Here we consider an area that is less explored: the ability to implement systematic strategies like trend following within an overlay program. We see a natural opportunity for integrating overlay and trend strategies, given that both have similar architecture as predominantly rules-based derivatives strategies.
Overlay strategies have long offered institutional investors flexibility to customize portfolios, with the potential to help them achieve policy objectives more efficiently. Trend-following strategies provide investors with exposure to a unique behavioral risk premium,1 which may be desirable as a diversifying exposure in some asset allocations.
Understanding trend strategies
Trend strategies employ a systematic approach to capture the trend risk premia, typically across a broad array of asset classes such as equities, fixed income, commodities and currencies. At a high level, trend portfolios are built to exploit a behavioral bias whereby investors tend to buy what is going up and sell what is going down—that is, following the trend. Academic research has shown that historically, these strategies have tended to offer an uncorrelated positive excess return in the long run, while also providing a natural offset to equity drawdowns during risk-off periods.2
With a trend strategy approach, signals are formed based on a series of trailing returns to determine the direction and magnitude of the prevailing trend. These signals are then converted to a position for each asset based on its corresponding trend signal. Volatility and liquidity-based parameters may also be used to further manage portfolio risk.
Traditionally, trend-following managers can be added to a portfolio in a diversifying asset class or categorized within the hedge fund asset class. Often these asset classes have been associated with a lower degree of liquidity. However, trend strategies are typically built using liquid instruments such as exchanged-traded futures contracts—the same type of securities often used in traditional overlay programs.
By combining these two programs, investors may be able to gain the benefits of trend, delivered through a more liquid vehicle.
Integrating with the overlay program
Trend strategies are traditionally funded mandates, implemented in isolation as one of many portfolio separate accounts. However, these strategies can also be implemented as an extension of an overlay program. Like an overlay program, notional exposure for trend can be achieved without allocating the full cash value of the investment. Note that a prudent buffer for variation margin of 10% to 20% is usually set aside, so that most of the underlying cash supporting the trend exposure is available for the investor to use. This process helps to increase the liquidity profile of the total portfolio and provide more flexibility.
Since many of the operational mechanics of trend and overlay strategies are the same, we find a clear opportunity for program synergies. For example, the strategies can be managed holistically from a margin and collateral perspective.
An integrated program can also allow for increased flexibility to coordinate rebalancing opportunities. For instance, if a risk-off event occurs, leading to drawdowns in the equity portfolio and gains in the trend portfolio, then the integrated program can streamline the rebalancing process. In this way, rebalancing can occur more promptly and with better coordination than rebalancing these assets independently.
Customized overlays for institutional risk management
The bottom line on implementation
Many investors use overlay programs and trend-following strategies, but we have seen relatively few integrate the two. Given that both strategies use the same infrastructure, we find natural opportunities to combine their implementation. By leveraging the ability to cross-collateralize, combining these strategies has the potential to increase portfolio liquidity compared to implementing them independently.
Further, the efficient rebalancing mechanism of overlay programs may increase the nimbleness of the portfolio when harvesting rebalancing opportunities between each strategy. By integrating these exposures, investors can broaden the horizons of what an overlay can be, increasing their flexibility to manage portfolio objectives.
1 A risk premium is a persistent source of return—derived from exposure over time to a particular characteristic—that may allow investors to access attractive risk-adjusted returns and increase overall portfolio diversification.
2 Journal of Portfolio Management, “A Century of Evidence on Trend-Following Investing” by Brian Hurst, Yao Hua Ooi and Lasse Hehe Pedersen, 44:1, Fall 2017.
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01.06.2026 | RO 4109230
