Event shortfall: Taking account of unmeasured opportunity costs
Investors reallocate their portfolios for many reasons. They may be looking to generate alpha, meet funding levels, remove underperforming managers or protect a portfolio from pending risks. These decisions are often critical in achieving long-term risk and return goals.
While portfolio analysis typically focuses on the risk and return of a new investment allocation in relation to the current portfolio, the implementation costs will also be in the spotlight. If not carefully managed, these costs can erode or even eradicate the projected benefits of the target investment allocation. The potential opportunity cost incurred between the point when the investment decision is made and when trading begins – a period that can easily span several months – is often overlooked. Like trading-period costs, external market factors prior to trading can easily erode the benefits of the reallocation.
While there has been some focus on implementation cost in the investment decision-making process, the delay cost between reaching a decision and implementing it is often under-appreciated. Delays can span two weeks to 18 months for some long-term investors, resulting in significant portfolio risk. The delay can cause uncompensated risk when an underperforming active manager continues to fall short after the decision to change but prior to termination.
Likewise, for many pension funds, a timely reallocation may be necessary to maintain asset-liability matching or meet important ratios. If a fund decides to implement a tilt from its strategic asset allocation, the timing of this tilt will often be a key factor in its success.
A new study conducted by State Street has found that asset owners and pension funds may be running significant unmandated and unrewarded risk through unintended delay in implementing changes to asset allocation and investment decisions.
We took the concept of implementation shortfall – intended to measure the cost of effecting investment decisions – and extended the way it is applied to focus on the costs incurred before the execution benchmark (that is trading-period costs). Event shortfall is a composite of implementation shortfall and portfolio shortfall – a measure of the opportunity cost incurred between the time the investment decision is made and the execution benchmark. When these two measures are calculated separately and taken together, an asset owner can gain a better understanding of the total cost of a reallocation event – that is, the total risk from decision to settlement. That way it can organise its decision making more effectively.
We analysed almost 6,000 transition events over nine years, looking at the delay between first enquiry and agreed implementation. Although the average period was 23 days, one in six events was between three and six months. This period of appointing a transition manager may be only a small fraction of the total delay in organising the change of investments.
The bottom line is that there is risk in waiting to implement an investment decision. This risk, realised as portfolio shortfall, can diminish or even eliminate the perceived benefits of the reallocation decision. Furthermore, the delay costs may have an impact on risk and return assumptions as well as allocation requirements.
Unsurprisingly, asset classes tend to experience higher tracking error over longer periods of time. The same can be said for active managers within the same asset class (assuming the strategy is active and unique). If we assume that a single day’s relative index return represents the implementation shortfall, we can get a sense of the relative magnitude of portfolio shortfall.
For example, the daily tracking error between MSCI EAFE and the Barclays Global Aggregate is 113bps, while the quarterly tracking error is more than 9%. A delay cost of three months could easily eliminate years of alpha expectations.
Here is an example to demonstrate an event shortfall. Assume a pension plan decides to increase its allocation to US small-cap equities (with the Russell 2000 index acting as proxy) and decrease its allocation proportionally to large-cap US equities (with the S&P 500 as a proxy). This decision is made on 30 September. After the meeting the plan completes both manager and transition manager searches and sets the benchmark date for implementation at 31 October.
Over this period, the Russell 2000 index grew 6.5% while the S&P 500 index only increased by 2.3%, resulting in a portfolio shortfall of 4.2%. The implementation (transition) is then completed over the following three days, resulting in an implementation shortfall of 59bps attributed to commissions, bid/ask spreads, market impact and trading-related opportunity costs. The event shortfall is therefore 4.79% (4.2% for the portfolio shortfall; +0.59% for the implementation shortfall). In this example, the implementation shortfall is about 12% of the event shortfall.
The figure shows the components of event shortfall. The blue line represents the plan’s portfolio. The portfolio returns mirror the legacy assets (S&P 500) until the implementation benchmark. At this point, the portfolio will grow closer to the target portfolio as legacy assets are sold and target assets purchased. For this example we have not considered the relative management fees between the legacy and target managers.
Failing to measure and report benchmark risk from the point of decision may lead to inaccuracies in a fund’s statement of overall investment risks. At present less than 10% of pension funds actively seek to address these risks from the point of decision, we believe.
Assume a plan decides to terminate a manager as a result of continued underperformance. The plan can begin a manager search at the decision point and experience portfolio shortfall for several months until implementation can begin. Alternatively, the plan can terminate the manager, and hire an interim manager to de-risk the portfolio while seeking a new active manager. This strategy eliminates much of the risk that the existing manager will continue to underperform the benchmark, allowing the plan to achieve market-like returns in the interim.
The plan has several ways of reducing the risk of the asset allocation, including a programme of managed futures, exchange-traded funds or physical exposure. In choosing an appropriate exposure management vehicle, an investor should consider both risk (tracking error) and costs (transaction costs, management fees and administration costs).
Fortunately, a wide array of interim exposure management strategies exist that can be tailored to an investor’s needs. The optimal exposure management strategy should consider the cost, tracking and operational features across multiple investment vehicles. A range of event-specific factors should also be considered, such as holding period, legacy portfolio composition, settlement timing requirements and the level of certainty around the target allocation.
The most effective interim exposure management strategies will balance risk and cost to mitigate portfolio shortfall and ultimately the total cost of the reallocation event — the event shortfall. This enables pension funds not only to calculate the full scale of their risk exposure and the resulting potential costs, but also to access solutions to mitigate these risks.
Steve Webster is head of portfolio solutions sales, EMEA, at State Street