What is Overlay
Overlay refers to a management style that harmonizes an investor's separately managed accounts, preventing the formation of inefficiencies. 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. In summary, overlay portfolio management makes sure the investor’s strategies are implemented and coordinated successfully.
BREAKING DOWN Overlay
When an investor has separately managed portfolios, they are placing assets under the control of different managers. This can cause inefficiencies if the managers begin making transactions that either increase the risk of the overall portfolio, have negative tax effects or unbalance the investor's positions.
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.
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. (For more, see: Deducting Stock Losses: A Guide.)
- Simplicity: Overlay portfolio management makes a complex multi-strategy easy to implement. Accounts can be consolidated into a single account to minimize statements and client compliance agreements. If the investor has a query about his portfolio, he or she has a single point of contact.
Limitations of Overlay Portfolio Management
Portfolios that have complex investment strategies 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. An overlay portfolio typically needs to be approved by various compliance departments before it can be established. 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.