The following feature appeared in the April 2008 edition of AsianInvestor magazine. For subscriptions, please contact Richard Santoro on [email protected].
Transition managers report a rapid rise in mandates from institutional investors in Asia and Japan. In many cases, such mandates have yet to be implemented, or are still under discussion. Investors from this region have not yet committed themselves to re-entering capital markets following a flight to cash and to Treasuries in the fourth quarter of 2008. But transition managers in the region say they have never been busier. The region’s institutions are getting ready to make some moves.
So far, Asian investors have hesitated to implement their new strategic asset allocations – unlike investors in Australia, America and Europe. In western countries, pension funds continue to pursue a disciplined rebalancing strategy. In Australia, for example, many superannuation funds continue to have a domestic equity bias, and have been steadily filling up on stocks in order to maintain a certain weighting.
Asian investors, in contrast, have shown greater willingness to keep their cash on the sidelines. This is not just true of central banks and sovereign wealth funds, but of those with liabilities, such as pension funds and insurance companies. Investors have uniformly been prepared to wait despite cheap valuations across asset classes, because they have no certainty that markets are near bottom.
This hesitation masks an enormous amount of work in preparation for executing a variety of strategies. Transition managers are brought in to help an institutional investor shift assets out of one portfolio to another without having to go to cash, using their access to liquidity to effect transitions that are as swift as possible without creating undue market impact or other costs.
Amid the wreckage of the global financial crisis, transition management has also become an important risk-management (or more accurately, risk-mitigation) tool.
“Hiring a transition manager makes someone accountable for moving assets from a legacy manager to a target manager,” notes Nick McDonald, Hong Kong-based principal at Mercer Sentinel. “There’s performance to measure, which is important when you want to preserve capital.”
But deals in Asia get sealed more slowly. Duncan Klein, head of transition management for Asia ex-Japan at JP Morgan Worldwide Securities Services, notes that the managers running government or quasi-public funds may be keen to implement a mandate, but need to get internal sign offs and approvals. He expects the second half of 2009 and most of 2010 to be extremely busy.
For once, however, a rise in transition activity does not suggest a particular trend. This is new for Asia and Japan. Transition management has only been in use here for four or five years, and service providers – brokers, consultants, custodians – have spent most of that time ‘educating’ clients (ie trying to sell) rather than actually doing many deals. But when there has been activity, managers could identify general trends, as the region’s investors moved to specialist managers or international allocations, for example.
The industry entered a unique period in the fourth quarter of 2008. After the Lehman Brothers collapse, transitions suddenly became about just one thing: liquidating positions. This was unusual, because the point of transitions is to avoid going to cash. The raging credit crisis, however, had prompted Asian investors to hire experts to help them exit volatile markets with their assets intact.
Having exited markets, Asian investors’ strategy is no longer easy to pin down. This is a welcome development. The fact that many mandates are being awarded or considered, but across a variety of strategies, is a sign that the region’s institutions are not following the pack. They are acting in accordance with their own risk appetites, in-house capabilities and diverse strategic asset allocations to an extent never seen before.
But to some extent this variety reflects the impact that market volatility has had on fund managers’ performance. Dispersions of returns are now so great, that it is forcing investors to react in different ways.
“Volatility exceeded investors’ expectations, therefore many funds are looking to make adjustments,” says Gene Reilly, managing director at Goldman Sachs in Hong Kong. He says this runs the gamut from shifting out of badly performing fund managers to fundamental changes in asset allocation.
Nonetheless, some transition managers discern two patterns that account for much of the current positioning.
“We’re starting to see rebalancing trades, because investors’ fixed-income holdings have become so overweight within their strategic asset allocation,” says John Moore, director of implementation services at Russell Investment Group in Sydney. Institutions in Asia and Japan have not been as fast as western peers to adjust their portfolios – and given the ongoing turmoil in equity markets and performance in US Treasuries and other fixed instruments, many investors are prepared to wait even longer. But they are laying the groundwork for an inevitable shift.
Second is a move to passive investments, including the use of exchange-traded funds, at the expense of active managers. This is particularly true in equities, where cheap beta is seen as the best way to tap markets right now. “Investors can’t tell if an active manager’s performance problems are due to bad luck or poor skill,” notes Hari Achuten, a director in transition management at Credit Suisse in London. “Beta makes sense when it’s practically impossible to figure out which managers are the best.”
Not all investors are rebalancing or going to passive, of course, and many transitions reflect other concerns. These include switching among fixed-income asset classes or taking mandates in-house.
Both the need to rebalance as well as a desire to de-risk has put a new emphasis on fixed-income transitions. For example, Peter Walker, London-based managing director at BlackRock Solutions, reckons fixed-income transitions made up 40% of business in 2007 and only 10% in 2008; he predicts far more transactions this year will be fixed income-related.
The great majority of Asian international assets are in fixed income, and it is in areas such as mortgage-backed securities and corporate bonds where investors have suffered the most. They are often left with illiquid and distressed assets they can’t get rid of.
This is creating demand for those transition managers equally comfortable handling bonds and stocks. All managers claim they have this capability but investors are advised to demand hard evidence of this.
The need to sell fixed-income portfolios has added to investors’ hesitation, because doing so will force them to realise losses. This process is teaching them that the valuations given them by a custodian or a legacy manager often don’t match what, in reality, a transition manager reckons an asset will fetch. This used to be the case only with junk bonds, but now applies to blue chips like General Electric.
“Costs have gone up in many pre-trade analyses,” warns Tom Clapham, director of transition management at Deutsche Bank in Hong Kong. “For distressed or impaired securities in a portfolio, we take time to explain how the market environment has affected price discovery, and how prices could be further impacted by a transition.”
If a transition manager really can use its global network, internal crossings or other sources of liquidity to sell toxic instruments, that manager is probably proving its worth. To ease the pain for clients, transition managers note their services should be seen as an exercise in managing risks rather than in trading.
Equities (at least listed ones) are not as tricky because an exchange’s pricing is transparent. Volatility has become a challenge, however, in some cases forcing transition managers to extend the time required to fulfil a mandate. Market timing becomes all-important when stock prices are moving so violently within a single day. And illiquid fixed-income instruments may take weeks to move.
To alleviate some of these issues, transition managers are recommending clients consider hedges. In the past, investors have been reluctant to pay to hedge against market volatility. When intraday market ‘gapping’ can be 5-7%, however, it may start to make sense for investors to pay 2-3 basis points in spread in order to insure against such moves, suggests Hari Achuthan.
Transition managers are busy preparing for deals. Investors, however, have yet to pull the trigger. Industry executives expect a robust 2009, but that assumes macro factors and market volatility settle down. What if a deepening global recession doesn’t allay investors’ hesitation?
“If there’s no market stability, the question is can investors wait,” Tom Clapham says. Investors with liabilities have been expected to return to the markets already, but, “They’re still waiting.”
At some point investors must make a move. Transition managers hope to convince investors of their ability to minimise the costs when the time finally comes.