The days when transition events were restricted to basic equities-to-equities reallocations have long since passed. Institutional investors have increasingly been allocating to more esoteric parts of the markets in pursuit of broader diversification and/or higher returns and transition managers are often being asked to facilitate the moves.
The prevalence of low interest rates and low growth has demanded a more nuanced approach to investment, with asset owners as well as regulators putting downward pressure on costs.
The move to passive funds has been one of the clearest and most enduring trends of recent years. Active mutual funds lost around $350bn during 2016 to withdrawals amid widespread scepticism about whether unambitious benchmark-hugging strategies justify their fees.
As a result, asset owners are increasingly clearly dividing their investments between cheap index-tracking beta funds and high-conviction or alternative alpha funds, the so-called barbell investment strategy. William Cobbett, head of transition management, Americas, at Citi, said the shift from active to passive accounts for a significant amount of transition flow, with their clients increasingly adopting the barbell strategy.
With an equity-to-equity transition, a shift from active to passive is generally a relatively straightforward transition. As much as 80% of the assets may be funded with legacy assets. “The complexities in building equity index funds lie in the operational capacity to book out thousands of trades in dozens of countries seamlessly across a single day. Unless the fund is of a massive size, the assets are pretty liquid,” said Cobbett.
The money flowing into passive funds has mainly gone into market cap weighted index funds but also into factor strategies, which focus on the drivers of risk and return, and this has introduced a new complication for transitions.
“Factor investing lies between active and passive and we have seen some flow move that way,” said Cobbett. “We have helped move a number of large US pension funds into factor models. These are relatively straightforward to build from a liquidity point of view, but they do bring another risk to manage – it is imperative that the factor tilts are closed early.”
Russell Investments has set up factor funds, such as a low volatility product, to ease transitions involving the sector. Asset owners can park capital in these funds until they make a final allocation. Chris Adolph, head of transition management, Emea, at Russell Investments, said this is still relatively rare at the moment, but he expects it to happen more and more.
The search for yield
There are greater complexities inherent in building passive mandates from fixed income, said Cobbett. Individual bond issuers may offer multiple fixed income securities and an active portfolio manager may buy many different types of fixed income securities to deliver their returns.
By contrast, fixed income passive strategies aim to replicate the performance of an index using far fewer securities. This adds complexity to the conversion and is exacerbated by the fact that fixed income securities are traded over the counter (OTC) and liquidity can be poor. Cobbett said that there is a challenge in ensuring client portfolios are transitioned using the cheapest-to-acquire portfolios and getting both in and out at an advantageous price.
Sourcing bond liquidity has been made easier thanks to the electronification of the US Dollar denominated corporate credit bonds. According to Cyril Vidal, co-head of portfolio transition solution, Goldman Sachs: “We now have algorithms that can compute executable bond prices on a wide investment universe for orders below $1m. This is a significant step forward for allowing transition manager to screen for liquidity and implement client’s passive strategies efficiently.”
James Mitchell, co-head of portfolio transition solution, Goldman Sachs, said: “The execution and liquidity landscape will transform as we move into a Mifid II compliant world in January 2018. One example will be the wholesale removal of broker crossing networks and the migration of flow to other venues, including systematic internalisers. Access to a transition manager who is close to these changes and has the technology, experience and personnel to continue to efficiently access the right liquidity for clients will be critical in achieving value for money in execution.”
Transition managers will hold bonds to help manage the transition, both as part of its fiduciary duty and as a regulatory requirement. For example, Cobbett said Citi has built technology to analyse its own inventory against the exchange-traded fund (ETF) equivalent to ensure it has the right options to help investors to transition. He added: “This is both within and beyond transition management, but is important.”
In response to persistently low interest rates, investors have had to look at high yield bonds or emerging market debt to deliver higher income. But rates cannot stay low forever. Cobbett said that he has recently seen asset owners preparing for interest rates to go higher and this is reflected in some investment allocations. BlackRock has recently lowered the fee on its mortgage-backed security ETF from 29 basis points to 9bps in anticipation of this trend.
The trend to tolerate greater risk in search of returns is evident elsewhere. On the equity side, Adolph said that he is increasingly seeing clients move into emerging markets. However, emerging market equities present less of a problem as long as the volumes are not huge. It may be more expensive and require greater local knowledge to trade but there are usually constant prices and some liquidity.
The problem with this search for yield is that, in general, assets are moving from liquid to less liquid areas, rather than just from one credit or equity manager to another. It means transition managers have a more complicated task – but also the opportunity to add more value.
Adolph said: “There are challenges in transitioning to less developed asset classes. For example, in emerging markets there is typically less liquidity and trading is more broker-driven and there are fewer electronic trading platforms.
“There are also challenges on the foreign exchange side, with certain restricted currencies needing to be traded with the client’s custodian, with the transition manager often having little control over the timing and quality of those trades. Furthermore, new regulations on the collaterisation of non-deliverable forwards (NDFs) may further inhibit currency hedging.”
For frontier markets, the situation may be even more complex and require significant planning.
In addition, less liquid assets can be unduly influenced by outside issues. For example, at one point the high yield bond market was very influenced by the oil price, because many US issuers are in oil-related areas, and this reverberated through the rest of the market and made it became very expensive to trade.
These types of problems are surprisingly common; indeed, clients may have been prompted to make a transition in the first place by worsening market conditions for the assets they hold.
Adolph said this increasingly requires specialist skills and transition managers have adapted: “Among the biggest developments in the transition industry has been the enhancement of fixed income capabilities and the broader use of hedging strategies.”
At the same time, he said, asset managers have tended to become more narrowly focused and may be less able to deal with transitions between asset classes internally.
The inevitable question in defined benefit (DB) pension scheme investment strategy is when to de-risk. De-risking is desirable for maturing schemes (especially when pension payments exceed new contributions) but the timing is problematic given how low yields are, and have been in recent years.
However, there are also strong signs that some equity markets look expensive. A recent report by Goldman Sachs shows the forward price/earnings multiple of the S&P 500 is up 80% since 2011, while the trailing P/E multiple is 22x, against a long-term average of 16.7x.
However, many pension funds are not in a position to de-risk. Many remain poorly funded and cannot afford to move away from higher growth assets. In the UK, for example, the funding position of pension funds has deteriorated over the past 12 months.
Adolph said: “Although the much-publicised worsening of many pension schemes’ funding levels is a setback, as a whole pension schemes are still focused on their end game. How can they move out of growth assets and into assets matching their liabilities? What are their triggers, and if these are hit how quickly can we respond?
“Transition managers can play a vital role here in not only monitoring those funding levels, but also, should any triggers be hit, being able to quickly reposition a scheme’s asset allocation using derivatives and then unwinding those positions in conjunction with managing the changes to the underlying physical assets.”
He added that some clients are looking to protect their growth assets from a correction in equity markets. “This interest, in some instances, is also driven by the scheme’s sponsors, who don’t want a negative surprise on the contribution side if markets significantly correct.
“Derivative strategies that provide downside protection tend to be bespoke in nature, depending on the amount of protection the scheme or sponsor requires and how much up-side they are willing to forego to minimise the cost of the downside protection.”
Looking to the future
One issue on the horizon is how much longer the trend from active to passive funds will continue. In the years following the financial crisis, there was a far greater correlation between individual securities, sectors and countries than is typically the case.
Over the last couple of years, with a reduction of quantitative easing and a return to more widespread growth, this has started to break down. The relatively low level of volatility at the index level is deceptive. Bubbling below the surface there is already a greater dispersion, which should be good for active managers. The question is whether this may be enough to tempt investors to reverse the longstanding trend from active to passive funds.
Another investment trend, which is already evident, is towards multi-asset investing and alternative asset classes. Russell Investments, which has a well-established multi-manager range, reports more asset owners converting, usually to improve diversification and to reduce the overall cost level and complexity associated with managing multiple portfolios. However, from a transition management perspective, it is still in its infancy and they have not seen much volume in this type of transition.
Transition managers have needed to become more sophisticated and develop specialist skills. Most have risen to the challenge, broadening their expertise across a greater range asset classes. It is a trend that is certain to continue.