Plan sponsors and their consultants may spend considerable time designing strategic asset-allocation strategies, but “through the course of time, due to market movements and cash flows in or out due to contributions and distributions, target allocations may get out of balance,” explains Brian Roberts, senior consultant at NEPC, LLC in Boston.
An NEPC paper written by Roberts says derivative overlay strategies offer an array of benefits, which can include securitizing idle cash, maintaining policy target exposures and managing transitions within the portfolio. An overlay solution can also help manage risk related to currency exposure, equity beta or, particularly for corporate pension plans, interest rates. In addition to maximizing the efficiency of an investment portfolio, overlay strategies also aim to keep costs low through the use of liquid and transparent derivatives that are a cheaper alternative to trading physical securities.
Roberts explains to PLANSPONSOR that an overlay strategy is one for which a plan sponsor has a manager in place that oversees the overall asset allocation and makes adjustments using derivatives to keep the asset allocation at its target. For example, if the asset allocation is out of balance due to a run up of equities, an overlay manager, based on very specific, pre-determined rules agreed with the plan sponsor, using derivatives, will obtain the market exposure that is missing.
Roberts says “derivatives” is a broad term, but the primary focus of the paper is the use of exchange-traded futures. “This is the type we would anticipate most plan sponsors would employ,” he says. A futures contract is an agreement between two parties to exchange a security at a future date at an agreed upon price. But, you get that asset class exposure for only a fraction of the capital required to purchase a security.
How Does a Derivative Overlay Strategy Work?
Roberts uses the example of a long-term target allocation of 60% in the S&P 500 and 40% in the Barclays Aggregate Index that gets off balance because cash is needed on hand in preparation for paying a distribution. The asset allocation may be only 55% S&P 500/35% Barclays, with 10% in cash. An overlay manager can allocate 5% to equity and 5% to fixed income without using all the cash to get the exposure.
The paper explains that if the portfolio has $100 in cash, it may require only $5 in initial margin to get the equity exposure—leaving $95 in cash available. “Once benefits are paid to plan participants, the overlay manager can adjust the derivatives exposure to the most up-to-date cash position,” Roberts adds. “Whatever cash is there is effectively invested, not more or less. That’s an example of how an overlay manager can move quickly in and out of positions.”
Just with any investment, there is no guarantee with the derivative overlay that the portfolio will always gain. The gain or loss gets credited every day, Roberts says. Every day there is a mark to market where the buyer or seller will pay a variation margin to maintain the value of the contract. It is really about measuring over the long term how keeping cash invested will benefit the portfolio. Cash is a drag on return over time. According to the paper, based solely on the estimated historical value provided by equitizing cash and rebalancing, an overlay provider’s net benefit-to-cost ratio can be as much as 7:1.
One of the benefits of an overlay strategy specific to pension plans is interest rate hedging. This is beneficial to corporate pension plans that have adopted a liability-driven investing (LDI) framework, Roberts notes. The overlay strategy gives plan sponsors the ability to manage assets to liabilities in such a way that when interest rates move, assets in the plan move to match liabilities. There are two ways an overlay strategy can help, he says.
First, an overlay manager can monitor and maintain the interest rate hedge ratio more closely. “If you want to hedge 50% of interest rate exposure, you can do that fairly well with other investments, but market moves, etcetera, can put it off balance,” Roberts says. “An overlay manager can look at it daily to maintain the hedge ratio.” He adds that for plans that have a glide path in place, and want to increase the hedge at a certain trigger, an overlay manager can act on that intra-month at any given day. “Doing that intra-month captures spikes in the market instead of waiting until you get the month-end report and risking that the market is off again; you can capitalize on shorter-term market movements.”
The second way overlay strategies can be helpful with interest rate hedging is they help manage the hedge ratio across the yield curve. According to the paper, for LDI implementation done with fixed income strategies benchmarked to a common index, such as the Barclays Long Credit Index, there may be a mismatch in duration between assets and liabilities along the yield curve. An overlay manager can improve the effectiveness of the hedge by filling in the gaps that may exist between liabilities and assets at various points in the yield curve, that is, key rate durations, and move a plan’s target hedge ratio along a pre-determined “glide path” on any given day, thereby taking greater advantage of intra-month moves in rates and return-seeking assets.
There are things to keep in mind when selecting an overlay provider and when implementing the overlay strategy—all discussed in the paper—but, the bottom line is incorporating an overlay strategy helps maintain target allocations with greater liquidity, and for plans using LDI, the strategy helps the portfolio move along the glide path more efficiently, Roberts concludes.
The NEPC paper, “Overlay Strategies: Increasing Portfolio Efficiency Through Derivatives” is here.