The TEXPERS Blog

Untangling the Gordian knot of modern portfolios

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By William Emmett, Guest Columnist

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.

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, 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. This strategy can encompass a number of variations with different effects; because our issue is excess cash, we will focus on cash overlay and rebalancing.

A cash overlay occurs when an investment manager is retained to manage a portfolio of derivatives 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. I 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 changed 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. A cash overlay can be used to allow an asset owner to maintain a higher cash allocation without sacrificing total portfolio return by owning an asset class with a low return (cash).

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. But 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 exactly 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 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 critical, and bad reporting can lead to mistakes in oversight and monitoring with 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.

Asset owners face a wide array of challenges and opportunities in terms of new investments and return or risk enhancements to consider. Cash overlay oftentimes doesn’t make it to the “front burner.” 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.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Callan or TEXPERS.

William Emmett

About the Author: 

William Emmett is a senior vice president in Callan’s Atlanta Fund Sponsor Consulting office. His responsibilities include client service, investment manager reviews, asset/liability hedge construction, fee reviews, investment policy construction, performance measurement, research and continuing education, and coordination of special client proposals and requests. Emmett earned a bachelor's degree in Finance from Georgia State University.