By Travis Morgan, CFA, CIPM
Understanding overlays can be quite the chore if you’re not dealing with them on a daily basis. Arriving at an accurate return calculation represents an additional level of complexity that tends to leave people scratching their heads in confusion. An overlay is not your typical strategy where a manager invests assets in stocks or bonds. Overlay, can be partially funded or unfunded, with the exception of a small amount of cash set aside to take care of any realized losses. There is a separate basket of assets that represents the underlying portfolio; however, an overlay manager typically has little to no knowledge regarding these assets. Instead, the overlay manager will manage their portfolio to a targeted exposure amount agreed upon between the manager and the asset owner. For performance, this is the root of the problem.
Typically with performance you would take the profit/loss for the period and divide it by the portfolio’s beginning capital base. Calculating the profit/loss is the easy part; simply sum up the realized and unrealized gains and losses for the period, plus any income generated during the period. The denominator, or capital base, is where the confusion lies. Overlay managers typically do not know what the value of the underlying assets are so you can’t rely on using that as the denominator. You wouldn’t use the value of the cash set aside. Using that value assumes that you could only lose that amount which isn’t the case. The most practical course of action is to use the notional exposure as your denominator. The notional exposure is defined as the value of the underlying assets and would result in the same change in value as would the underlying asset in the event of a price change.
For example, let’s assume that you are managing an overlay in which you are adding equity exposure through S&P Futures. You are given $100,000 to cover any realized losses and you are expected to add $1,000,000 in equity notional exposure. You are told that the underlying assets are valued at $15,000,000. During the first month of performance you realized $15,000 in realized gains and another $2,000 in unrealized gains. The overlay’s monthly performance is simply the sum of the realized and unrealized gains ($17,000) divided by the targeted notional exposure of $1,000,000 which equates to a return of 1.7%.
Let’s assume that you took the alternative approach and utilized the $15,000,000 as your denominator. Suddenly, your return is 0.11%. This number may represent what the client experienced but the manager should be judged based on the exposure he was allowed to manage to, which is the $1,000,000.
The methodology required by the Global Investment Performance Standards (GIPS®) is not clear at this time but guidance is expected to be forthcoming in the near future. The methodology discussed is based on what we see in the industry and guidance from the CFTC, the NFA and leading performance experts.
The next question is how to take these periodic returns and come up with a multi-period return. We will cover this in Part 2 next month.
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