Enhanced Portfolio Implementation, Part 1: How EPI separates implementation from insight
In Part 1, Global Chief Investment Officer, Peter Gunning discusses the evolution of Enhanced Portfolio Implementation (EPI), and the vital role it plays in helping investors.
- Implementation matters. Cash drag makes outcomes harder to reach. And centralised portfolio management is more than a nice-to-have.
- Enhanced Portfolio Implementation means underlying managers are hired for what they’re good at—picking stocks. We do what we’re good at—centralised portfolio management.
- The two goals of EPI: Greater control and lower cost.
Global growth is slowing. Corporate profits are shrinking. Business investment is waning. And the seemingly-perpetual bull market, buoyed by the longest U.S. expansion on record as evidenced by the S&P 500, may be entering its final stages.
If there’s ever a time to make sure every dollar and cent in your portfolio is accounted for, that time is today.
At Russell Investments, one of our key mandates is helping advisors and investors achieve their desired outcomes. This means putting our clients on the path to maximising their full potential. How can we accomplish this if their hard-earned money is squandered away through sloppy implementation?
With decades of asset management experience under our belt, we’ve seen it all: the good, the bad and the ugly of portfolio implementation. Changes in capital markets, shifting money-manager mentalities and the evolving preferences of our own clients have prompted us to continually hone both our implementation strategies and capabilities. After all, what’s the use in hiring great money managers and crafting a stellar investing strategy if the implementation process is lousy?
The evolution of implementation: How cash drag gave birth to transition management
We’ve been selecting and combining money managers and portfolios for institutional and individual investors since the 1980s. As the years ticked by, we noticed many managers were prone to leaving a little bit of cash in their portfolios after buying a range of securities—almost as if they were waiting for the next good idea.
The problem with doing this? Markets rise more than they fall. Leaving money on the sidelines, therefore, often means missing out on long-term gains. We call this cash drag. This drag is often most pronounced in a multi-manager portfolio, as the effects become compounded when more than one manager leaves cash in the portfolio. Many times, this leads to the unintended consequence of holding a portfolio with an overall cash position much larger than originally intended.
To combat this problem, we began equitising cash by employing the use of derivatives—with a focus on futures in particular. This proved to be highly beneficial to our clients, essentially eliminating cash drag from most portfolios.
Manager changes also made us uncomfortable on behalf of our clients. Why? Moving from one manager to another often meant a sizeable portion of the total portfolio was out of the market during the transition period, once again resulting in money left on the table. While it may not seem like a big deal to be off-market for two or three days, consider that in an average year, the S&P500 Index moves by 1% or more on 52 days1. Suffice it to say, you don’t want to be out of the market when one or more of those days is an upward bounce.
Awareness of this problem inspired us to derive a better solution for our clients: Transition management.
What is transition management?
Transition management is the process by which we take control of a departing money manager’s portfolio until the replacement manager comes online. In a nutshell, we oversee the transition between old and new managers for our clients, so that no part of a portfolio, no matter how small, is out of market.
Centralising the strategy with Enhanced Portfolio Implementation
It’s also critically important, in our view, to ensure that the portfolio is optimised at the total-portfolio level. What we noticed over the years, particularly in global-equity portfolios, was a wide variance in investment strategies between managers within differing segments of the portfolio.
This is a classic challenge for multi-manager portfolios: A manager is hired for a specific mandate, based on the belief that they exhibit a special skill, and is assigned a specific role within the portfolio. Yet, the manager has no oversight, let alone transparency, into what other managers in the portfolio are doing. While each manager typically has their own optimisation strategy, they’re usually unaware of other strategies, not to mention whether or not those strategies complement or harm theirs.
Enhanced Portfolio Implementation: What is it?
Our Enhanced Portfolio Implementation—EPI, for shorthand—is designed to solve this problem. We use this strategy specifically for listed securities, including equities and listed infrastructure.
How does EPI work? In a nutshell, we gather the investment insight from each manager—what they want to buy and sell and when they want to do so—but we no longer ask them to implement the trades. Managers are hired for what they’re good at—picking stocks. We do what we’re good at—centralised portfolio management.
This helps eliminate many of the problems that typically arise when differing strategies are at play in a portfolio, such as the issue of one manager unintentionally buying a security while another manager is selling it. This old-school approach creates unintentional transactional costs, custody costs, brokerage fees and taxes—all without really having any beneficial impact. EPI is designed to mitigate non-value-add transactions like these. In doing so, we can help prevent our clients from losing valuable basis points and increase portfolio control at a centralised level. The two goals: Greater control and lower cost.
In the beginning: The genesis of EPI
The catalyst that spurred us to develop Enhanced Portfolio Implementation occurred in the mid-2000s in Australia, a country with a relatively concentrated equity market. Broadly speaking, four major banks and a handful of minor ones make up a very large proportion of the country’s listed index.
In practice, we saw managers with different styles—within our Australian equity mandates—bumping into one another other. For instance, one manager might be buying Commonwealth Bank of Australia (CBA) stock, and another might be selling CBA stock—if not on the same day, then within a relatively short period.
This put us all-too frequently in situations where managers were optimising to generate excess returns against benchmarks within their individual sleeve of the portfolio but had no idea what was happening across other manager sleeves.
We knew this was a problem that needed addressing, so we dug deep into potential fixes. Our first step was conducting research into how we could potentially minimise turnover and transactions by centralising all manager trades into, effectively, one pot.
After extensive research and planning, we launched EPI for our Australian clients in 2007. A decade later, we’re pleased to report that this strategy stacks up favourably when compared to the traditional siloed approach of portfolio implementation, with a reduction in portfolio turnover. The number of actual trades within a portfolio has likewise decreased, with many trades that probably would have happened within a particular market in Australia no longer occurring.
EPI spreads to the UK
EPI’s positive impact in Australia led us to ask: What other regions of the globe could we apply this to?
Our research team dug into the issue, and pointed next to the UK equity market. While it’s not as concentrated as its Australian counterpart, it’s not without its own nuances, chief among them the imposition of a tax on every stock purchase made within a portfolio. This was the aha moment for us: If we could minimise manager trades in UK portfolios, we could really cut down on the money lost to taxes.
Furthermore, there really seemed to be no need to pay these particular taxes, because from a beneficial ownership perspective, individual securities (in most cases) stayed within the portfolio. They just happened to be bought and sold by one manager, then bought and sold by another manager, at different times.
Suffice it to say, we’ve since observed an equally positive impact among our UK clients that use EPI.
Can EPI work globally?
Our research team has conducted in-depth research on equity markets worldwide, and concluded that there are tangible benefits everywhere—even within the highly-diversified U.S. equity market. The U.S. market, after all, sees a fair amount of frictional trading among the highly-valued FAANG stocks2. We believe our ability to minimise this by mitigating some of the transaction costs is crucial. While U.S. funds and client accounts may not experience the same level of efficiencies as compared to the Australian experience, there are still efficiencies to be gained in trading that would likely be beneficial to both US funds and clients.
We also think EPI can be of great value to both global and emerging-market equities. Why? Because another benefit we believe EPI provides is the ability to mitigate transaction costs—not just at the security level, but all the way down to the currency level. In these asset classes in particular, many of the currencies that are traded are not particularly liquid, with big spreads existing between them. Our ability to mitigate many of these currency trades can therefore have a profound impact. From our vantage point, this leads to an extra bonus: Not only are we minimising the level of security turnover, we’re also mitigating the market impact coming from currencies as well.
EPI, ESG and taxes
Another potential benefit we see from Enhanced Portfolio Implementation is that it allows us to move closer to being able to customise portfolios to the preferences of underlying investors. We can potentially employ customisation at the individual level, and certainly at the institutional level. This allows pain points like taxes to be mitigated—a strategy we’ve been employing for some time with our U.S. clientele. In a similar vein, cost- and fee-mitigation strategies can also be applied to superannuation accounts and pensions in Australia, the UK, Europe and Japan.
Within this realm, we’re also continuing to identify investment managers we think will add value to our clients over pretty specified benchmarks. Beyond mitigating portfolio turnover and trades, we’re also able to delve right down into the actual trade lots being executed. For instance, in many countries, depending on when a capital gain is realised, there can be a substantial tax hit. With EPI, we’re able to finesse the way we execute trades within a multi-manger portfolio, in order to minimise those short-term gains, and push them out into long-term gains. This leads to what we call tax-managed investing—in our view, a much smarter way of managing a fund’s tax position.
Another potential benefit we see to EPI is its application to environmental, social and governance (ESG) mandates. For instance, many of our clients today want their overall portfolio to have a certain carbon footprint. With EPI, we can accomplish this by first identifying good managers to meet a typical global equity mandate—not just ESG-type managers—for our clients from the entire universe, with no restrictions. This last part is key: We want to be able to fish in the largest pond, and have the best investment managers at our disposal, irrespective of whether they explicitly take ESG into account or not.
So, at the beginning of the process, we’re without constraints—allowing us to build a centralised portfolio embedded with the best ideas of our hire managers. Then, using EPI ,we overlay a carbon-footprint mandate on top of all of this. Doing so from a centralised approach leads to a portfolio with the same excess return expectations, but less of a carbon footprint—resulting in what we see as an exceptionally powerful tool for our clients.
The bottom line
We didn't dream up Enhanced Portfolio Implementation overnight. Decades of asset management experience and manager research have allowed us to continuously evolve EPI. We’ve now been using this approach for more than ten years, testing it in the harsh reality of real-world markets. Now we’re implementing it globally. We believe it’s a key tool in the toolset. We believe it can help increase control and reduce costs. By doing so, it can help bring our clients one step closer to fulfilling their goals.
In part 2, we’ll drill further into the details behind our overlays, and the value we see in harnessing investment insights—rather than capabilities— from our managers. To hear our entire conversation on EPI, check out our podcast.
1 Source: https://www.forbes.com/sites/sarahhansen/2018/12/12/market-volatility/#4879faf671f0
2 FAANG stocks are defined as Facebook, Apple, Amazon, Netflix and Alphabet’s Google.