From the July 2007 issue of Investment Advisor • Subscribe!

Overlay Uses 101

Separation of alpha and beta appears to be the mantra du jour in portfolio management, though long-time observers are aware that the concept is hardly a new one. Portable alpha and hedge fund replication indexes are among the common applications of the underlying idea. One investment tool at the heart of those variable applications is the "overlay."

Known mostly for its protection against downside risk, the overlay can also be used to actively manage a portfolio and can be applied to portable alpha portfolios or asset allocation rebalancing.

A Hedge is One Definition

An overlay is often defined as a hedge. For instance, a manager with a market exposure to the Standard and Poor's 500 stock index will need to protect his equity portfolio against a stock market decline. One way to garner that protection is by buying a put option on the index as puts are bets on a price decline. In such a case, if the S&P 500 index drops, the put will offset the losses in the portfolio. In this example, the put option is the derivative overlay.

"Overlay is derived from the same concept as portable alpha. But with an overlay, you neutralize the market exposure; you use it as a hedge," said Olivier Le Marois, chief executive of Riskdata S.A., a Paris-based provider of risk management solutions. "Investors add derivatives overlay to their portfolios in order to actively manage market risk."

Another use of the overlay can be when it comes to handling problems managing liquidity risk. "If a portfolio is illiquid and turns sour, don't liquidate it, just hedge it," adds Le Marois.

The Portable Alpha Application

The overlay strategy can also be used by managers in the implementation of portable alpha programs.

"Portable alpha typically combines an alpha exposure obtained through an alternative investment such as a fund of hedge funds, direct hedge funds, private equity or real estate and beta exposure through a derivative instrument, such as a futures contract or swap. People often refer to the beta exposure as a type of overlay," according to Robert Kulperger, vice president of marketing at Northwater Capital Management Inc., a hedge fund of funds company with offices in Toronto, New York, and Chicago that has more than $9.2 billion in AUM.

A Tool for Rebalancing

Another important application of overlays, Kulperger says, is as an effective tool to rebalance a portfolio. When an institutional investor's allocation to a particular asset class is off target, the use of an overlay trade may allow that investor to fill the gap in the interim, he points out.

For instance, the investor may have a stated equity target allocation of 30% but currently has only 25% in the class for any number of reasons, such as because a manager was terminated or because the asset class has been guilty of underperformance. In such a case, by using derivatives, the institutional investor may be able to quickly add the extra 5% exposure. The same type of trade may be employed at the end of the year to quickly rebalance a portfolio back to its strategic allocation, Kulperger said.--Jeff Joseph and Emma Trincal

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Jeff Joseph serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products. Emma Trincal is a senior financial correspondent for HedgeWorld. For information about HedgeWorld's services, send e-mail to: inquiry@hedgeworld.com

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