David Rae, senior portfolio manager, EMEA and Chris Adolph, head of transition management, EMEA discuss the changing face of TM
The investment challenge in 2010
For many institutional investors, particularly pension funds, the landscape has dramatically altered, with changing scheme demographics, worsening funding ratios, scheme closures and increasing scrutiny from their corporate sponsors.
If there is no one conducting the orchestra full time, the tune may fall flat
Alongside these changes, trustee bodies are looking for more sophisticated solutions to manage these investment challenges, such as:
- reducing their reliance on the equity risk premium;
- international diversification;
- introducing alternative beta sources and skill-based strategies;
- liability and currency hedging; and
- a desire to be more responsive to market conditions.
The old strategy of a 60:40 equity:bond portfolio is well and truly behind us.
That said, investors are faced with a dilemma. Maintaining the traditional investment model is not an option. However, the demands on staff associated with making these changes (often simultaneously) are enough to challenge even the best-resourced teams. Even after any change is completed, a host of potential inefficiencies threaten to negate the benefits of the new strategy. While each individual strategy and/or manager is selected to beat their benchmark or play their role, if there is no-one conducting the orchestra full time, the tune may fall flat.
Introducing the exposure manager
As investment strategies have become more complex and the number of investment managers has multiplied, the executing and monitoring responsibility for pensions managers and chief investment officers can become arduous. One way to alleviate the burden is to outsource more. But even this can be onerous if you have many relationships to manage and multiple reporting requirements. Some investors have now recognised the need to engage external providers to assist in the management of the fund-level exposures, employing an exposure manager to manage some or all of the following functions:
- implementing asset allocation changes tied to funding level rather than simply linear de-risking, i.e. liability-responsive asset allocation;
- a passive currency overlay;
- gaining beta exposure in a portable alpha assignment;
- transitioning assets between individual investment managers;
- more complex cashflow management at the plan level, including gains/losses on derivative positions and capital calls and distributions associated with investments in alternative asset classes;
- unintended bets, often associated with asset class drift or unintended cash exposure;
- liability-relative interest rate and inflation risk; and
- specific portfolio tilts in response to the market conditions and asset class return expectations.
Requirements of an exposure manager
At its core, the role of the exposure manager is to gather and analyse data to determine the overall exposures of the portfolio and their appropriateness given the investment strategy. Requirements are:
- an in-depth understanding of the objectives and rationale behind each investment strategy, as well as the challenges facing the investor;
- the ability to determine the most cost- and risk-effective approach to adjust the exposures under the prevailing market conditions;
- the development of a rapid consultation and decision procedure with the investment committee or CIO, so they act in collaboration;
- the ability to effectively manage the investment, operational and counterparty risks associated with using over the counter (OTC) instruments;
- an understanding of the implications of non-linear pay-off structures on both assets and liabilities, and the ability to implement these on a real-time basis; and
- total fund-level reporting in both asset and surplus space, separating the contribution from intended and unintended risk exposures.
The evolution from transition manager to exposure manager
Evolving transition management roles to encompass exposure management has a number of benefits, in particular:
- Efficient implementation: the exposure manager is uniquely placed to implement complex fund restructurings, such that a traditional “big bang” approach may not be required. Major strategic changes can be implemented efficiently and on a timely basis, without having to wait until the nuance of every investment managers’ IMA has been finalised. Manager changes can thus be implemented on a rolling basis, safe in the knowledge that the overall asset allocation remains controlled; and
- Strategic management: transition managers are typically employed on a project-by-project basis and focus on minimising implementation shortfall in a risk-controlled fashion for each event. The exposure manager does not consider each event as a unique assignment, but manages the implementation of the plan’s decisions on an ongoing, longer-term basis. Exposure managers take a more holistic view, with individual transition events forming only one component of the mandate.
The bottom line
The introduction of a qualified exposure manager, with all the tools at its disposal to implement the trustee’s decisions brings tremendous benefits. In addition to reducing the risk and costs associated with portfolio change, it enables the fund to become more responsive to market conditions. It is one thing to identify the right strategy but getting that strategy into the portfolio efficiently and at the right time is an entirely different challenge. Finally, the internal investment professionals can devote a greater proportion of their time to identifying, analysing and monitoring new investment strategies.