Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
How to (efficiently) change your manager
Demand for specialist transition services is on the rise as institutional investors focus on containing the upfront and hidden costs of firing fund managers, according to a new Mercer study.
Authored by Mercer NZ head of consulting, David Scobie, the report says institutions need to carefully consider the bottom-line expenses and risks of sacking underlying managers to “keep undesirable surprises to a minimum”.
While many large investors typically manage mandate changes in-house, the paper highlights a long list of both quantifiable and indirect costs that can add considerable expense to the process.
“Institutional portfolios are becoming more diverse in asset types and more global in exposure, while at the same time market trading environments are growing increasingly complex,” Scobie says in the report. “It is also worth noting that, while specialist transition management has its origins in the equity sector, it has evolved into fixed interest markets.”
The study, called ‘Money on the Move’, says the decision to appoint a third-party transition manager would “depend on the complexity of the trades involved, the absolute size of the portfolio and the amount of value at risk from market volatility”.
Scobie says investors could look for external assistance where the mandate change amounts to at least US$50 million but factors such as asset type, ‘out of market’ risks and the timeframe all influence the decision to hire a specialist transition manager.
Furthermore, the report says a transition manager could make sense where the “degree of trust in the terminated manager is low”.
“To elaborate on the last point, if a transition manager is not used, by default the responsibility for the selling down of any stocks rests with the terminated manager,” the Mercer paper says. “Prima facie, this scenario does not represent a strong alignment of interests with the investor, albeit that the terminated fund manager will have an incentive not to depress the prices of stocks they still have holdings in on behalf of other clients.”
Similarly, handing the transfer process to the incoming manager also brings problems that could see end investors suffer via performance leakage.
Independent transition managers, however, have more freedom to use “a broad range of trading strategies” including maximising in-specie transfers, efficient brokerage deals and employing derivatives or exchange-traded funds to minimise out-of-market risks.
Scobie lists five upfront transition costs that institutional investors should be aware of, covering:
- bid/offer spreads on underlying securities;
- pooled fund buy/sell spreads;
- broker commissions;
- taxes; and,
- transition manager fees.
The report also highlights five indirect manager change expenses, namely;
- market impact – where trading underlying securities moves prices to the detriment of investors;
- opportunity costs – missing out on returns due to a staggered on-market transfer process; and,
- out-of-market risks – skewing asset allocation away from targets during the transition that could create “unpredictable losses or gains”;
- administrative expenses; and,
- operational risks – or the danger of human or system errors in organisations managing the transition in-house.
Scobie says while some costs can be estimated – such as broking commissions – others “are not easy to quantify, and what is difficult to measure tends not to get managed”.
“The subject area is quite topical (to the extent there has been an uptick in manager switching going on in NZ in recent times), and I would say it is an aspect that tends not to be given full attention by some institutional investors, despite there being scope for material value detraction if not done well,” he says.
