  • The role of an overlay manager often develops into a trusted advisor and an extension of staff.
  • Prepare for tomorrow's challenges by flexing the power of a multi-faceted portfolio tool.

Our director of Customized Portfolio Solutions and overlay portfolio management, Brian Causey, shares his key takeaways from 20 years working on overlay solutions.

Confession #1: Cash is every portfolio's necessary evil and occasional best friend.

Among the world's most useful inventions, cash is essential to the smooth operation of most aspects of life—from purchasing daily necessities to one-off expenditures to retirement planning. It's the same with portfolio management. Cash is needed for expenses, capital calls, and paying beneficiaries, while also being the primary method for manager redemptions, private market distributions, and plan sponsor contributions.

There aren't many jobs that would consider cash as the enemy. Most jobs are in pursuit of obtaining more of it! But as an overlay manager, I look at cash in a total portfolio context, recognize its long-term drag on performance, and seek to eliminate it. The enemy here is cash drag and it's not trivial—over the last 40 years, a typical institutional portfolio would've missed out on 15.3 basis points per annum.1 To put this in dollar terms, a $5 billion portfolio is missing out on $7.7 million of gains per year. Thankfully, most institutional investors recognize the necessary evil that cash plays in a portfolio—they need it for operations but would much rather have it invested in higher-yielding assets. This is a dilemma, but there's a viable solution thanks to another invention: derivatives. An overlay manager can use derivatives to capture the market risk premium while only needing a small portion of the cash to do so. In the world of finance, this is about as close to having your cake (market risk premium) and eating it too (having cash on hand for operations). Despite over 20 years of working with derivatives, I still marvel at these simple advantages.

One ancillary benefit here is that with an overlay program in place, investors are less pressured to run thin cash balances. In times of crisis, cash is king. So, having more liquidity in the portfolio can make a crisis a bit easier to manage.