What is a primary practical difference between overlay management and changing asset allocation?

• A. Overlay changes the asset mix by selling or buying underlying assets.
• B. Overlay uses derivatives to adjust risk exposures without changing asset allocation.
• C. Overlay primarily adjusts the risk tilt through derivatives while keeping the core asset allocation intact.
• D. Overlay has no impact on risk management.

Answer: (C)

Overlay management keeps the core portfolio of assets intact and uses derivatives to adjust risk exposures, effectively tilting the portfolio’s risk profile without changing the actual asset mix. This means you can hedge or modulate factors like duration, currency risk, or equity beta through instruments such as futures, forwards, swaps, or options, while the underlying holdings remain as originally selected. Changing asset allocation, by contrast, would involve buying or selling the underlying assets to shift the mix (e.g., moving from stocks to bonds), thus altering the core holdings rather than just the risk characteristics. That’s why the practical difference is that overlay tunes risk with derivatives while preserving the core asset allocation.