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“Transition management used to be thought of as trades that were big, but relatively straightforward—firing one manager and hiring another and, in two weeks, you were done, and on with the rest of your life,” observes Travis Bagley, Head of Fixed Income Transitions at Seattle-based Russell Investments. In the last 24 months, however, he points out a change in the nature of transition assignments, where the legacy and target accounts invest in different classes of assets. For years, there’s been a shift toward alternative assets, but much of the recent action in transition management is toward decreasing plans’ reliance on U.S. equities—in particular, de-risking pension plans through liability-driven investing (LDI) strategies, where sponsors migrate into longer-duration fixed income. “We didn’t see this sort of transition 10 years ago,” Bagley says: “They call for sophisticated trading in markets all over the world, and managing risks for long periods, as sponsors line up the new exposures they’re looking for.”
Institutional assets were in motion during the financial crisis, but more so from allocation shifts than the up and down of the markets, reports eVestment Alliance, an Atlanta firm that chronicles manager performance. Excluding the effects of returns, investors moved a net $351 billion away from equities to other managers between June 2008 and December 2010, nearly all from U.S.-centric strategies. (At the end of calendar 2010, eVestment Alliance’s database of managers around the globe held a total of $11.7 trillion in bonds and equities—a relatively small increase of $270 billion from mid-year 2008, before the financial crisis.)
What the high-level eVestment Alliance data do not show, however, is the massive move within equities, but away from an age-old institutional favorite—actively managed large-cap U.S. equity. In a pension plan with a traditional 60/40 stock and bond allocation, and weightings according to market size, active large-cap domestic equities historically have constituted the largest potential for excess return. Yet now, sponsors apparently do not see much potential for excess return from large caps. “North of 90% of the value of assets being transitioned in the U.S. large-cap space has been going to passive strategies,” remarks Scott McLellan, Global Head of Transition Management at State Street Global Markets, Boston. “Even the enhanced index managers are feeling the brunt.”
Although the extent and timing of the move between active to passive for large-cap stocks might be surprising, the direction is not. The shortfall between investors’ hopes and active managers’ potential is a perennial favorite for financial research, including a recent work by academic titans Eugene Fama and Kenneth French in the October 2010 Journal of Finance, concluding yet again that few U.S. mutual funds produce enough excess return to cover their costs.
The 10% or so remainder of equity real-location has tended to go to managers that could be called hyperactive—running portfolios deemed “focused” or “concentrated,” often containing 50 or fewer positions, and less constrained by company size, industry, or geography than traditional benchmark-sensitive strategies. Such managers have drawn considerable attention from investment consultants, and are seeing large proportional gains in their own managed assets (although they still make up a small part of equity’s total dollar value).
In the fixed-income world, while pension sponsors’ transitions to LDI portfolios have gathered momentum, sponsors’ shift to bonds is not limited to long durations. “Something that is new to me, after 14 years in the business,” says McLellan of State Street, “is that, since the bottom in interest rates last summer, many sponsors have been making a tactical move to decrease their portfolio duration. They’re anticipating a further rise in interest rates, and investing in bond strategies with maturities of just 90 to 180 days.”
Transactions that cross the lines of asset classes, whether from equities to bonds or alternative assets, place greater demands on transition managers and have resulted in a higher expression of the industry’s art. “It’s simpler to sell stocks than it is to buy bonds,” says Bagley of Russell. “The long-duration corporate market has only so many bonds, and the futures market only goes out about 14 years in duration, so we have to rely on long Treasury strips or long-dated interest-rate swaps. Many clients want to phase in the bonds over six or 12 months, to reduce the risk of buying a lot of bonds at one time. All those considerations create an interesting dynamic—adding in the futures, selling the equities, and then buying the bonds patiently.” Equity transactions are similarly complex, involving currency hedging, gaps in trading hours, and spotty futures markets.
“In the last three years, the investing world has called for a greater level of sophistication in transition management in fixed income and multi-asset hedging,” says Paul Sachs, Principal in Mercer Sentinel, consultants on investment operations. Sachs serves as the conscience of the industry, studying transition management organizations, and comparing projected costs and time frames to realized results. “Proposals are more nuanced, and hedging solutions are more sophisticated and better tailored to meet client needs. The industry is developing better managed solutions, and that makes it easier for us to pick the transition managers that are winners.” —John Keefe