The Derivatives Overlay: Changing Exposure, Not Holdings

A derivatives overlay changes what a portfolio is exposed to without buying or selling the holdings underneath it. The equity sleeve stays where it is; the exposure the portfolio carries to equity markets moves. Two consequences follow: the reported weights stop describing the exposure, and the change can be made and reversed far faster than the holdings could be traded.

The answer above is short and the trouble it causes is not. Almost everything a portfolio person reads about a portfolio arrives as a list of holdings with a percentage beside each one. Once an overlay is on, that list is still completely accurate and has quietly stopped answering the question it is usually asked. The gap between an accurate holdings list and the exposure it no longer describes is what follows, worked entirely at the level of the portfolio.

Everything below depends on one line, drawn at the outset. The instrument itself is covered separately. A futures contract, an option, and how either is priced, margined, exercised or settled all belong to the material on the instruments. A reader arriving here has already been through that material. The effect of a position on the portfolio as a whole sits at a different level.

The running example is the Anantara Multi-Asset Portfolio, an invented discretionary mandate of Rs 500 crore run by Faiz Ahmad Ansari for an invented charitable endowment whose investment committee is chaired by Rukmini Deshpande. Its policy weights are equity 60.0 per cent at Rs 300 crore, fixed income 30.0 per cent at Rs 150 crore and cash 10.0 per cent at Rs 50 crore, summing to Rs 500 crore exactly. The mandate carries a stated equity band of 50 to 70 per cent. Every figure below belongs to one stated twelve month period.

What is a derivatives overlay, and where does it sit?

A derivatives overlayA position placed over a portfolio to change its exposure while the holdings stay in place. is a position placed over an existing portfolio that changes the portfolio's exposure while every holding underneath it stays exactly where it was. The word doing the work in that sentence is over. Nothing is sold. Nothing is bought in the holdings. The list of 28 equity names in the Anantara Multi-Asset Portfolio is the same list on the day after the overlay goes on as it was on the day before, at the same sizes, with the same reasons behind each one.

Here is the everyday version. A cloth trader has already bought the season's stock. The stock sits in the godown, paid for, chosen carefully, and there is nothing wrong with any of it. Separately, and without touching a single bale, the trader arranges cover against a bad monsoon. The stock never moves off the shelf. The bales have not changed. The trader's dependence on the monsoon has. A stock register kept in that godown would show precisely the same bales before and after the arrangement, and would be a perfectly honest register that no longer states what the trader's year depends on.

Two consequences follow immediately, and most of what follows is working them out. The first is that the physical weightThe share of a portfolio actually held in an asset, read straight off a holdings report. and the exposure part company. The Anantara portfolio's equity line reads 60.0 per cent on the holdings report at every overlay size, including one that covers the whole sleeve. The second is speed. Trading across 28 names to move an exposure takes days and leaves marks in the market. A position placed over the top goes on and comes off far faster, and that speed is why the arrangement exists at all.

What is the short answer to how derivatives can be used in portfolio management?

Three uses, and each one is a statement about the portfolio rather than a statement about any instrument. The first, made just above, is adjusting exposure without disturbing the holdings. The second is bridging a gap while a decision is being implemented. The third is keeping the selection work intact while the market exposure is moved. All three name an effect on the portfolio. None of the three is by itself a reason to act.

The second use is the one people miss, so it is worth slowing down on. Suppose the committee decides on a Monday that the equity exposure should be lower. The holdings cannot move on Monday. Twenty eight names have to be sold down in sizes that do not move their own prices, and that takes days. During those days the portfolio carries an exposure that nobody chose. The old exposure has been decided against. The new one has not arrived. An overlay can carry the intended exposure across that stretch while the holdings are traded underneath it.

The third use is the one a selection person feels hardest. The Anantara equity sleeve holds 28 names that were each chosen individually, with a reason written down for each. Taking the equity exposure down by selling means selling across those 28 names, and each sale partly undoes a separate decision that had nothing wrong with it. The exposure was the thing the manager wanted to change, and the selection was not. An overlay lets one of those move while the other stands.

What does a Futures Overlay do to the exposure beneath it?

A futures overlay moves exposure symmetrically. The word symmetrically carries the whole of what matters at the portfolio level. A symmetric adjustmentA change that moves the up side and the down side in the same proportion. takes the same proportion off both directions: if the portfolio has given up a share of what a fall would have done to it, it has given up the identical share of what a rise would have done. The protection does not come without the give up, and that is the defining portfolio level feature of this kind of adjustment.

Think of a farmer who has agreed a price for the harvest before it is cut. A bad price no longer hurts, and a good price no longer helps. The arrangement did not remove uncertainty from the farm; it exchanged a range of outcomes for a narrower one, in both directions at once. Nobody sensible calls that free, and nobody sensible calls it protection either. The arrangement swaps one shape of outcome for another.

How the contract itself works is covered separately. Price, margin, expiry mechanics and settlement belong to the material on derivatives. The specifications are published by the exchanges and the clearing corporation, and a portfolio person reads them at the source.

What does an Options Overlay change that a futures one does not?

An options overlay changes exposure asymmetrically. An asymmetric adjustmentA change that moves one direction more than the other, and is paid for accordingly. moves one direction more than the other, and the asymmetry is not free. The asymmetry is the entire portfolio level distinction, and it is enough to make the two arrangements genuinely different objects to hold rather than two flavours of the same thing.

The payoff, the strike, the premium and the settlement sit in the material on the instruments. What belongs here is the consequence for the portfolio. A symmetric adjustment and an asymmetric one leave the portfolio in different positions and cost differently, and a committee choosing between them at the portfolio level is choosing between those two shapes rather than between two contracts.

One more word belongs here and then the instrument goes back where it came from. The size an overlay stands for is its notionalThe size of exposure a position stands for, as against what it cost to put on., and the notional is the number that matters for exposure arithmetic. The notional is not what the position cost. Confusing the two is the commonest arithmetic error in this area, and writing every figure in rupees of exposure is what prevents it.

How far does a hedge move the effective exposure, in rupees?

Effective exposure is a subtraction and nothing more. Write the exposure in rupees beside the holding, in the same unit and on the same line, and the entire difficulty people have with overlays disappears. The equity sleeveThe part of a mixed portfolio held in equities, here Rs 300 crore of Rs 500 crore. is Rs 300 crore, which is 60.0 per cent of Rs 500 crore. If a hedge covers a share of that sleeve, the effective exposureWhat a portfolio is actually exposed to once an overlay is counted, as against what it holds. is what is left uncovered. The subtraction is the whole formula.

Work it at two stated settings. The record does not say how large this mandate's overlay actually was, so neither setting is the mandate's own. Hedge Rs 30 crore, or 10.0 per cent of the sleeve. Effective equity exposure is Rs 300 crore less Rs 30 crore, or Rs 270 crore. Against the Rs 500 crore mandate that is 54.0 per cent. The holding is unchanged at Rs 300 crore and 60.0 per cent. Now hedge Rs 50 crore, one sixth of the sleeve or 16.7 per cent of it. Effective equity exposure is Rs 250 crore, or 50.0 per cent, sitting exactly on the floor of the band. The holding still reads 60.0 per cent.

The pair of numbers carries the whole point: two figures describe the same portfolio on the same day, one sitting in the middle of the band and one sitting on its floor, and nothing dishonest has happened anywhere. The holdings report is right. The exposure figure is right. The two figures answer two different questions, and the trouble starts only when somebody asks one question and reads the other one's answer.

Is the equity band tested against the holding or against the exposure?

The basis of the band is the hardest point in this guide and the most useful. The band says equity between 50 and 70 per cent. The band does not say 50 to 70 per cent of what quantity, and the record does not settle it either. The basis of a limitThe quantity a limit is written against, which decides what the limit test actually reads. is the quantity the limit is written against. Until the mandate states which quantity, the same band means two different things.

Set both readings down. On the holding basis, a hedge changes the tested figure by nothing at all: the equity line reads 60.0 per cent at every setting on the table above, including one that covers the whole sleeve. On the exposure basis, the same hedge can walk the tested figure straight to the floor: Rs 50 crore hedged takes it to 50.0 per cent, and anything beyond that takes it through. The mandate has to say which, and the absence of that sentence in this record is a real absence rather than a teaching device.

So what does the arithmetic produce? Not a compliance verdict. The output is a written question back to whoever wrote the mandate, asking which of the two quantities the band is about. A question sounds like an evasion and is the opposite of one: the arithmetic is finished and unambiguous, and the only thing missing is a sentence that a person has to supply. Supplying it yourself, in either direction, would be inventing the mandate rather than reading it.

What does an overlay do to the beta and the turnover already reported?

Both figures are in the record for the stated twelve month period, and an overlay disturbs both of them in ways the figures themselves cannot show. Take the beta first. The portfolio's beta against the composite benchmark was 1.08, struck across the whole of that year. If exposure changed part way through, that single figure describes neither the hedged stretch nor the unhedged one. The 1.08 is an average of two different portfolios wearing one number.

Now take turnoverThe share of a portfolio's holdings replaced over a period, counted on trades in the holdings., 34 per cent for the stated year. Turnover counts the holdings that were replaced. An overlay changes the exposure without trading any of the 28 names, so it leaves no mark on it whatsoever. The record holds no dates and no size for this overlay, so both effects are real and neither can be computed.

There is a useful discipline hiding in that. When the record is silent, the silence is stated arithmetically rather than met with a refusal. The equity sleeve's own beta is not in this record, so the beta the portfolio would have carried at any other hedge setting cannot be reached, and no number for it is available. One statement is fixed by arithmetic and needs no missing figure at all: less equity exposure carries less of whatever the benchmark's equity part does, in both directions. The direction survives. The size of it does not.

What does an overlay cost, and what does this record say about it?

An overlay costs something. Always. There is no arrangement of this kind that is free, and anyone presenting one as free has left something out of the description. The record holds no size, no dates and no cost figure for the Anantara portfolio's overlay. Each of the three absences blocks a different calculation.

An exposure change reported without its cost is half a report, and the missing half is the half the holder pays. The temptation with a missing number is always to supply a plausible one. A plausible number would read as a description of what this mandate actually did, and the record cannot support that description. The empty space is the more honest answer.

What does an overlay not do?

An overlay does not remove risk. An overlay moves exposure, and every position has something on the other side of it. Reducing exposure to one thing means taking on a dependence on the arrangement itself and on whoever is on the other side of it. A dependence is an exposure of a different kind, not none at all. The counterpartyWhoever stands on the other side of an arrangement, and whom it therefore depends on. is part of the position, not a detail beside it.

The cloth trader from the first block has the same problem. The monsoon cover is only as good as its writer and the arrangement behind it. A trader who says the season is now safe has stopped counting one thing and started depending on another, and the honest description names both. The dependences and their management are covered separately.

How does anybody use this in a room, on a Tuesday?

Three questions, asked in order, before anybody opens the holdings list. What does the holdings report read? What is the effective equity exposure in rupees once every overlay is counted? And which of those two does the band actually test? A committee like Rukmini Deshpande's gets a clean answer to the first two on any Tuesday of the year and, on this record, no answer at all to the third. The missing third answer is exactly the finding worth carrying out of the room.

The same discipline scales all the way down. A household that has taken a home loan at a floating rate and separately fixed part of it has done exactly this: the loan on the statement has not changed, and what the household depends on has. Anybody reading only the statement would describe the position accurately and describe the household's year wrongly. The instrument is different and the reading error is identical.