In the interim
The challenges of the past two years have led to a broadening of transition management services, and in particular growth in interim asset management, writes Lachlan French
The rapidly changing market conditions of the past two years have motivated an increase in demand from plan sponsors for flexibility in the implementation of their investment strategies. This has led to the broadening of the services provided by transition managers and, in particular, growth in ‘interim asset management’ assignments. These more complex and challenging projects are designed to provide plan sponsors with benefits in terms of implementation speed, risk control and cost reduction - placing additional demands upon the transition manager.
From the simple to the complex
Interim asset management assignments come in many different forms, from the simple to the complex:
• Simple - The most common interim asset management mandate is the warehousing/caretaker management of an actively-managed portfolio, typically following termination of the legacy manager and preceding the appointment of a new manager. Having taken the decision to terminate a manager, the plan
sponsor’s first objective is to avoid further underperformance. To achieve this, the legacy manager’s active positions must be neutralised quickly. The period until a new manager is appointed is often unclear at the beginning of this process.
• Complex - A warehousing mandate such as the one described above is often combined with other changes to a portfolio. Recently, portfolio alterations have been driven by events such as significant differences in relative asset class returns. The variability in the relative performance of assets can result in a drift away from a scheme’s strategic benchmark, or even changes to the strategic benchmark following a review of investment strategy.
Let us consider two client case studies, first a segregated $500m active global equity portfolio, and second, a segregated $2bn Barcap Global Aggregate fixed income portfolio. Both were managed by active investment managers and the client wished to reduce risk while not incurring significant transaction costs.
For the active global equity portfolio, two approaches were considered. First, moving to an indexed pooled fund to completely remove active risk. Second, minimising dealing costs for a given residual tracking error. When considering this trade-off between possible opportunity costs (ie, the possibility of underperformance) versus the actual dealing costs of restructuring the portfolio, the length of time the portfolio would be in this ‘holding pattern’ was important. The longer the period, the larger the potential opportunity costs and the more palatable the dealing costs associated with restructuring; for a shorter period of, say, less than three months, an optimised approach may be more appealing. Figure 1 gives some insight into this trade-off and suggested optimal solutions.
With a holding period of three months, the client decided to adopt the 1.5% tracking error solution, resulting in a 32% reduction in cost while maintaining 88% of the tracking error risk reduction.
For the latter simple example, the Barcap Global Aggregate fixed income portfolio, the client had a defined cost budget and wanted to achieve the biggest risk reduction for this fixed amount. This required a strategy based on executing the transactions that had the largest contribution to overall tracking error first. In this case, this was a reduction in the portfolio’s overweight position in financials.
The result was an optimised solution with the largest tracking error reduction for the defined budget, as shown in figure 3 .
A recent example of a more involved mandate saw many of the changes typical to this type of interim assignment occurring simultaneously. This posed a more complex transition problem but resulted in a final solution with significant cost savings. These savings came directly from a holistic approach that combined the interim management mandate with the straightforward warehousing mandate.
The restructuring included the following mandate changes:
1) The warehousing and risk reduction of an underperforming active global equity manager (£280m);
2) A £400m investment into passive global equities;
3) A benchmark change within the global equity portfolio reducing the home country bias; and
4) The reduction of an overweight position in index-linked bonds (£200m) and cash (£200m).
The most common approach to this assignment would be to look at each of the four sections separately as they involve a number of different managers, executing the changes independently. However, there are significant savings available in combining the separate parts of the restructuring. Looking at this at the simplest level, you can use the additional cash investment into global equities to fill the gaps in the active equity portfolio and similarly to purchase the markets with an increased weighting in the new global equity benchmark. This minimises the extent of any selling - as detailed in figure 2. Looking at the two final columns on the right-hand side of the table, total turnover was reduced by 35% from £581m to £378m via the combined approach, leading to a significant reduction in cost.
Additional savings were obtained by using a £200m futures overlay to gain global equity benchmark exposure ahead of the appointment of the new active manager. This meant that the new active portfolio could be built from cash, rather than by restructuring an existing indexed portfolio. Overall, this demonstrates the advantage of employing a single manager on interim asset management as well as providing transition management services.
There is more to managing interim asset management mandates than purely looking after a portfolio on a ‘care and maintenance’ basis. In particular, the application of a scientific approach to reducing cost and risk is vital to delivering the best solutions. Therefore, it is important to select a manager with the experience and expertise to achieve an optimal outcome. This will be a manager with a proven track record in transition management solutions, as well as a rigorous and scientific approach to risk management and trade execution.
The platform from which these services are provided is also highly important. Given the significant growth in providers, most of whom provide these services on an ad hoc basis, there is considerable risk associated with the operational and governance structures applied to these mandates. During the last year or so, the significant risks involved in not maintaining appropriate levels of oversight and due diligence when selecting an interim manager have been underscored.
In conclusion, when choosing an interim asset manager, a pension plan should look for a provider able to demonstrate a proven track record in transition management solutions that are based on a quantitative approach to risk management, combined with a robust operational infrastructure and the highest levels of governance and fiduciary oversight.
Lachlan French is head of transition management, Europe and Asia ex-Japan at Barclays Global Investors