Transition Management Today
Dexton Blackstock, director, head of institutional business development, Russell Investments Canada, and Travis Bagley, director, Transition Management, at Russell Investments Americas, talk about the current state of transition management with Joe Hornyak, executive editor of Benefits and Pensions Monitor.
What is the state of transition management in Canada today?
Travis Bagley: The recent activity that we have seen in Canada almost always involves international markets. We are seeing domestic assets and equities shift from Canadian equities to EAFE equities. We have seen domestic fixed income also move offshore to international fixed income. This may result from a search for higher yield or it may signal an attempt to use international opportunities both to get more return and to diversify away from Canada to reduce risk in their portfolios.
Is this across the board – small, large, medium plans?
Bagley: Most of my personal interactions have been with the larger sized plans.
Dexton Blackstock: I can tell you just from being in the market that it is pretty much across the board. The manner in which the plans facilitate that change might differ depending on the size of the plan. Smaller plans may need to gain access to the international market through a commingled vehicle while larger plans will have the option of using separate accounts.
In fixed income, we have a huge home country bias. What is prompting this long overdue interest in international fixed income?
Blackstock: In our experience it appears that Canadian pension plans do still have a home country bias. However, a lot of the plans have acknowledged this fact and have taken steps to reduce their exposure to Canadian equity by increasing allocations to global and emerging markets strategies. Even so, they are still left with a large exposure to equity risk. The plans are all in different phases of this transition away from Canadian equities and fixed income. Some still have a very strong domestic bias so they will have a higher percentage of Canadian exposure. Others, though, have reduced it to try to be closer aligned with the broader global indices.
Has the value of the dollar had an impact?
Bagley: There is a risk perspective that most pension plan funds are focused on which is international assets provide a diversification, both from an equity market standpoint and a currency standpoint so you get diversification that allows you to run a more efficient plan than if all your assets were just in Canada. That may be the bigger picture. The question is how can I increase my return and maintain or lower my risk. Currency exposure (gained in a number of possible ways) can, at times, contribute to that.
Is there still as much domestic transition management taking place?
Blackstock: There has been some of that usually as a result of underperformance by a particular manager. The allocations may vary from plan to plan, but all plans need Canadian exposure. There will always be equity and fixed income transitions going on in the marketplace.
If I am a pension fund and I am looking for transition management, would I be looking for different characteristics in someone to do my domestic transitions as opposed to someone doing my international or is it the same?
Bagley: You are looking for capabilities across the board to help you implement your ideas. That is what Russell built for its own internal funds, the capabilities to transition assets across asset classes and around the globe efficiently. Clients come to us with an implementation challenge and we help them with a number of different solutions. In some cases, that involves moving from physical securities. In other cases, it means using derivatives and overlays to help them manage risk, as well as currency exposures.
There are some firms opting out of this space. Why are they leaving?
Bagley: There are some firms who have left the space. It is possible that other firms could leave, but that is purely speculation.
A number of the firms have left or will leave because their business models did not have the transparency to fees that clients and regulators seek. There are certain business models out there that are structured to charge what we call ‘below the line’ fees that are not transparent to the client. That is not where we see the future of transition management. Our business model, how we structured our business, is completely transparent. All our fees are transparent. Clients are drawn to that and clients like the fact that the fee is what we state it is. This type of business model, we think, is where the industry should go and there are certain providers who would not be interested in the business if it were to go in that direction.
In terms of switching from one equity holding to another, is it just commonplace that all the pension funds are using transition managers or do some of them still use other methods?
Blackstock: It is a bit of an evolution over time. If you were to go back 14 years, transition management was just in its infancy. It was not well known and required a lot of education – sitting down and talking to the plans and doing a lot of legwork, trying to impart some of the lessons we had learned from managing our own multi-manager structures. We did spend a lot of time educating folks.
Fast forward to now, it has become part of the investment process, especially for larger plans, and has influenced how the smaller plans are looking at implementing changes to their fund.
Bagley: It has become, I would say, a fundamental governance policy now for many plans to have a transition expert manage an event. That way, they have transparency to what the costs are prior to the event. They know the performance of the assets during the transition and they have post-transition reports that include time-weighted performance, transaction costs, and details regarding the operational aspects of the event.
As far as investment committees or investment boards are concerned, that is the type of governance structure under which you want to manage your plan. Transition management fits very well into that and we have seen greater acceptance. A majority of transition activity done on the equity side is done by a transition manager.
On the fixed income side, the industry still has a way to go. We are seeing the evolution there and seeing more acceptance. Historically, plans have used investment managers, most often the new incoming manager to do the transition. Now, we are seeing plan sponsors look more towards transition managers to help them move between managers or reallocate assets in fixed income.
Is that possibly because in the past there may have been less movement on fixed income?
Blackstock: Fixed income has less turnover than equities in general. That is what we have seen. But when it does move, historically, clients have used managers and used the expertise of managers for trading fixed income. A transition manager has become much more important from a risk management standpoint.
This goes back to the governance piece, having transparency to what the costs are. Transition managers are playing a more important role from that standpoint. If you have three managers on the buy side and three managers on the sell side, managing that overall transition – the project, the risk, and the trading – is why clients are now also coming to transition managers for fixed income.
So you can anticipate that if, in fact, interest rates rise and the floodgates open to liability driven investing, this could suddenly become huge?
Blackstock: We anticipate that it will. We have been spending the time, just like we have been on the equity side, educating folks. The same risks that exist in equity transitions exist even more so on the fixed income side. It is even more important to control those risks because the impact is going to be large on the value of that fund in terms of trying to recover whatever is lost by moving a fixed income portfolio from one manager to another manager.
In an equity market, there is some hope of making that up. You hire a manager because you expect that they are going to outperform. If you lose a significant portion of the value of the portfolio while making the change, it will be very difficult to recover that value in a fixed income portfolio no matter how well the manager performs. For this reason, we do expect to see an increase in fixed income transitions over time. Transition management has become a best practice in terms of governance for equity. We expect to see that happening on the fixed income side.
Are they laying the groundwork for when they are ready to pull the plug and move to their LDI strategy?
Blackstock: It does not necessarily have to be preparing for that LDI shift. In some ways, some are doing it for de-risking purposes, but not going all the way to an LDI solution. It could be just extending duration and moving out of the DEX universe specifically and getting a wider broad exposure that is more in line with the liabilities on the other side.
When you are out talking to clients about this, about using transition management for their fixed income, what sort of concerns do they raise?
Bagley: The primary concern that we hear from clients is ‘how can I be assured that I am going to get quality execution.’ That has been the client’s primary focus, trading and execution managers, on the other hand, have internal trading capabilities, which are very good and sufficient for purchasing and selling assets that they have in their portfolio every day.
We, as a transition manager, cover global markets and trade fixed income on a global basis. As a part of our core competency, we have to be able to transact and manage risk in global markets. The focus for us as a transition manager is on risk management and when plans start to de-risk, if that happens, there is going to be a big interest rate sensitivity change. Pension plans are going to increase the duration of their assets to match their liabilities more closely and that shift needs to be done efficiently in a risk-managed process. This is all a slightly different set of problems (although related) to the day-to-day portfolio management issues most managers are set up to deal with.
That is the value that Russell brings to the table. We seek quality execution for not just the target securities, but also the legacy securities of the managers. We seek to bring the combination of the execution, risk management, and accountability for the assets in transition as part of the transition process.
What we have seen historically is asset managers on the fixed income side will not be accountable for performance during a transition to their portfolio. That is the big gap and we strive to fill that gap. We are accountable for the performance during that period.
What are some of the things a pension fund that is thinking about using a transition manager should be considering?
Bagley: First and foremost is choosing a provider who has a business structure that is aligned with the client’s interest. I believe a transition manager should be hired as an investment advisor, as this requires the highest standard of care.
The other consideration is capabilities. Do they have the capabilities in the asset classes and the markets that you need to transact in?
The next piece that then goes with capabilities is the strategy. What strategies is the provider bringing to your transition so they can deliver the best solution for your plan, not just the standard solution for every transition client? There is strategy differentiation between providers and a lot of providers will have a standard transition process. They focus on a few aspects of trading and potential risks. A lot of it is around crossing and execution. Is your provider looking at the big picture, the same picture that you are looking at, performance? How will they manage the event to minimize the performance slippage to your target portfolio? What tools do they have available to do that? Can they use derivatives or currency overlays to manage risk? These are all the tools that you need in transition management to deliver successful outcomes and deliver a custom solution for each client; you need to look at aspects to determine whether they are the right transition manager for your fund.
Blackstock: Along with the tools, they will require a team that has the depth and breadth in terms of experience. How many transitions have they actually worked on and what is the breadth in terms of the types of transitions that they have worked on. That is the fourth piece. It is great to have the tools, but you need the people who know what to do and how to use them.
Russell has been in this area for how long?
Bagley: Russell has been doing transition management for the Russell funds since the ’80s. We started providing it to third-party clients in 1992.
So you were actually doing this before people started tramping around talking about it?
Blackstock: Exactly, and that is why Travis referred to our own funds because that is where we identified what the inefficiencies were in terms of how things were done traditionally. We started measuring the cost of some of these slippages – be it opportunity cost or not having the proper exposure. Being able to measure that and the impact it was having on the performance for our clients, the unit holders, was the genesis of the whole transition management business.
Then, some of our consulting clients who were larger plans caught wind or knew that we were doing this for our funds and wanted us to take a look at possibly doing it for their assets and it just took off from there.
Bagley: That is the reason why Russell is committed to the business moving forward. We have to do this for our own funds and our own multi-asset strategies and outsourcing to clients so we need to have these capabilities. We will continue to invest in the business and we have done that and we will continue to do that so that we can be a strong asset manager in the future as well as a third-party transition provider.
Does being an asset manager help you in terms of transition management?
Bagley: Yes, absolutely. As an asset manager, first and foremost, when we approach a transition, we approach it very much from the same perspective that a client would. Investment performance is first and foremost. Secondly, it forces us, as a provider, to align our interests with our clients. One of the first caveats of being an investment advisor is transparency to your fees. We are transparent in our fees. We put our client’s interest first. That is how we structured the business. It aligns very well with an investment advisory business.
When you are talking transition management, it is equities to equities, fixed income to fixed income? Do we see it happening equities to fixed income?
Are you seeing more growth or more interest in that area?
Bagley: In particular, with multi-asset strategies, some of the smaller to mid-sized plans are going to an outsourcing solution, which is sometimes called multi-asset. It is just that, multiple asset classes moving to a new structure. So we are seeing more and more multi-asset class transitions which is one of the reasons that we have put so much effort into building out and developing our fixed income transition capabilities globally, so that we can manage these large multi-asset transitions that we see increasing demand for.
For money managers, is transition management a necessary evil or is it something that they started to embrace early?
Bagley: When we started out 13 years ago, they were a bit hesitant about it – ‘why am I sending a list to you to build a portfolio.’ There has been an education process to demonstrate the benefits of transition management. Clients hired us to manage this portfolio, manage the risk, and minimize the transaction cost. There are a number of different things we do. It has been recognized as a specialty that defined benefit plans and other institutional investors have or use to move assets and managers have accepted that as the reality. There are certain managers, particularly some fixed income managers, who are less accepting of transition management. However, we have actually seen a change recently with fixed income managers, instances where fixed income managers are actually telling their clients ‘there is a lot of complexity here, there are a number of managers involved, maybe you should hire a transition manager to do this.’ That is a tipping point on the fixed income.
Blackstock: On the equity side, not only do money managers accept it, but some have embraced it to the point where they will not add any new commitment to their funds without using a transition manager. I am talking very large managers that are saying ‘look, I think you should hire a transition manager. Here are some I suggest you speak to’ and they will direct their clients to get the transition manager involved in the process and to do the funding to their actual pool or their segregated account. That is a big change.
Bagley: That is a critical portion of the Russell business as well. As a consultant, a manager of managers, and a manager research group, we have very good relationships with the investment management community. Our ability to work with those managers on a day in and day out basis on transitions, either within our own funds or for third-party clients, really does differentiate us from some of the other transition providers who are direct competitors to the other investment managers. We can help facilitate the communication with the managers and basically manage the process and the transition in a non-competitive format with our money manager partners.