Stuck between a rock and a hard place? How interim transition management can help.
Managing exposures in 2021
Interim transition management (TM). Compared to traditional approaches, interim TM promises both ease–of–use and significant cost savings. But is it possible to have the best of both worlds? We believe the answer is yes.
Investment manager changes are a frequent occurrence for institutional investors and sometimes these changes are required on a moment’s notice. There are times when the need arises to move assets from an existing investment manager to a new one before the ultimate new manager is selected.
Some common reasons for making an investment manager change include portfolio manager lift–outs, investment manager closure of the business or winding down a specific strategy, scandals or improper conduct and underperformance. In these scenarios, there is typically a desire to make a change quickly, but institutional investors can be faced with options that are not ideal and can leave assets in limbo while a new manager is vetted and selected. Often this manager search and selection process can take months to complete.
Once the decision has been made to terminate an existing manager or mandate, institutional investors are then faced with what to do with the assets until a new manager is selected and under contract. We believe there is an ideal way to handle this situation, but let’s first review some of the more common, but less ideal solutions to this challenge.
- Leave the mandate with the existing manager (where able)
- Terminate the mandate and require care and maintenance
- Restructure the mandate to a passive mandate
Each of these options has a number of disadvantages, which tend to outweigh any potential advantages.
Option 1: Leave the mandate with the existing manager (where able)
Surprisingly, this is a common solution often used by organizations to keep the legacy manager in place until a new manager is ready to be funded. However, the advantages with this approach are few and far between.
- Least amount of work/administrative ease.
- Concerns over governance of your organization’s assets. If you’re holding on to a manager in which confidence has been lost, are you really doing your fiduciary duty?
- Continuing to pay for active management fees when the active manager’s insights are no longer desired.
- A junior portfolio manager could potentially take charge of your portfolio. This often arises in instances where the old manager has been lifted out. You may be left with a manager you’ve potentially never researched.
- Your organization may ultimately be forced out anyway, along with all other investors, if the manager is closing up shop. You might be left with a fire sale.
Option 2: Terminate the mandate and require care and maintenance
Under this approach, the legacy manager is told to stop trading and instructed to only manage corporate actions, proxies and other administrative matters until officially terminated.
- Administrative ease.
- Compared to the do nothing approach, perhaps governance is at least improved under this approach, as no new active decisions are being made by the manager in which confidence has been lost.
- Still sitting on active bets taken by the manager that will become stale over time
- No real active oversight over the portfolio, let alone accountability for it.
- Continuing to pay active management fees.
Option 3: Restructure to a passive mandate
This option entails moving the assets from an actively managed portfolio into an exchanged–traded fund (ETF) or index fund.
- Administrative ease.
- It's very costly to transition from active to passive, then back from passive to active, as you end up paying transaction costs for selling and buying assets on both ends.
- You were already paying active management fees to meet a particular alpha target or investment exposure. Moving away from an actively managed portfolio may increase the chances you won’t meet your investment objectives.
The costs of these simplistic approaches are significant. But the one consistent advantage seen in all three is the ease–of–use factor—that is, the lack of an administrative burden. In other words, not getting bogged down in the weeds of a portfolio restructure that isn’t even core to your business.
What if there was a solution that could satisfy both of these needs and relieve the administrative burden while still saving on cost?
We believe the solution to this exists in a fourth option—interim transition management.
The better option: Interim transition management
In interim transition management, a transition manager is held accountable for the performance of the portfolio during the interim period between the departure of the old manager and the onboarding of the new manager. During this timeframe, the assets are held in an implementation account set up by the transition manager. Meanwhile, the transition manager is responsible for minimizing the performance impact of the portfolio restructure and maintaining the desired investment exposure. This includes employing strategies, such as derivatives, that minimize unnecessary trading costs for the asset owner, in addition to mitigating unrewarded risks. This eliminates so–called performance holidays, ensuring there are no gaps in overall performance. This is key to ensuring accountability and proper fiduciary oversight of the portfolio.
Just as important, the workload is transferred from the asset owner to the transition manager, preventing vital resources in the organization from becoming overly burdened by non–core administrative tasks.
As a result, the asset owner often receives active management with reduced risk without paying the active management fees. Depending on the asset owner’s appetite for risk, for instance, the portfolio can be optimized to a specific benchmark, which cuts down on tracking error. This is done by running multiple iterations to determine the optimal tracking error, and then establishing trading bands around the targeted tracking error for rebalancing purposes.
Advantages of interim transition management
- Lower cost, optimized beta exposure.
- Dramatic cost savings when compared to pure passive approach—i.e., don’t have to buy/sell every security in an index fund when transitioning in and out of passive management.
- Maximize in–kind transfers with each transition.
- Reduction in trading and transaction costs by consolidating multiple transitions.
- Increased ability for flexibility and nimbleness, as the transition manager is not held to the terms and conditions of a pooled product.
- Ability to quickly and efficiently leave the legacy manager, plus more time to determine which manager to ultimately place your assets with.
- Ability to utilize existing securities to fund new manager once chosen. By maximizing any in–kind transfers, overall transaction costs are reduced.
Case study # 1: Building an optimized representation of the MSCI All Country World Index (ACWI)
A client of ours, desiring to get out of a global mandate, initially tasked us with building a full–representation of the MSCI ACWI—an index with nearly 3,000 names. Notably, some of the restricted, non–transferrable markets were not open in the transition account.
Our team was able to analyze the client’s portfolio and build an optimized portfolio of individual securities and a few ETFs, tracking the index within 35 basis points (bps) of annualized tracking error. We were able to retain a significant amount of the legacy portfolio by only purchasing approximately 1,200 names in the index—leading to dramatic savings in trading costs and custody fees. This also allowed for more time to get out of the very illiquid names, rather than having to do this quickly and incur higher costs.
Over time, the portfolio consistently tracked the index, which meant we only had to rebalance when assets were coming into or out of the account. After the initial optimization, the client used this as an implementation account for the next six years. The account fluctuated between US$200 million and US$5 billion in value, depending upon what the client was doing, with the client transitioning in and out of the implementation account eight to ten times per year. This provided the client with a powerful tool that helped them manage their manager changes and overall liquidity needs.
Case study #2: Transition from AJO
Last October, AJO Partners announced that it would be closing its doors at the end of 2020, meaning that clients would need to move their assets to another investment manager. Following this news, we were approached by multiple clients in need of finding a solution for their assets.
Ultimately, we were hired by seven clients in the U.S. to take over their AJO portfolios, trim the tracking error risk from around 4% of the benchmark to somewhere around 1.5% to 2% of the benchmark, and then manage the assets on an interim basis until the clients could find a long–term solution with another investment manager.
For one particular U.S. pension plan which held an AJO mandate, we presented them with several scenarios. These ranged from going all the way to a passive index approach (with an estimated cost of -46.5 bps, +/-23.6 bps) to a quantitatively managed portfolio that tracked the benchmark by 2% (with an estimated cost to restructure of -9.8 bps, +/-12.7 bps).
The client chose to go with a 1.75% tracking error to the benchmark (with an estimated cost of -12.5 bps, +/-14.2 bps), which saved them an estimated 34 bps in transactions costs versus going all the way to the index. We were able to achieve these results with only a 15% turnover in the portfolio, while still maintaining their desired investment exposure.
Importantly, this solution also allows the client to maintain an actively managed portfolio until it chooses a new long–term solution for its plan. It’s worth noting that this interim portfolio has also outperformed the benchmark by 34 bps since inception.
Case study #3: Pension plan with Emerging Markets debt manager
In early 2020, a public pension plan approached us with a common dilemma. It wanted to terminate an emerging–market (EM) debt manager, but did not have a new manager contracted yet. The organization knew it would take up to six months to choose a new manager, but it wanted to terminate its relationship with its current EM manager as soon as practical. We helped them evaluate a few options by first running multiple portfolio optimizations against the client’s custom benchmark, to provide various risk and cost scenarios. This analysis also factored in various turnover scenarios, ranging from 5% turnover to 20% turnover—and the risks and cost impacts associated with each scenario. The costs ranged from -0.4 bps to -7.2 bps for the various scenarios. In the end, we were able to reduce the tracking error by approximately 40% by turning over just 5% of the portfolio, while preserving the desired investment exposure.
The initial activity was implemented in February of last year. We managed the portfolio until late August, when the client had researched, contracted and hired a new manager—at which point we transitioned to the new mandate.
The bottom line
For institutional investors, the need for an investment manager change is fairly common—if not ordinary. However, we believe the approach used to transition between old and new managers should be anything but ordinary. Your portfolio demands top–notch oversight and management at all times—especially during times of change.
Your portfolios may be exposed to more risks than ever before. How do you mitigate these risks? Who do you turn to? We have the experience and deep capability set to help you manage your exposures and to help you navigate the challenging road ahead. Let us know how we can help.