Adding an overlay allows you to further qualify the securities that meet your buy criteria or to limit exposure to any one area of the market.
If you would like to include an overlay on your model your buy criteria should be larger than your target number of holdings so your model will still end up with your desired number of holdings.
There are three types of overlays you can add to a model.
Change Selection Criteria
The Change Selection Criteria dropdown allows you to base your final buying decision on additional data or factors while still ensuring you are buying from among the highest Relative Strength names in your matrix.
Notice the rank column has become jumbled because we are now ranking these stocks by dividend yield. In this case, the model is instructed to get as much yield as possible from the highest Relative Strength securities. If traditionally high-yield sectors are out of favor, you may be able to avoid their periods of underperformance while still generating some income in your portfolio.
If you choose to use this feature to re-sort the securities in your buy territory, make sure your buy criteria is set to allow more than your target number of holdings in but be careful not to move it so far down that weaker securities are entering the portfolio.
Overlay Filters
Adding a filter sets minimum or maximum levels the securities in your Buy Range must meet for inclusion in the portfolio.
The most common use for filters tends to be Technical Attribute/Score. This example shows a model set to invest only in stocks that are rated 4 or above.
Notice that unlike the example above, the rank stays the same, but we skip stocks that do not meet the TA/Score criteria.
When using an overlay filter, make sure your rules are not so restrictive that your model ends up with fewer holdings than you want or that it creates unnecessary turnover that is not additive to the model's performance or downside protection.
Allocation Maximums
Adding a maximum allocation for sectors, asset classes, or other investment categories allows you to increase your portfolio's diversification and avoid becoming over-concentrated in a particular area of the market.
As shown here, you can set a general maximum to apply to all members of one category and then a more specific maximum to limit a specific member of that category. The rules shown will limit Consumer Cyclical to 20% of the portfolio but allow all other sectors to occupy up to 30% of the portfolio. You’ll notice Financials are given three positions before AIG is skipped over, but Consumer Cyclical only two before WBA is skipped over.
This feature will not consider the classification of a mutual fund or ETF's underlying holdings. It will only apply to how the overall fund itself is classified. For example, if SPY is a holding in the model and you have a maximum set on Technology sector exposure, SPY's allocation to Technology will not be factored into your model's Technology allocation.
Take your model's Drift Tolerance settings into account when setting your maximum levels. If your goal is to limit your portfolio to a certain number of holdings per sector, make sure you account for holdings moving away from their target weighting. For example, if you have a 10 holding model with drift of up to 2% allowed, and you want to limit the model to 3 holdings per sector, rather than setting your maximum at 30% (3 x 10% target weight), consider moving it up to 36% (3 x ( 10% target weight + 2% drift tolerance)). This will allow you to buy a third position even if the first two have each drifted over their 10% targets but will still restrict you from buying a fourth.
Overlay Filter Templates
You can create and save overlay templates so you can easily replicate sets of overlay rules across multiple models. In order to do so:
- Go to your Custom Model Homepage
- Click "Edit my Premades"
- On the "Filters" tab, click "Create New Template"
- Select the Model Type you want these overlays to apply to and add any filters or maximums you want to apply to this rule template
- You will now see a dropdown on the Overlay page of the model creation process that allows you to Select a Filter Template