Overlay strategies are investment strategies that use derivatives instruments to increase or reduce certain portfolio exposures, said Bruce Geddes, vice-president with Phillips, Hager & North, speaking at the 12th annual Risk Management Conference in Muskoka, Ont.
Why should we use these? Overlay strategies can help to offset the market value volatility in liabilities and short-term financing costs, Geddes explained.
Overlays can increase interest rate hedging in various types of plans, he said, including those with a traditional 60/40 asset mix or those with universe to long duration fixed income. “The reduction of interest rate mismatch risk can be achieved,” Geddes maintains.
However, there are a number of risk factors in using overlays. Investment risk (portfolio structuring, liquidity, benchmarking) and operations risk (collateral rules/parameters, legal structure and documentation, operational risk infrastructure) are directly manageable risks, he said.
However, counterparty and liquidity risk can be introduced, warns Geddes. And heightened headline risks and unexpected outcomes can also come into play.
Counterparty risk with increasing systemic leverage is also an important consideration. Because if systemic leverage becomes a problem, says Geddes, what is Plan B? It’s important to envision a scenario when hedging is compromised, he added.
There are other effective approaches to overlays, too. Overlay doesn’t necessarily mean interest rate hedging. For example, extra-long duration fixed income (i.e., strips) may be worth exploring, he said.
In terms of governance, overlay strategies should be shared between the plan, the consultant and the investment manager. Plan sponsors must disclose and discuss the potential risks and should also measure the effectiveness and appropriateness of the strategy.
Geddes said it’s important to remember the following when considering an overlay strategy:
• walk through the overlay solution before implementation;
• remember that a range of structures may also be effective;
• make sure the risk/reward trade-offs are sufficiently enhanced; and
• ensure that your investment committee addresses potential unintended outcomes.