Learning Outcomes
After studying this article, you will be able to explain the role of portfolio overlays and risk budgeting in constructing multi-asset portfolios, evaluate the use of currency management tools, and assess the impact of asset allocation overlays on portfolio risk and returns. You will be able to identify best practices for dynamic asset allocation and apply risk budgeting frameworks to meet specific investment objectives.
CFA Level 2 Syllabus
For CFA Level 2, you are required to understand how overlays and currency management are used to construct and adjust multi-asset portfolios. Ensure you focus your revision on:
- Explaining the concept and application of portfolio overlays for asset classes and risk exposures
- Describing the framework and objectives of risk budgeting in portfolio management
- Evaluating the rationale for implementing multi-asset allocation overlays
- Analyzing the key approaches for active and passive currency management
- Assessing the impact of currency overlay strategies on total portfolio risk and return
- Applying risk budgeting to maintain target risk profiles under changing market conditions
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the main purpose of a portfolio overlay in a multi-asset allocation?
- How does risk budgeting help a portfolio manager under changing market conditions?
- Which of the following is a passive currency management technique: (a) Forward contracts, (b) Currency hedged ETFs, (c) Currency options, (d) Tactical overlays?
- Why might a manager use an asset allocation overlay instead of rebalancing the core portfolio directly?
Introduction
Portfolio construction at the institutional level increasingly relies on overlays and risk budgeting to balance risk and return efficiently. Overlays are used to achieve dynamic allocation adjustments and to manage exposures such as currency risk without trading the actual physical assets. Risk budgeting provides a discipline for allocating risk across asset classes or strategies in line with the investor’s targets. For CFA Level 2, understanding how these tools fit into the overall portfolio management process is critical.
Key Term: Overlay
An overlay is a separate account or strategy layered on top of an existing portfolio to efficiently modify exposure to specific asset classes, risk factors, or currencies.Key Term: Risk Budgeting
The process of allocating allowable risk by setting quantitative risk limits for individual portfolio components based on total risk objectives.Key Term: Currency Overlay
A dedicated strategy used to adjust or hedge a portfolio’s currency exposures separately from actual asset positions.
Portfolio Overlays in Multi-Asset Portfolios
Portfolio overlays are strategies that allow managers to adjust portfolio exposures rapidly and with minimal disruption to the existing portfolio. They are implemented using derivatives, ETFs, swaps, and forward contracts. Overlays are especially valuable in multi-asset portfolios where strategic and tactical asset allocation decisions frequently change.
Portfolio overlays enable:
- Efficient rebalancing to target weights after market moves
- Fast strategic or tactical exposure shifts without liquidating core holdings
- Risk management through hedging (e.g., interest rate, equity, credit, or currency risks)
- Implementation of regulatory or policy constraints (such as limiting asset class weights or regional exposures)
Worked Example 1.1
A pension fund’s strategic asset allocation is 60% equities and 40% bonds. After a sharp equity rally, the portfolio drifts to 68% equities. Instead of selling equities, the manager uses equity index futures to reduce equity exposure back to target.
Answer:
The manager sells equity futures with a notional value equal to 8% of the portfolio, efficiently rebalancing exposure while minimizing trading costs and taxes. The physical portfolio remains intact, and target risk is restored.
Risk Budgeting in Portfolio Construction
Risk budgeting is the discipline of assigning specific risk limits to portfolio components to ensure the entire portfolio remains within acceptable risk bounds. Rather than simply managing asset weights, a risk budgeting approach focuses on each investment’s contribution to total portfolio risk.
Key applications include:
- Ensuring the largest sources of portfolio risk are deliberate choices, not unintentional drifts
- Adjusting asset class, sub-asset class, or strategy exposures to meet a specific total volatility target
- Dynamic reallocation of risk as market conditions change, responding to volatility spikes or structural breaks
- Efficient allocation of risk capital among internal and external managers or sleeves
Worked Example 1.2
A balanced portfolio has equities, bonds, and alternatives. Despite alternatives having a 20% portfolio allocation, their high volatility means they contribute over 40% of portfolio risk. The CIO discovers that most risk is coming from alternatives, not equities.
Answer:
By capping alternatives at 25% of total portfolio risk using risk budgeting, the CIO reduces potential downside and aligns actual risk with investment beliefs. Weights are adjusted, or overlay strategies are used to restrict risk from alternatives.
Currency Management Using Overlays
For globally diversified investors, currency exposures often become major contributors to total risk and return. Currency overlays allow managers to separate currency risk and manage it explicitly, without altering the actual asset positions. Currency management strategies include passive, active, and hybrid approaches.
Key Term: Passive Currency Hedge
A systematic approach using forward contracts or currency-hedged instruments to reduce currency risk, typically aiming for a fixed hedge ratio.Key Term: Active Currency Overlay
A discretionary or rule-based approach to manage currency exposures, seeking to generate alpha or control risk through tactical hedging or speculation.
Passive vs Active Currency Management
Passive currency overlays aim to reduce the volatility caused by currency fluctuations by targeting a set hedge ratio (e.g., 50% or 100% hedged against the investor’s base currency). Active overlays, in contrast, selectively hedge or unhedge exposures, or even take speculative currency positions if strong views are held.
Worked Example 1.3
A euro-based investor holds US equities, gaining when the dollar rises versus the euro and losing when the dollar falls. The manager implements a 70% passive currency hedge using rolling forward contracts.
Answer:
If the dollar appreciates against the euro, the portfolio still benefits from 30% unhedged exposure, while 70% of currency risk is neutralized.
Exam Warning
In multi-asset portfolios, currency overlay strategies can have material impacts on portfolio risk and returns. Failing to monitor hedge ratios can cause large deviations from intended risk budgets. Always verify how derivatives, hedges, and overlays affect notional and effective exposures.
Overlays, Dynamic Allocation, and Rebalancing
Overlays and risk budgeting are central to dynamic asset allocation. As markets move, managers need flexible tools to maintain the portfolio’s desired risk/return profile:
- Overlays allow managers to change exposure without liquidating positions, thus saving costs and minimizing market impact.
- Overlay-driven rebalancing can rapidly bring portfolios back to target allocations after large market swings, supporting discipline and risk control.
- Overlays are also used to impose or relax risk constraints dynamically—e.g., to prevent overall portfolio volatility from exceeding a threshold during stress periods.
Key Term: Dynamic Asset Allocation
The ongoing process of adjusting portfolio exposures over time in response to changing market conditions, often using overlays and rebalancing tools.
Summary
In today’s multi-asset portfolios, overlays and risk budgeting provide essential tools for controlling exposures, implementing investment views, and limiting unwanted risks. Overlay strategies efficiently adjust allocations and hedges, while risk budgeting links position sizes and risk contributions to overall objectives, ensuring that portfolios remain aligned with investor goals even as markets change.
Key Point Checklist
This article has covered the following key knowledge points:
- The use of overlays in multi-asset portfolios for efficient exposure management and rebalancing
- Risk budgeting as a framework for controlling and allocating risk across portfolio components
- Passive and active currency overlay techniques, and their impact on portfolio risk and return
- The application of dynamic asset allocation, enabled by overlays, for sustaining target risk profiles
- Best practices for monitoring, rebalancing, and maintaining risk limits using overlays and risk budgets
Key Terms and Concepts
- Overlay
- Risk Budgeting
- Currency Overlay
- Passive Currency Hedge
- Active Currency Overlay
- Dynamic Asset Allocation