What Is Overlay?

Overlay refers to a management style that harmonizes an investor's separately managed accounts. Overlay management uses software to track an investor's combined position from separate accounts. The overlay system analyzes any portfolio adjustments to ensure the overall portfolio remains in balance and to prevent any inefficient transactions from occurring. Overlay portfolio management makes sure the investor’s strategies are implemented and coordinated successfully.

Overlay portfolio management is often used with the portfolios of institutional investors and ultra high net worth individuals. Money managers and financial advisors employ it to oversee and track the various investor accounts in their care.

Key Takeaways

  • Overlay refers to an asset management style that uses software to harmonize an investor's separately managed accounts.
  • The overlay system analyzes any portfolio adjustments to ensure the overall portfolio remains in balance, preventing inefficiencies and coordinating efforts in line with a client's tax situation and risk tolerance.
  • Overlay often involves the assets being combined in a unified management portfolio, overseen by a manager, to whom individual asset managers make recommendations.

How Overlay Works

When an investor has separately managed portfolios, he is placing assets under the control of different managers. This set-up can cause inefficiencies if the managers begin making transactions that either increase the risk of the overall portfolio, have negative tax effects, unbalance the investor's positions, or work at cross purposes. For example, if one of the separately managed account traders purchases an asset, and another trader sells it, the investor is left with a neutral position and two transaction fees.

Overlay management seeks to improve the communication between the separate managers, allowing for increases in transaction efficiency. In traditional separately managed account structures, clients' capital is delegated to multiple outside managers to invest, but in an
overlay system, the assets—and the ultimate responsibility—stay together
in a unified managed account. Overlay portfolios should have a stated purpose and specific guidelines to avoid issues arising. For instance, the overlay manager may determine maximum allocations across an entire portfolio or require that investments are made in a particular asset class.

In some ways, the role of the overlay manager is analogous to that of an orchestra conductor. The overlay manager (conductor) coordinates the activities of the underlying managers (musicians) to ensure a harmonious outcome.

Advantages of Overlay Portfolio Management

  • Rebalancing: An overlay manager ensures an investor’s total holdings are rebalanced when necessary. For example, an investor may want a portfolio allocation of 30% equities, 30% fixed income and 20% cash. If these asset classes are held in three different accounts, the overlay manager makes adjustments to maintain these allocations.                                                     
  • Risk Management: Risk can be managed more effectively using an overlay manager. Portfolios that hold different asset classes, investment types and hedging strategies can be monitored to make sure the portfolio is remaining within the investor’s risk parameters. For example, if an investor is employing a long/short investment strategy through different trading accounts, an overlay manager can monitor the overall net exposure.                                                                                   
  • Tax Management: Overlay managers can monitor capital gains and losses across an investor’s separate accounts to help manage their tax obligations. For instance, an overlay manager may decide to sell a losing investment in one account to partially offset a large capital gain in another account.                             
  • Simplicity: Overlay portfolio management makes a complex multi-investment strategy easy to implement. Accounts can be consolidated into a single master portfolio, with a single statement, to minimize paperwork and client compliance agreements. If the investor has a query about his portfolio, he or she has a single point of contact.

Pros

  • Professional asset management and allocation

  • Near-automatic rebalancing, risk management

  • Tax management

  • Single contact for investor

Cons

  • Time-consuming to establish

  • Compliance approval needed

  • Ongoing communication, meetings

  • Accounts, assets all at one firm

Limitations of Overlay Portfolio Management

If the different portfolios have complex investment strategies, an overlay system may be time-consuming to set up. Gathering documentation from various fund managers and understanding their approach toward portfolio construction and risk management may require numerous meetings to ensure effective coordination—not just initially, but ongoing.

Also, an overlay portfolio typically needs to be approved by various compliance departments before it can be established.

Real World Example of Overlay

Many wealth/asset management firms and trust companies offer overlay services to their clients. Piper Jaffray is one such. Clients who opt for a Unified Managed Account are assigned an overlay portfolio manager, who has responsibility for the day-to-day management of the assets, based on the client's stated goals, needs, preferences, risk tolerance, etc. This manager, in turn, receives investment advice from other investment managers in the form of a model portfolio—a recommendation of specific securities and transactions. The overlay portfolio manager decides whether or not to execute these recommendations, and to what degree, in line with the client's tax situation, current asset allocation, and degree of aggressiveness.