(August 14, 2018) – The 2018 global financial landscape has featured sweeping tax reform, rising interest rates, regulatory upheaval, and escalating trade wars. The result of this economic maelstrom has been a deluge of investment uncertainty, which wouldn’t be so bad if it weren’t paired with spontaneous spin cycles of neck-twisting volatility. Experienced portfolio managers, investment consultants, pension fund agents and plan sponsors view this capricious scenario as so much business as usual. After all, Investment Axiom 101 decrees that one man’s crisis is another man’s opportunity.
Investment opportunities evolve dynamically, requiring the rebalancing of portfolios over time. The challenges faced by a portfolio transition management team today hasn’t changed much from a decade ago; reach a target portfolio in a smooth and speedy manner while minimizing transactions costs and market impact. You know what has changed? The available tools to manage risk.
In 2018, not only does a transition management team have to consider events across an ever-widening range of asset classes, geographical markets and fund structures, but they must now utilize risk management tools such as complex derivatives and ETFs. General George Patton once said, “A good plan executed right now is far better than a perfect plan executed next week.” In a global investment environment where a single tweet from a mid-level government official or a cable news talking head can trigger an algorithmic temper tantrum and put entire portfolios at risk, efficient and cost-effective portfolio transitions require three key ingredients;[1]
- Sound judgement and extensive experience to plan and execute each transition
- Proven portfolio-optimization techniques to reduce opportunity costs relative to the desired portfolio
- Access to multiple sources of liquidity to minimize costs and enhance performance
Passive vs. Active Management
Throughout 2017, the shift to passive equity investment, particularly among public defined benefit plans, led to a spike in the use of transition management services, with as much as 60% of activity attributable to the strategy shift.[2] Zlatko Martinic, Managing Director and Head of Transition Management at Penserra, takes a magnifying glass to this trend, noting that the move to passive management generally focused on strategies involving large-cap equities and developed markets. “That’s not necessarily in the emerging markets space, where there are transferability issues, especially among commingled funds,” says Martinic. “But otherwise, there definitely is a shift going on. Still, when it comes to the sum of the observations, folks still like to make active plays in small caps and emerging markets equities. But large caps and EAFE are what’s moving to passive.”[3]
Currency Risk
Geopolitical tensions seemingly surface with every news cycle, raising the spectrum of heightened currency risk during the second half of 2018 and beyond. Transition managers have long used futures to manage market volatility and hedge against adverse currency movements. For instance, a transition from the Eurostoxx 50 index to the S&P 500 index will be at risk from the dollar rallying relative to the euro during the transition period. To hedge himself, a transition manager will take a position in FX forward contracts or a long-dated FX spot to avoid a situation where there are insufficient funds to settle the S&P 500 purchase.[4]
A potential weakness faced by transition management teams is a mismatch between the portfolio and the index used to match it, whether that is the legacy or the target exposure. According to Steve Webster, senior advisor at Allenbridge, “The effectiveness of hedging using equity futures is limited by a number of both practical and exposure constraints. From an exposure perspective, hedging using equity index futures will mostly be limited to the more common index benchmarks, so the less the transition is correlated to available benchmark indices, the less effective a derivative hedge might be.”[5]
Hedging against currency risk has some practical considerations, not least that the rate of the FX forward may be different from the current FX spot rate, owing to the currency interest rate differential. Moreover, some emerging market currencies are restricted in the way they can be executed, requiring the underlying custodian of the client account to execute the transaction. Money managers that use a global custodian may also have to rely on pre-agreed terms to manage foreign exchange balances at the point of settlement, which can be sub-optimal for a transition, potentially increasing the exposure timeframe and risk.
Futures
There are advantages to using futures which give flexibility in terms of timing and cash availability. Futures contracts can be purchased or sold, and futures do not require “settled cash.” On the back end, to reduce a futures position, it is as simple as closing out the position and the cash is for all intents and purposes immediately available.
However, there are challenges. In order to use futures, investors must have an account and be able to manage collateral. And as if that wasn’t enough, opening such an account can be complex and time consuming, with reporting requirements adding to the legal and administrative burden.
ETF Investing
Assets in exchange-traded funds surpassed $4.3 trillion in 2017, up nearly five-fold over a 10-year period. With a proportionate increase in liquidity, ETFs have become an indispensable tool for institutional investors transitioning portfolios from one investment manager to another.[6]
To reduce FOMO risk (Fear of Missing Out), investors who would otherwise be on the sidelines for extended periods may consider using ETFs to gain temporary exposure to coveted segments of the market. This cash “equitization” or “bondization” is a way to gain or maintain exposure to the target allocation. In other words, instead of just holding cash during portfolio transitions, institutions can invest in ETFs to gain market exposure and reduce potential opportunity costs.
This solution may be particularly attractive when an institution has terminated an investment mandate but is still weeks or months away from selecting a replacement.[7]
Transition Performance
At its core, transition management is analogous to a multiple-objective, dynamic portfolio-optimization problem. But unlike mathematical formulas, actual transitions cannot be devoid of human judgement. Because all risks associated with the transition process cannot be anticipated, trading remains as much art as science, and working with the right transition management team remains crucial. In 2018, as in previous years, the key features of a successful transition management are;[8]
- Project and risk management. As transitions become more complex, clients rely upon a transition manager’s ability to create an implementation strategy. This includes management of all aspects of the restructure and detailed timelines for each transition.
- Trade execution and performance. Specifically, global-based execution utilizing derivative-based overlays or custom-built quantitative strategies.
- Report preparation and analysis. This includes cost estimate and performance analysis at all stages of the transition, including pre-trade and post-trade reports which detail the actual costs against estimates and transaction level of transparency.
“We realize there’s no ‘one-size fits all’ approach to transitioning assets,” says Calvin Lee, Senior Portfolio Manager at Penserra. Lee continues, “Once we’ve gathered all of the information, including any or all expectations and constraints, we come up with a customized execution strategy that is accurate, realistic and cost-effective. From a performance standpoint, this means our projected risk/cost estimates provided on the pre-trade analysis are generally in line with the outcome.”
Summary
The French novelist and critic Jean-Babtiste Alphonse Karr famously said, “plus ça change, plus c’est la même chose,” which roughly translates to “the more things change, the more they stay the same.” In 2018, despite the increased complexity of transition events, that statement accurately summarizes the world of portfolio transition management.
[1] “A Practitioner’s Guide to Establishing a Prudent Transition Process,” ITG, February 2009
[2] “Passive Shift a Boon For Transition Management,” Pension and Investments, June 12, 2017.
[3] “Passive Shift a Boon For Transition Management,” Pension and Investments, June 12, 2017.
[4] “Safety By Design,” Global Investor Group,” February 2, 2018
[5] “Safety By Design,” Global Investor Group,” February 2, 2018
[6] “Record Inflows Boost Global ETF Assets to $4.3 Trillion,” Forbes, August 23, 2017
[7] “Bridging the Gap: ETF Solutions for Transition Management,” Pimco, December 2012
[8] “Transition Management Guide 2017,” Global Investor/ISF Transition Management Guide 2017