Thoughts Regarding Overlay Performance, Part II

By Travis Morgan, CFA, CIPM

Last month we touched on the challenge portfolio manager’s face when determining which value to use in the denominator (or beginning capital base) to calculate overlay performance for a single period.  But what about calculating performance for more than one period? Is it appropriate to geometrically link single period returns to derive a multi-period return for an overlay portfolio? To address this, let’s start with discussing the most common approach of geometrically linking monthly returns to come up with an annual return.  The purpose of geometrically linking is to account for the compounding effect of returns on a portfolio. What I mean by this is if a portfolio returns 50% off of a $100 portfolio in January, it has $150 to invest in February. Let’s then assume that in February the portfolio losses 50% and has an ending value of $75. To come up with the total return for January and February you would geometrically link the two monthly returns:  You can spot check by simply multiplying the starting value of $100 by 1 plus -25% and confirm that you come up with the ending value of $75.  The issue with overlays is that they don’t build upon themselves from one month to the next so the question is “should monthly overlay performance be geometrically linked?”

Let’s use our example from last month where we had an overlay in which we were adding equity exposure through S&P Futures. In that example, you were given $100,000 to add $1,000,000 in equity notional exposure to a $15,000,000 portfolio.  Let’s assume that the notional exposure of $1,000,000 results in a 50% return in January and -50% in February.  The gain of $500,000 in January does not change the target exposure of $1,000,000 but instead flows back into the underlying portfolio.  The February return of -50% would result in a loss of $500,000 and the net gain over the two months would be $0.  As noted above, if we geometrically link the two months returns we come up with a total return of -25% which doesn’t make sense in our overlay portfolio which actually achieved a 0% return over the two months.  You’ll note that the return is simply the sum of the two monthly returns (50% and -50%).

An alternative, and probably a more accurate approach, would be to subtract the total hedged return (underlying portfolio plus overlay portfolio) by the unhedged return (the underlying portfolio return). The problem with this approach is what we discussed last month in that the overlay manager typically is not aware of the underlying portfolio’s assets, let alone the total hedged portfolio assets. For the time being, a simple sum of the single period returns may be the best approach until we receive further guidance from CFA Institute.  With that being said, we would like to hear from you about this subject in the comment section below.

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