One of the potential solutions outlined for managing excessive risk concentration is the use of an overlay portfolio. Overlay portfolios are managed by the plan sponsor or by a third party, and can be used for tactical asset allocation or for hedging of risks incurred by an external manager to which the plan sponsor does not want exposure. The creation and maintenance of such a portfolio is not trivial and its cost must be weighed against the potential advantages of such an approach.
Advantages
The major advantages of an overlay portfolio are customization and non-interference. The targeted risks are customized to the needs of the fund, such that all residual risks are those desired by the managers of the fund.
Since an overlay portfolio is managed outside the confines of other portfolios, it must respond to the risks taken in those portfolios. It does not, however, mandate or impose any further restrictions on a portfolio manager. For example, a fund may choose to hedge the currency exposure of a global equity mandate by using a currency overlay portfolio. The overlay portfolio would hedge the currency exposures based on positions in the global equity portfolio but would not impose any currency exposure restrictions on the managers of the underlying equity portfolio.
The ability to customize risk without imposing restrictions on underlying portfolios is a significant advantage of an overlay portfolio but must be weighed against the drawbacks.
Disadvantages
The hurdles for establishing an overlay portfolio are numerous. Approval for such a portfolio must be obtained before establishing an overlay portfolio. The portfolio must have clear guidelines with respect to the risks it is expected to hedge and what risk levels trigger a need for hedging transactions. This requires an understanding of and a measure of the risks in the underlying portfolios in aggregate since some portfolios may have offsetting risks.
Once the portfolio has been established along with its purpose and guidelines, a list of acceptable hedging instruments must be outlined in the portfolio Statement of Investment Policies and Procedures (SIPP) as well as the acceptable amount of risk in the portfolio.
Outsourcing
Expertise for implementing the risk mitigating transactions must be either generated internally or outsourced to a third party. Depending on the types of instruments available for hedging and their complexity, it may be easier to outsource this function.
Outsourcing the management of an overlay portfolio introduces the need for clear communication so that the third-party manager is informed of hedging requirements immediately and can suggest hedging alternatives to the fund manager. This communication is crucial to the implementation of hedges that are both effective in hedging risk and efficient from a cost perspective. Finally, the fund must monitor hedge effectiveness to ensure the overlay portfolio serves its intended purpose.
To summarize, the overlay portfolio requires a SIPP that introduces the purpose of the portfolio, the intended hedging instruments and the risk vectors that are being hedged. It requires risk measurement of the aggregate fund and efficient communication of the risks to the internal or external experts charged with transacting hedges on behalf of the fund.
Overlay portfolios can be an excellent method of reducing targeted risk but require risk management infrastructure to aggregate fund risk in order to do so effectively.