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