Rethinking overlay manager diversification
Diversification is the foundation of risk management and asset allocation. The core principles associated with this framework reason that more uncorrelated investment strategies and perspectives should result in lower volatility, especially as those perspectives are increasingly specialized. These principles, as well as the overarching theme of efficiency, are top-of-mind for all institutional investors.
Efficiency is especially relevant for those who have implemented a derivative overlay strategy in their portfolio. After all, any overlay strategy, whether it’s cash equitization or dynamic rebalancing, is designed to capitalize on the advantages that derivatives can provide to a plan. However, we believe many sponsors who have chosen this structure are unknowingly undermining these objectives by employing multiple overlay managers.
It is prudent for plan sponsors to hire numerous managers to oversee their physical investments. Employing several equity managers can provide diversification while generating outperformance due to style differences between the firms. The same can be said for fixed income. But the considerations are different when appointing an overlay manager. Because overlay structures are designed to work in concert with the underlying portfolio allocations, the benefits of manager diversification are already present within the program; unfortunately, this is often overlooked. What’s worse, plans that are using multiple overlay managers are incurring greater costs without necessarily achieving any greater benefit.
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Rethinking overlay manager diversification
LDI
At LGIM America, we believe overlay manager diversification is likely inefficient and creates uncompensated risks. Using multiple overlay managers can result in increased costs, collateral inefficiency and higher governance burdens.
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