Modern portfolios are increasingly complicated as they have expanded beyond stocks and bonds. The management of those portfolios—and the attendant illiquidity that can come with alternative investments—has many asset owners staring at a Gordian knot very much in need of untangling. With Alexandrian efficiency, a futures-based cash overlay can slice through many of the issues complicating cash allocations and return the portfolio to its targeted risk and return expectations.
Both the return of volatility to markets and the continued low return of cash emphasize the importance of asset owners using every tool at their disposal to manage their portfolio allocations. Holding cash is a necessary but painful requirement to manage both outgoing cash flow requirements and the uncertain timing of funding or liquidity of alternative assets. Unfortunately, this “cash drag” can cause portfolios to painfully undershoot their target returns.
In addition, volatility and low covariance among assets within a portfolio create more opportunities to rebalance (one investment zigs while the other zags, statistically speaking), but the timing and transaction costs associated with moving securities can be an obstacle. So how can an asset owner maintain a properly diversified portfolio and manage costs while still taking advantage of the opportunities created by volatility?
One potential solution is what is known broadly as a “portfolio overlay.” There are different names for this strategy, because it can encompass a number of variations with different effects. Because our issue is excess cash, we will focus on cash overlay and rebalancing.
Simplistically, a cash overlay occurs when an investment manager is retained to manage a portfolio of derivatives (usually futures, held long and potentially short) to modify the market exposure of the cash portion of the portfolio. Specifically, the manager will be adding beta and/or duration in order to more closely mirror the target allocation of the portfolio. We mention rebalancing as a component of a cash overlay because if the overlay manager is allowed to use long and short derivatives exposures, the market exposures of other parts of the total portfolio (and not just cash) can be increased or decreased to almost exactly mirror the target allocation (without incurring the transaction and market impact costs of selling the physical securities).
As the margin requirement for maintaining futures exposures is relatively low, a small funding account can result in a large change in economic exposure. In its most limited version, a cash overlay can be used to allow an asset owner to maintain a higher cash allocation (to meet cash requirements for benefit payments, for instance, or to fund alternatives) without sacrificing total portfolio return by owning an asset class with a low return (cash).
How It Works in Practice
Here’s a simple model to explain how cash overlay works in practice. Assume a portfolio’s target allocation is 60% equities and 40% fixed income. If the expected returns on equities, bonds, and cash are 7%, 3.5%, and 1%, respectively, the target return on the portfolio would be 5.6%. But in practice, 10% of the portfolio is in cash for operational liquidity needs, and the other assets are in a 55%-35% equities/fixed income split. Now the portfolio has an expected return of 5.2%, revealing 40 basis points of expected performance drag due to the portfolio’s operational cash needs.
Thus, the actual portfolio is already underrisked and below target for return purposes. In an era when every basis point matters, leaving 40 bps unaccounted for because of a non-strategic cash allocation is problematic. To maintain the flexibility of cash while allowing the portfolio to achieve returns closer to target, a fund sponsor could incorporate a cash overlay solution.
What are the issues to contemplate with a cash overlay?
- Typical cash overlays are funded with a small margin account and use exchange-traded futures, which provide liquidity and eliminate counterparty risk. But the tradeoff is that not all asset classes (particularly alternatives) have an active market in these futures. Thus, the overlay benchmark created to “equitize” the cash allocation may not mirror the overall portfolio benchmark.
- Because the economic exposures of the cash overlay exceed the size of the margin account, asset owners will have to slightly adjust their performance reporting to reflect returns with and without the overlay.
- The quality of the reporting on the cash overlay program, provided by the manager, is a highly important part of fully understanding these investments. Bad reporting can lead to mistakes in oversight and monitoring and a potentially bad outcome.
- The overlay manager has a separate fee schedule. While not typically as high as a traditional manager, it is not zero.
- The investment policy statement may have to be amended to include a specific derivatives policy.
Once plan sponsors are comfortable with the idea of using an overlay to equitize cash, they can explore other compelling opportunities to synthetically alter their portfolio allocations in a relatively lower-cost way without having to trade or settle cash securities. A portfolio overlay strategy can:
- Adjust duration for defined benefit plans that have reached a trigger on a derisking glide path
- Adjust overall portfolio risk for all or a portion of a portfolio that is needed to fund something with a specific timing, such as an annuity purchase
- Immediately “invest” a large cash contribution at the target portfolio risk and return without having to wait on the investment managers to purchase the actual securities
- Quickly rebalance portfolio allocations during periods of volatility
- Implement near-term asset allocation decisions, if desired
Asset owners face a wide array of challenges and opportunities in terms of new investments and return or risk enhancements. Cash overlay oftentimes doesn’t make it to the “front burner,” and the idea of using derivatives in the portfolio can present an educational hurdle for both committee members and other internal/external stakeholders. However, as long as holding cash is a return drag versus the target return on the portfolio, a small change to the operation of the portfolio can bring to bear a powerful set of tools to assist asset owners in accomplishing their goals.