For overlay managers, the sky may be the limit.
The firms have once again reported a significant annual increase in total U.S. institutional tax-exempt overlay assets, which spiked by 48% to $586.9 billion for the year ended Dec. 31, according to data from Pensions & Investments’ annual survey of the largest money managers.
While last year’s increase is considerable, the growth seen over the last three years is even more staggering. Since the end of 2003, the notional value of overlay strategies run on top of U.S. institutional tax-exempt assets has increased roughly 172%.
Overlay managers in interviews for this story noted that in 2006 more pension executives, particularly from public retirement systems, accepted and understood the use of such strategies — which might include derivative, currency, dollar duration, options overwriting, market-neutral or global tactical asset allocation strategies. As a result, some predict the current level of assets in overlay strategies, while significant, could be the beginning of something larger.
“In two years, it would not be surprising to see that number rise to $750 billion, or even $1 trillion,” said Bruno Gerard, director of currency strategies at Mellon Capital Management, San Francisco, which is responsible for the majority of the $52 billion in overlay assets reported by parent company Mellon Financial Corp., the third largest overlay manager in P&I’s survey.
“It has become more accepted, but not totally accepted yet,” Mr. Gerard added. “And there are still a large number of institutional investors who are in the process of educating themselves on the use of overlay strategies.”
Taking action
One example of an investor that took action last year was the $62 billion Pennsylvania Public School Employees’ Retirement System, Harrisburg, which implemented an overlay strategy to control the active currency risks associated with its international investments. The retirement system tapped Pareto Investment Management, another Mellon subsidiary, to manage a $5.2 billion currency overlay strategy that aims to reduce the negative impact a strengthening U.S. dollar would have on its non-U.S. investments.
The $14 billion Alaska Pension Investment Board, Juneau, also began using overlay strategies last year, hiring State Street Global Advisors, Boston, to manage a cash overlay on top of $8 billion in domestic and international equities.
Executives at several of the largest overlay management firms said they are hardly surprised by the rapid adoption of overlay strategies in recent years. “It was never a question of if, but when it would take off,” said Jess Yawitz, chairman and chief executive officer of NISA Investment Advisors LLC, St. Louis.
With roughly $128 billion in overlay assets at the end of 2006, NISA ranked as the largest in that category for P&I’s survey.
NISA’s overlay assets grew 67% in 2006, outpacing the industry growth, as a whole. But more importantly, the firm managed just $1.2 billion in overlay assets five years ago, Mr. Yawitz noted.
“That was at a time that a number of pension plans were dealing with major underfunding issues,” said Mr. Yawitz, who added that in addition to declining equity markets in 2000-’02, declining interest rates had a negative impact on funded status as well. “Since then, more and more pension plans have adopted overlay strategies to hedge their interest rate sensitivity. That’s first and foremost for the overall growth.”
As more pension plans have adopted portable alpha strategies in recent years, they have sought overlay managers to obtain a beta overlay on top of their portable alpha programs, he said.
For instance, the $46 billion Massachusetts Pension Reserves Investment Management Board, Boston, hired Russell Investment Group, Tacoma, Wash., to get beta overlay exposure on top of a $2 billion portable alpha strategy last August.
Public funds enter
Several years ago, U.S. and European corporate pension funds were first-movers and the major source of overlay business for money managers, according to multiple money management executives.
But now, public funds have steadily begun to adopt these strategies as well, which also played a major role in last year’s significant growth, said Mike Thomas, chief investment officer of Russell Implementation Services, Tacoma.
Mr. Thomas added that roughly half of Russell’s new overlay business last year came from public retirement systems. Russell reported $20.7 billion in overlay assets at the end of 2006, an increase of almost 50% for the year.
As more public retirement plans implement portable alpha and liability-driven investment strategies, Mr. Thomas said he expects the use of overlay strategies to continue to accelerate. Also, he added, many institutional investors are using overlay strategies to help tighten portfolios and keep them in line with the policy asset targets, another common use of overlays that will fuel growth.
To date, the majority of institutional investors have tapped money managers for currency overlay strategies: Money managers reported a total of $282 billion in tax-exempt currency overlay assets at the end of 2006, a little more than half of the total reported.
