Morgan Stanley IM – Overlay Completion: Minding a Portfolio's Global Equity Allocation

While many tariff deals have now been struck, a recent ruling from the U.S. Court of Appeals for the Federal Circuit puts the longevity of these tariffs into question. Whether tariffs remain in place, are revoked, or implemented in another form, the ultimate impact to the global economy remains uncertain. This reshaping of global trade policy may affect individual economies unevenly. We believe that illuminates the importance of managing risks in investors’ asset allocations.

Overlay programs can help to monitor global exposures, aim to fill in necessary gaps through portfolio completion and ultimately seek to mitigate unintended risks.

Take, for example, a global equity portfolio that is benchmarked to the MSCI All Country World Index (ACWI). Some investors may simply choose to fill this allocation using managers benchmarked to MSCI ACWI, while others might further subdivide their managers into regional exposures: U.S., international developed and emerging markets. Investors who choose the second approach are likely to need more prudent monitoring across these suballocations. These regional allocations may be historically correlated over the long term, but they can experience wildly different returns in discrete periods.

Isolating an example of the S&P 500® Index relative to the MSCI EAFE Index, let’s consider the quarterly performance differential over the past 20 years, with events in the 95th percentile highlighted in green.

Display 1 

MSCI EAFE net total return versus S&P 500 total return

Source: MSCI, S&P Global, index data from 12/31/2004 to 06/30/2025. For illustrative purposes only. It is not possible to invest directly in an index. Indexes are unmanaged and do not reflect the deduction of fees or expenses. Past performance is not indicative of future results. All investments are subject to risks, including the risk of loss.

In the fourth quarter of 2024 and the first quarter of 2025, the market experienced two 95th percentile events happening back-to-back, when uncertainty surrounding tariffs early this year offset a period of significant U.S. outperformance relative to international developed markets late last year. Such an unlikely occurrence vividly illustrates the potential impact that regionally misaligned portfolios can have. Although the overall global equity allocation may be on target, small discrepancies within regional allocations may leave the portfolio susceptible to significant tracking error relative to the benchmark.

In a world where the performance differentials can be +/-10% in a given quarter, seemingly small differences in allocation can matter a lot, and investors cannot afford to take unintended bets. To avoid these inadvertent risks and performance gaps, we think it’s imperative for investors to monitor their allocations. This is where overlay programs come in. Commonly, overlay programs are used between or inter asset classes—for example, rebalancing between equities and fixed income. A more tailored use of overlay programs focuses on more granular allocations within or intra asset classes, aiming to control for risks such as regional misalignments. By analyzing global equity holdings at this level, an overlay manager can help to identify and create solutions for unintentional portfolio tilts in specific asset classes. The bottom line

Customized overlay solutions like managing regional equity allocations may help to maintain a portfolio’s desired risk and return characteristics and reduce the potential risks presented by uncertain market environments.

RISK CONSIDERATIONS
There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. A separately managed account may not be appropriate for all investors. Separate accounts managed according to the particular strategy may include securities that may not necessarily track the performance of a particular index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment managers, please refer to Form ADV Part 2.