Traditionally, third party portfolio management is a process of managing a collective investment strategy to meet specified investment goals for the benefit of many investors (pooled investing). This is done mostly without regard to the individual investor’s specific constraints or unique circumstances. Mutual funds are a good example of this. To simplify, traditional portfolio management involves two key players: the manager of the portfolio and the client.
With overlay portfolio management however, another layer which functions as the “third layer of portfolio management” works between the manager and the end client. The third layer is known as the overlay manager. The role of the overlay manager consists of coordinating all activities between the investment manager and the investment advisor who acts on behalf of the client.
Here is how it works: each client has a different risk tolerance and specific situations that dictate how their portfolio should be managed; the overlay manager will view the client’s situation from a holistic perspective and customize the investment manager’s model to fit each client’s requirement.
As an example of the ability to tailor your investments, suppose that your profile indicates that you are comfortable with stocks but you do not want to hold any tobacco companies. The overlay manager will recommend one of its equity mandates managed by a third party manager and use the third party’s model to trade securities on behalf of the client. In the trading process, the manager will monitor the market to ensure timeliness of trades and will restrict the portfolio from any tobacco companies. Thus this process offers a level of customization that cannot be done in the mutual fund or pooled fund world.
The overlay manager applies the same strategies when managing client specific tax constraints. The overlay manager will also manage the overall portfolio in a tax efficient way to ensure the best after tax returns. The extra level of flexibility in the management of the client’s portfolio creates value added as a client’s specific needs can be factored into the management of the portfolio. At the same time, the overlay manager exercises more control on the timing of trades and managing taxes, thereby improving the portfolio performance. In fact studies (Senior Consultant Magazine, 2002) have shown that overlay portfolio management can add 0.33% to 1.00% per year in total portfolio performance; on a risk adjusted basis this can be even higher.