Insights
Extensive Capabilities of an Overlay Program: More than Meets the Eye
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Insight Article
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September 05, 2025
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Extensive Capabilities of an Overlay Program: More than Meets the Eye
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September 05, 2025
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Extensive Capabilities of an Overlay Program: More than Meets the Eye
Extensive Capabilities of an Overlay Program: More than Meets the Eye |
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Overlay programs seek to address numerous unique exposure or risk management challenges that investors face. Let’s consider the wide range of what an overlay can do.
For many institutional investors, overlay programs are considered a best practice. This approach may be narrowly understood as the use of futures to equitize cash or rebalance the portfolio. While these elements form the anchor of many programs, this limited characterization can obfuscate the full opportunity set of overlays.
Cash overlay and rebalancing have the potential to help investors optimize management to their broad strategic asset allocation. Once this broad allocation has been set in motion, investors still need to identify other key risks in the portfolio.
At Parametric, we believe consultation, customization and flexibility are three key elements of a successful and holistic overlay program that can expand beyond traditional asset classes to help curb residual portfolio risks and adjust quickly as conditions change.
Hidden misalignments—such as factor or sector exposures relative to the benchmark—often drive unintentional portfolio risks. Because these misalignments can occur within a portfolio both sporadically and systematically, we believe they must be periodically monitored. We see investors using an overlay to tackle these exposure challenges via three main methods: equity completion, duration management and nontraditional exposures.
Equity completion
No equity market narrative seemed more pervasive over the past year than the rise of the Magnificent Seven, highlighted by growing investor concern over concentration within major benchmarks such as the S&P 500© Index. A natural extension of this discussion is equity completion—a tool that can be used to address the concentration of “Mag 7” names.
When approaching completion problems like this, Parametric starts from a point of neutrality. Rather than expressing a tactical viewpoint on the direction of specific stocks or market factors, we consult with investors to provide quantitative data and analytics around portfolio exposures relative to their benchmarks. Armed with this holistic and objective understanding of their portfolios, investors can integrate their own market views with their sentiments on the portfolio’s misalignments.
What often comes to mind with equity completion is a manager filling the gaps to better match the benchmark. Yet it can also be a tool for investors to express explicit exposure tilts based on their distinct market outlooks.
Whether an investor is seeking to remove an unintentional risk or express a tactical tilt, equity overlay completion may provide the flexibility to accomplish these objectives in a transparent and capital efficient manner. Investors have partnered with Parametric to design custom solutions to achieve their desired equity exposures.
Duration management
With the rising prevalence of liability-driven investing (LDI) over the past decade, plan sponsors for corporate defined benefit plans have been well versed in duration management for years. In LDI, duration management is perhaps the single most consequential asset allocation decision. To that end, investment policy statements tend to explicitly define key parameters, and an overlay manager actively maintains the desired levels.
Increasingly, duration completion has been applied outside the scope of pension asset liability management. Anecdotally, we’ve seen more public plans, endowments and foundations making significant changes to their fixed income allocations to take advantage of yields untethered to zero.
As fixed income plays a bigger role in institutional portfolios, we think it’s essential to understand the duration positioning to avoid any unintentional tilt. With investors whose portfolios are systematically underweight to their fixed income benchmark duration, Parametric has discussed adding a duration overlay and designing custom duration extension portfolios to tactically move out on the yield curve.
Nontraditional exposures
Beyond equity and fixed income, overlay management has a wide array of applications to nontraditional exposures. As long as inflation remains an ongoing concern, commodities can be considered for their potential to hedge against an unexpected inflationary environment. The robust market for commodities derivatives may be used to carve out an easily adjustable, capital efficient and transparent allocation, either to a benchmark or a customized blend of exposures.
Investors have also sought allocations to diversifying strategies that are designed to hedge against market drawdowns. Direct hedging, such as put-spread collars, can alter the return profile of a portfolio. The investor pays an explicit upfront cost—and sometimes an implied opportunity cost—to protect against a possible unknown equity drawdown. Parametric works closely with investors to design the right options structure for their budgets and needs.
More recently, using trend following strategies for risk mitigation has regained traction. While not a direct market hedge like options, these strategies work through exploiting behavioral biases to create a return stream that is largely uncorrelated to the broad market. Trend following has been shown to produce a convex profile during market drawdowns.1
When implemented through traditional active managers, trend programs can be inflexible, illiquid and unruly to adjust. If implemented as part of an overlay, however, trend following has the potential to deliver trend beta in a flexible overlay wrapper, which can be seamlessly integrated into the portfolio.
The bottom line
For many investors, an overlay program is a deeply embedded tool to help efficiently manage and toggle beta exposure. For others, all the capabilities presented within the overlay toolbox can be complex and overwhelming. Parametric’s approach is to start with the highest impact projects while laying the foundation for other possible needs. Being prepared by having an overlay infrastructure in place may allow for quicker responses to unexpected portfolio needs as the risk environment evolves.
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Heather Wolf
CFA
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Managing Director, Co-Head of Overlay Solutions
Parametric
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