Overlay Strategies for Institutional Portfolios

Overlay strategies use derivatives layered on top of existing portfolios to adjust exposures without trading underlying assets. Institutional investors employ overlays for currency hedging, duration management, equity beta adjustment, and tactical asset allocation—reducing transaction costs and maintaining continuity with external managers.

Definition and Key Concepts

What Is an Overlay

Overlay: A derivatives-based strategy that modifies portfolio characteristics without changing underlying holdings.

Common Overlay Types

Overlay vs. Direct Investment

How It Works in Practice

Currency Overlay

Situation:

• Pension fund with $500 million in international equities
• Unhedged currency exposure: EUR (40%), GBP (25%), JPY (20%), Other (15%)
• Policy: Hedge 50% of developed market currencies

Overlay implementation: Sell forward contracts against USD:

Roll schedule: Quarterly forward rolls

Duration Overlay

Situation:

• Fixed income portfolio duration: 6.0 years
• Liability duration: 8.5 years
• Duration gap: 2.5 years
• Portfolio value: $300 million

Overlay solution: Extend duration using Treasury futures

Calculation: Required DV01 = $300M × 2.5 years × 0.01% = $750,000

10-year Treasury futures DV01 ≈ $800 per contract

Contracts needed = $750,000 / $800 = 938 contracts

Result: Long 938 T-Note futures extends duration to match liabilities.

Equity Beta Overlay

Situation:

• Equity portfolio: $400 million
• Current beta: 0.85 (defensive managers)
• Target beta: 1.00
• S&P 500 futures multiplier: $250 × index

Beta adjustment: Beta gap = 1.00 - 0.85 = 0.15

Dollar exposure needed = $400M × 0.15 = $60M

S&P 500 at 5,000: Contract value = $250 × 5,000 = $1,250,000

Contracts needed = $60M / $1.25M = 48 contracts long

Worked Example

Institutional setup:

• Total fund: $1 billion
• International equity: $300M (30%)
• Domestic equity: $400M (40%)
• Fixed income: $300M (30%)

Current characteristics:

Overlay Implementation

1. Currency overlay: Hedge $150M of international exposure:

• Sell €60M forward (EUR exposure: $120M × 50%)
• Sell £25M forward (GBP exposure: $60M × 50%)
• Sell ¥10B forward (JPY exposure: $80M × 50%)
• Other currencies: $40M × 50% = $20M equivalent

2. Equity overlay: Beta adjustment = $700M total equity × 0.08 = $56M S&P 500 contracts = $56M / $1.25M = 45 contracts long

3. Duration overlay: Required DV01 = $300M × 1.3 years × 0.0001 = $39,000 10-year futures contracts = $39,000 / $800 = 49 contracts long

VaR Analysis

Pre-overlay VaR (95%, 1-month):

Post-overlay VaR:

VaR reduction: 8% (currency hedge benefit exceeds added equity/duration risk)

Margin Requirements

Liquidity reserve needed: $14M (1.4% of fund)

Risks, Limitations, and Tradeoffs

Basis Risk

Operational Complexity

Cost Analysis

Compare to transaction costs of rebalancing underlying: 0.50-1.00%

Common Pitfalls

Governance and Controls

Overlay Policy Elements

Reporting Requirements

Daily:

• Mark-to-market P/L
• Margin utilization
• Counterparty exposure

Monthly:

• Hedge effectiveness
• VaR attribution
• Cost analysis

Quarterly:

• Policy compliance
• Strategy review
• Board reporting

Checklist and Next Steps

Pre-implementation checklist:

• Define overlay objectives
• Select instruments for each overlay type
• Calculate initial hedge ratios
• Establish counterparty relationships
• Set up margin funding facility
• Document overlay policy

Execution checklist:

• Verify current portfolio exposures
• Calculate required overlay positions
• Execute trades across asset classes
• Confirm trade details
• Set up position monitoring

Ongoing management:

• Monitor hedge ratios daily
• Rebalance when triggers hit
• Track roll calendar
• Manage margin calls
• Report to oversight committee
• Review effectiveness quarterly

Related articles:

• For hedge testing, see Hedge Effectiveness Testing for Accounting
• For hedging approaches, see Dynamic vs. Static Hedging Approaches