The importance of implementation efficiency
Note: This is the second in a three-part series of blog posts on principles of the low-return imperative. Part 1 can be viewed here.
Like loose fittings in plumbing, if the problem is not diagnosed and remedied, the performance damage from leaky portfolio implementation can be significant and long lasting.
In today’s world of low returns, keeping an airtight lid on your portfolio is arguably more important than ever, especially during times of transition—and this is where the value of implementation efficiency comes into play. As we’ve written about extensively in prior blog posts, we believe that an environment where expected future market returns are likely to be lower than the required rate of return creates a low-return imperative. This imperative means investors cannot afford to ignore any investment strategy that may offer incremental return, take on risks they do not expect to get paid for or disregard implementation efficiency.
While efficient implementation has always been important for investors, the expectation of lower returns in the future only amplifies the need. We believe it is nothing short of critical that investors manage costs and minimize risks in order to reach their investment goals. To take it further, we believe that managing implementation, when done well, is one of the most reliable sources of return. However, this is getting more difficult due to several factors:
- Investment strategies are becoming more complex in their pursuit of higher returns.
- Most implementation costs are not transparent, making management of these costs difficult.
- The impacts of unintended risks are having more dramatic effects on performance outcomes.
3 ways to improve implementation efficiency
We believe that three aspects of implementation that can best steer investors toward meeting their desired outcomes are:
- Managing changes effectively. Investors make many changes to their portfolios—for example, changing managers, switching between asset classes and managing cash flows. All of this can involve changes to a variety of investment allocations, ranging from physical securities (such as equities, bonds and cash) and currencies to more complex strategies such as derivative exposures. In many cases, there are more cost-effective options available to investors relative to the methods that they currently employ to manage changes. Transition management and interim portfolio management can help investors effectively manage these changes.
- Reducing deviation from target asset allocation. Investors spend a lot of resources determining their strategic asset allocation (SAA). However, without the proper monitoring, it can be easy to introduce unintended exposures at the total-portfolio level. When asset allocation weights drift as a result of market movements, discrepancies between actual allocations and target allocations can detract value relative to an investor’s strategic benchmark.We believe this asset allocation risk can be easily managed by frequently monitoring exposures and implementing a systematic program to align actual assets with target asset allocation. Overlay services and currency management both help investors maintain target exposures and avoid unwanted and uncompensated risk.
- Improving execution quality. It’s not always easy to have visibility into transaction costs within all parts of an investor’s portfolio. Visible or not, these costs exist and managing them helps to ensure more assets stay in the fund rather than eroding away. Quality execution preserves performance. An example of such transaction costs frequently mentioned in the press over recent years is foreign exchange (FX) costs. Execution services, transition management, commission recapture and agency FX all work together to help improve execution and minimize transaction costs.
For most investors, managing implementation needs is a daunting task. Even most large institutional investors do not have internal resources to monitor and manage portfolio implementation on an ongoing basis, especially while regulations are continually changing. Managing implementation with scale has become increasingly difficult, particularly as many investors seek to reduce internal resources and costs.
The good news? Third parties are now providing integrated implementation platforms. These allow investors to leverage implementation expertise to deliver potentially better performance outcomes across multiple implementation needs. The best way to demonstrate the benefits of an integrated implementation platform is a real-life case study.
Case study: Australian retirement fund
In isolation, cost savings within a single implementation area may not appear to be much, but aggregated across multiple areas, the savings can add up. An Australian retirement fund employed a third party to improve its implementation focus across a number of areas through a centralized platform of specialist implementation services. They saved AU$22.4m from 2013-2014 through this greater focus on implementation.
In addition to this centralized trading platform, the fund continues to save on additional costs by utilizing other specialist implementation disciplines, such as:
- A passive currency overlay to manage volatility—caused by the fluctuation of foreign currencies—of the plan’s international assets.
- A rebalancing overlay to maintain the plan’s asset allocation. Here, the overlay manager monitors the difference between the plan’s actual and strategic allocations and uses exchange-traded futures to rebalance the fund’s assets to strategic targets.
- Short-term cash management to fund margin requirements for the overlays, but with the additional objective of improved investment performance.
- Transition management services to restructure the plan’s portfolios.
- FX transaction assistance, in which the plan’s international private equity and global equity managers deliver FX orders to a central currency desk. A central desk nets the orders and efficiently trades them to reduce transaction costs, minimize liquidity and enhance reporting.
We believe that the Australian retirement fund case isn’t an isolated example. Improved implementation across the board can quickly add up. For example, consider a $5 billion pension fund. If you can save 25 basis points through better implementation, that’s $12 million that the sponsor would otherwise have to contribute at some point. And that is not a one-off gain; the savings compound year after year to add up significantly over time.
In today’s environment of low returns, managing costs and minimizing risks with efficient implementation is imperative to achieving desired outcomes. We believe that by utilizing effective transition and currency management techniques, in addition to employing overlay services and shining a wider light on transaction costs, investors may stand a better chance of meeting their goals. We recognize that many may lack the resources to do all of this on their own, which is why we encourage the consideration of third-party centralized implementation platforms when appropriate. Now more than ever, every basis point matters. 25 basis points of implementation savings could mean the difference between third quartile performance and first quartile performance. Investors can’t afford performance slippage due to poor implementation and must conscientiously manage implementation costs and risks to achieve successful performance outcomes.