Enhanced Portfolio Implementation, Part 2: How EPI separates implementation from insight
Peter Gunning drills further into the details behind our overlays, and the value we see in harnessing investment insights from our managers.
Greater control at a lower cost.
That’s the value proposition behind Enhanced Portfolio Implementation, the centralised portfolio-management approach we introduced you to in our previous blog post. Launched a decade ago in Australia, we’re now rolling it out on a global scale, driven by our belief that it has the potential to be a gamechanger for the industry.
To recap, Enhanced Portfolio Implementation (EPI) is our home-baked, differentiating approach to portfolio management. Instead of using money managers to execute trades, we collect their investment insights—the stocks they identify as the best to buy and sell, now or down the road—and take the implementation in-house. We pay for money manager insights. But we implement the portfolio. Not them.
Meet the new boss, not the same as the old boss: How the EPI way differs
To illustrate how this works, it’s helpful to understand what a traditional multi-manager approach usually entails. Typically, a multi-manager asset management firm will hire an underlying, independent money manager to help execute on a particular strategy. As part of this, the money manager goes out on behalf of its clients, purchases what they believe to be good stocks, puts them together in a sensible way and trades them on the open market. This eventually flows through into a client’s portfolio.
Under this approach, the portfolio manager (employed by the asset management firm) receives notification of a trade, but has no role in the actual implementation. So, while there’ll be an accounting book of record (ABOR) documenting the trade, there won’t necessarily be an investment book of record (IBOR). This means that while the portfolio manager will eventually find out the specifics of the trade, it won’t occur in tandem with the trade notification. In other words, the portfolio manager won’t receive all the information pertaining to the trade upfront.
Enhanced Portfolio Implementation presents a key difference. Rather than executing the trade, the money manager sends a model portfolio through to our implementation team. This model portfolio consists of the insights of the money manager—the stocks they’ve selected and combined in a way they feel will lead to outperformance of a specified benchmark. Our implementation team then takes it from there. So not only are we aware of the trades, we are executing them.
How EPI works
Let’s dive into this further with a hypothetical example. Say there are four underlying money managers assigned to a portfolio—each with their own separate portion to manage. Under the EPI approach, our implementation team would receive four separate model portfolios—one from each money manager. Before we executed any trades, we’d first combine all the model portfolios into a single, centralised portfolio. Then, we’d compare this portfolio to historic allocations.
Next, we’d implement any trades that needed to be carried out at the total-portfolio level. Over time, we’d receive new model portfolios from each of the four money managers, and our implementation team would continuously update the overall portfolio.
Mitigating turnover and trades
From a client perspective, the end result of this approach is nearly identical. The vital difference is that the trades that were previously done by one money manager are now no longer executed until all the portfolio segments have been combined into a single portfolio. This can result in one of the key benefits we see to Enhanced Portfolio Implementation—a reduction in turnover within the portfolio, which results in cost savings for clients.
How? Say, for instance, that one money manager’s model portfolio calls for buying more IBM stock, while another money manager’s model portfolio calls for selling IBM stock. In such a scenario, our clients wouldn’t see any changes in terms of beneficial ownership. To put it simply, these trades don’t make sense. With EPI, neither trade would happen, as we’d cancel both out at the total-portfolio level—rather than going out to the market twice to trade. Brokers, custodians and the tax man—all of whom profit from trading—might be miffed. Our clients wouldn’t be.
Another positive to EPI is a cutback in the amount of trades which have no material impact on the portfolio—typically, these consist of very small trades. Think of it this way: Say a portfolio has four money managers, each responsible for one segment of the portfolio. If Money Manager 1 decides to sell half a percent of a particular security within their segment of the portfolio, and Money Managers 2, 3 and 4 have no existing position with the security, the trade—as spelled out in the model portfolio Money Manager 1 sends to us—may not actually happen.
Why? An independent money manager doing something at a relatively small proportion within their segment of a portfolio is not enough to have a material impact on the overall portfolio. This is why, in EPI, very small trades often are not implemented, as they typically incur custodial fees and brokerage costs. We often refer to these tiny trades as rats or mice. They’re the types of trades brokers and custodians are happy to jump on, yet they don’t have much of an impact at the total-portfolio level, other than to nibble away at returns.
The skeptic asks: Is EPI second-guessing?
We firmly believe in a multi-manager investing approach and the benefits of active management. Yet some may consider EPI tantamount to second-guessing the decisions of the money managers we’ve hired. We understand why this concern may arise. At first glance, EPI can seem confusing: On the one hand, we believe in the money managers we’ve hired, and on the other hand, we might not be implementing everything the exact way they would have.
Let’s be very clear: In handling the implementation ourselves, we’re in no way trying to second-guess our money managers. Decades of experience in asset management have taught us that, especially on the equity side, our independent underlying money managers are quite skilled at picking great stocks and assembling them in a sensible way. We hire our money managers specifically to do this—to generate investment insight. EPI, far from mitigating their ability to do so, capitalizes on this skillset.
However, we’ve also learned that most money managers tend not to spend much time on the implementation side of things. In other words, once they’ve come up with a good idea, they’re happy to trade it one way or the other.
This differs considerably from what’s practiced within our walls, where we’ve continually invested in building our trading and implementation capabilities. If you include all the asset classes, overlays and currencies we manage, Russell Investments trades close to $3 trillion in assets.1 In other words, we’re pretty good at moving pools of capital from one place to the next.
This leads to what we see as a key benefit of EPI: It combines the best of both worlds. Our money managers are employed to do what they do best: picking great stocks. And we supplement this with what we’re really good at: implementation. That said, it would be disingenuous to claim that all our money managers—especially in the early days—embraced EPI. Change is a hard pill to swallow for most in the industry—and Enhanced Portfolio Implementation marks a substantial change to a long-standing business model. It’s a fair question, then, to ask if our addressable market of money managers has at all been reduced by those unwilling to participate in such a relationship.
What we’ve found in the decade since EPI launched, however, is a negligible-to-near-zero impact on our addressable universe. We’ve been able to adequately answer the initial concerns and questions among money managers, and, consequently, the universe of money managers available to us for hire has not meaningfully decreased. Interestingly enough, we’re on track to have 100% of our equity money managers, globally, employing Enhanced Portfolio Implementation by year’s end.
In other words, we’re eating our own cooking—and it tastes pretty good.
The bottom line
We believe Enhanced Portfolio Implementation means enhanced opportunities for investors to be able to achieve their long-term outcomes. By improving portfolio governance and trade oversight, in addition to lowering implementation charges, trading costs and tax penalties, we firmly believe we’re helping steer investors on a path to a brighter—and more financially secure—tomorrow.
1 Source: As of December 31, 2018.