Investors looking to reduce risk and enhance returns may be able to use overlays to better balance their portfolios, said Christopher Jernstrom, portfolio manager at Russell Implementation Services. He was speaking at the Investment Innovation Conference last November. In his presentation, “Using Overlays to Balance the Yin and Yang of Your Portfolio,” he explained that the Taoist symbol, the yin and yang, represents two opposite forces that join together cohesively, creating a well-balanced whole. That can be clearly tied back to portfolio management.“There are two areas in investment management which actually go hand-in-hand with yin and yang – risk management and return enhancement,” said Jernstrom. “Good investors realize you have to have both of these elements in a well-managed portfolio. If you focus on one more than the other, your portfolio can get out of balance.”Overlays can provide that balance through tools such as derivatives and exchange-traded funds (ETFs) that create a better balance between risk and return. This is particularly useful in three key areas of interest to plan sponsors right now: de-risking, currency management (relating to both return enhancement and risk mitigation) and tactical positioning (focused on return enhancement).
COPING WITH VOLATILITY
For example, Jernstrom explained, an overlay approach to de-risking can help plan sponsors move the biggest parts of the portfolio first, removing exposures they don’t want and maintaining the ones they do. It allows plans to move faster and lay a foundation that allows sponsors the time they need to make the physical shift.
An overlay approach is also an excellent way to manage currency exposure, particularly in today’s volatility environment. Jernstrom explained that a passive currency hedging overlay can help plan sponsors with global assets who don’t want to own the currency – and an active approach can benefit those plans that do want exposure.
Finally, he explained that they can be used to respond quickly to market opportunities – “An overlay gives you the time to make that physical portfolio shift without worrying about the market opportunity slipping away,” he said.
At the end of the day, as plans face increasing market volatility and risk, they remain under intense pressure to balance their risk management and return enhancements. “One of the nice things about an overlay is that it allows you to implement multiple types of yin-yang balancing strategies, all on a single investment platform,” Jernstrom concluded.