Given the need to balance risk management and return enhancement, pension plans would do well to consider overlays as one strategy, according to Christopher Jernstrom of Russell Implementation Services.
Good investors will look at both of these issues equally, he told Benefits Canada’s DB Investment Forum in Toronto on Dec 11. “If managers focus on one more than the other, your portfolio can get out of balance,” he said.
Overlays, he noted, can help keep that balance within the portfolio in three ways: using them to implement de-risking or asset allocation changes, currency management and tactical positioning.
De-risking
The return differential between equities and fixed income investments has been volatile over time. For corporate pensions, the volatility has had an affect on funded ratios. “Even if you are not a corporate pension plan, certainly this differential and market impact can create opportunities as well as headwinds,” said Jernstrom.
As a result, plan sponsors can use overlays such as short positions in equity futures to take advantage of opportunities presented by market fluctuations.
Currency management
No matter one’s position on currency — bullish or bearish — it’s still important to consider how it affects portions of an international portfolio, says Jernstrom. Some investors may want to own the currency they invest in while others may not. Overlay tools such as currency forwards or currency smart beta can help balance the desire to own the assets and the currency for a more active currency option. Currency momentum is another way to track currency, but the best way to manage it is to have a diverse set of currency drivers that provide a more attractive risk-return profile and overlay for international assets, said Jernstrom.
Tactical positioning
Investments have a tendency to drift and pose risk in the form of tracking error against policy benchmarks. Overlays can provide a passive rebalancing approach that offsets unintended drift and brings the investor back to policy targets.
Market volatility can create opportunities and overlays can be cost-effective with low trading and holding costs. There can be minimal spread impacts and they can use instruments that are cash efficient, Jernstrom noted.
All the articles from the event can be found in our special section: 2015 DB Investment Forum coverage.