Managing change

Nick Martindale highlights the key points trustees need to bear in mind when making any changes to their investment management process

Periods of economic turbulence usually result in a desire to review financial arrangements, and pension schemes are no exception. While this may result in no more than a reallocation of assets from one class to another, it can also mean
a more fundamental shift in an organisation's entire strategy, including their choice of investment manager. Managers can in fact be changed for a variety of reasons, suggests David Morley, director of UK institutional at Henderson Global Investors. “The most common causes are strategy and asset allocation changes – moves from equities to bonds and from benchmarked to absolute return bond mandates being two recent examples – and manager-related factors such as underperformance and organisational change.”

Perceived underperformance in particular is a common motivation to switch managers, says Ed Pennings, senior managing director, portfolio solutions group, at State Street Global Markets. “Investors are in constant search of outperformance and have less patience with underperforming managers. Gone are the days where funds had investment managers for 20 years based on relationships. The down-turn has only increased the drive to find additional performance, albeit within more conservative investment guidelines.”

There are also other reasons why trustees might want to switch. Ralph Frank, head of solutions at solvency management company Cardano, for instance, points out that organisations might want to make a transition if there are material changes at the management firm in question or if they become uncomfortable with certain aspects of performance. “The toughest one sometimes is picking up the phone to a manager who has outperformed and saying you’re leaving because you don’t think it is sustainable and you think it represents a risk,” he says.

Yet switching managers can be a dangerous business, especially if organisations fail to take into account the original brief their existing provider was given or their ability to recover losses, warns Morley. “The key risk is around the quality of the decision, and the possibility of crystallising an unrealised loss when replacing an underperforming manager who may have gone on to recover that and outperform in the future,” he says.

Other factors also come into play in determining whether switching managers is advisable, says Tim Wilkinson, managing director, EMEA, at Russell Investments, including the nature of the underlying mandates, the complexity of the proposed changes and prevailing market conditions.

And when it comes to picking a new manager, the main criteria should be the confidence trustees have in their ability to deliver on requirements in the relevant investment field, suggests Frank. “You may look at some managers because you have confidence in their ability to deliver relative to a market benchmark but others may operate in markets where bench-marks are not quite as clear, such as the property world,” he says. “There, you may want a manager who will build your portfolio based on a certain rental yield over time with some capital appreciation, or you may want a total return out of the manager. It depends on the brief.”

There are two approaches to moving investment managers, says Ben Gunnee, European director at Mercer Sentinel Group; the easy way and the hard way. “The difficult way is to ask the legacy and target managers to deal with each other and to work out how to get those assets across,” he says.

“The easy way is to employ an intermediary body between the legacy manager and the target portfolio to project manage the whole event, carry out all the trading, look for crossing opportunities, minimise market risk exposure and offer the client some level of transparency.”

Failing to use a transition manager in this way could see years of per-formance wiped out, adds Michael Gardner, managing director, J.P. Morgan Transition Management. “Clients need to match their event with the resources of the transition provider,” he says. “For instance, emerging markets carry a great deal of complexity with respect to varied cash settlement cycles, restricted currencies and prefunded trades so it’s good to have a provider that has local knowledge and capability in these markets.”

Portfolio restructuring is not simple and turnover can often be well over 100%, so choosing a good transition partner is critical, argues Lachlan French, head of BlackRock’s transition management team, EMEA. “The key criteria should be clear alignment of interests with the client, a demonstrable ability to reduce costs and the infrastructure and expertise to manage risk.”

Graham Dixon, director at fund manager analysis firm Inalytics, meanwhile, suggests organisations should carry out at least the same level of due diligence on their transition manager as they apply to their asset managers, including a full understanding of their performance track record.

The cost of switching managers is also something to consider when making any decision, although overhauling an underperforming strategy is likely to recoup these several times over. “The main costs are in broker commissions and dealing spreads, both of which will vary with the asset class, (real estate, for example, is very expensive to buy and sell), and potentially the cost of using a transition manager,” says Morley. “They should be a factor in the decision, without driving the decision to change or not change.”

“Restructuring costs arise from explicit costs, such as taxes and commissions, and implicit costs such as bid-offer spreads, market impact and opportunity costs,” adds French. “The latter tend to be the major contributor, often in excess of 80%. It’s important to manage these properly so that the expected excess return or risk management gain exceeds the cost.”

The transactions themselves can also have an impact on the wider market, adds Frank, affecting the price during the course of the process, while external forces can also create fluctuations. “Your transition manager might have done a fantastic job but events beyond their control can cause the costs to be greater than anticipated,” he warns. “But it’s not one-way traffic; we’ve seen transitions happen where the client has been a net beneficiary because the transition manager got lucky.”

The turbulence seen during the economic downturn led to a greater focus on risk management, says Gardner, with huge fluctuations over short timeframes meaning portfolio valuations rapidly became out of date. “Many positions were valued with prices that were not necessarily where the market was trading, so
to transact in these securities the client would not only endure a frictional cost of execution but a realisation of stale valuation as well,” he says. “The result of this was that we quite often found ourselves working with clients over extended periods either postponing or segmenting events into standard and distressed tranches.”

To conclude, it is worth highlighting that those hoping that changing investment managers will be a panacea for all that has disappointed with their current pensions strategy might be best off staying put. “If you’re moving from one manager to another where your expectation of performance and risk management are not that different, then you have to question why,” warns Frank.

“There’s always the temptation, particularly after a period of time to look at absolute performance, and to kick the messenger. Sometimes you just have to take a step backwards and say that making a change isn't sensible. The tough bit is distinguishing between that and inertia.”

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