What is an "Overlay" Strategy in Multi-Asset Funds?

Multi-asset funds are designed to spread investments across equities, debt, commodities, and other asset classes. This diversification helps manage risk, but it does not eliminate it entirely. Market conditions can shift rapidly, and even a well-diversified portfolio can experience significant drawdowns during periods of sharp volatility. This is where an overlay strategy becomes relevant. An overlay strategy is a layer of risk management applied on top of an existing portfolio, typically using derivative instruments, to reduce exposure to adverse market movements without requiring the fund manager to sell the underlying holdings.

Understanding the Concept of an Overlay

The term overlay refers to a set of positions, usually in derivatives such as futures, options, or swaps, that sit above the existing portfolio. These positions are not part of the core investment thesis. Instead, they are designed to offset or cushion potential losses that may arise from specific market risks. Think of it as a protective shield that a fund manager deploys when they anticipate heightened uncertainty or when the portfolio's risk profile exceeds a desired level. The overlay does not replace the portfolio's holdings but works alongside them to modulate overall risk.

In a multi-asset fund, the underlying portfolio might include equity shares, government bonds, corporate debt, and gold. Each of these carries its own risk. Equities are vulnerable to market-wide sell-offs. Bonds carry interest rate risk. Gold can be affected by currency movements and global sentiment. An overlay strategy attempts to address these varied risks in a coordinated manner using a single layer of derivative positions.

How Derivatives Enable the Overlay

Derivatives are financial contracts whose value is derived from an underlying asset such as an index, a commodity, or a currency. Common derivatives used in overlay strategies include index futures, put options on equity indices, interest rate futures, and currency forward contracts. Fund managers use these instruments because they are cost-efficient relative to buying or selling large quantities of the underlying assets, they can be deployed or unwound quickly, and they allow precision in targeting specific risk exposures.

For example, if a multi-asset fund holds a significant allocation to equities and the fund manager believes that equity markets are likely to face short-term headwinds, the manager may purchase put options on a relevant index. If the market falls, the gain on the put options partially offsets the decline in the equity holdings. Once the manager's view changes or the risk passes, the options can be allowed to expire or can be sold. All of this happens without touching the underlying equity positions.

Dynamic Hedging Within an Overlay Framework

Dynamic hedging in multi-asset funds refers to the practice of continuously adjusting the overlay positions in response to changing market conditions. Unlike a static hedge, which is set once and left unchanged, a dynamic hedge evolves as the portfolio's risk profile changes. This requires active monitoring and frequent rebalancing of derivative positions.

A fund manager employing dynamic hedging might increase the hedge ratio, which is the proportion of the portfolio protected by the overlay, during periods of high market volatility. Conversely, during calmer periods when markets appear stable, the hedge ratio may be reduced to allow the portfolio to participate more fully in potential gains. This flexibility is one of the key advantages of an overlay strategy. It allows the fund to adapt its risk posture in real time rather than being locked into a fixed defensive position.

Dynamic hedging also involves managing the Greeks in options-based overlays. Delta, gamma, and vega are measures of how an option's price changes in response to movements in the underlying asset, changes in volatility, and the passage of time. A sophisticated overlay manager will monitor these sensitivities and adjust positions accordingly to maintain the desired level of protection.

Why Multi-Asset Funds Use Overlay Strategies

Multi-asset funds serve investors who want exposure to a range of asset classes within a single product. These investors often include those with a moderate risk appetite who seek growth but also want some protection against sharp losses. An overlay strategy helps the fund manager deliver on this dual objective.

Without an overlay, the only way to reduce risk in a multi-asset fund during a difficult market environment is to sell assets and move to cash or lower-risk instruments. This approach has drawbacks. It involves transaction costs, potential tax implications, and the risk of mistiming the re-entry into the market. An overlay allows the manager to maintain the strategic asset allocation while still managing short-term risk. This is sometimes described as separating the investment decision from the risk management decision.

SEBI and AMFI have established guidelines around the use of derivatives in mutual funds in India. Fund managers operating within this regulatory framework are required to use derivatives for hedging and portfolio rebalancing purposes in a manner consistent with the fund's stated investment objective. Investors should always read the scheme information document to understand how and to what extent a fund uses derivative instruments.

Costs and Limitations of Overlay Strategies

While overlay strategies offer meaningful risk management benefits, they are not without costs. Purchasing options requires payment of a premium, which is an expense that can reduce the fund's net returns during periods when the hedge is not triggered. Futures-based overlays involve margin requirements and rollover costs as contracts approach expiry. These costs accumulate over time and can meaningfully affect long-term performance if the overlay is maintained continuously.

There is also the risk of imperfect hedging, often called basis risk. This occurs when the derivative instrument used in the overlay does not move in perfect tandem with the underlying portfolio. For instance, if a fund holds a diversified equity portfolio and hedges using an index future, the portfolio's performance may diverge from the index, leaving a portion of the risk unhedged. Skilled overlay managers work to minimise basis risk by selecting instruments that closely track the portfolio's actual exposures.

Another limitation is the complexity involved. Overlay strategies require specialised expertise in derivatives, risk modelling, and portfolio analytics. Not all fund houses have the same depth of capability in this area. Investors should consider the fund manager's track record and the fund house's overall risk management infrastructure when evaluating a multi-asset fund that employs an overlay.

What This Means for Investors

For an investor in a multi-asset fund, the presence of an overlay strategy signals that the fund manager is taking an active approach to risk management beyond simple asset diversification. It does not guarantee protection against all losses, but it does indicate a structured effort to limit downside during adverse conditions. Investors should look for transparency in how the fund discloses its derivative usage in its portfolio disclosures and factsheets.

Understanding the overlay strategy also helps investors set realistic expectations. During strong bull markets, an active overlay may act as a mild drag on returns because the cost of protection reduces net gains. During volatile or falling markets, the overlay may provide meaningful cushion. This trade-off is inherent to the strategy and reflects the fund's orientation towards risk-adjusted outcomes rather than pure return maximisation.

If you are considering investing in a multi-asset fund that uses derivative overlays, platforms like Stashfin can help you explore available options and understand fund features in a clear and accessible manner. Stashfin offers a straightforward way to explore mutual fund investments aligned with your financial goals.

Mutual fund investments are subject to market risks. Past performance is not an indicator of future returns. Please read all scheme-related documents carefully before investing.