Centralised Management December 2014 At its heart, Centralised Management is a simple concept portfolio implementation and execution is separated from investment idea generation and managed through a single platform via a centralised provider the CPM manager. Executive summary Today, more than ever, there is an increased level of scrutiny on fiduciaries to improve outcomes for beneficiaries. Minimising costs be they associated with implementation, execution, investment manager fees or taxation has been a key area of focus of recent times. Centralised Management (CPM), while far from a new concept, has been increasingly considered as an avenue for cost savings by a number of large investors in the Australian market. At its heart, CPM is a simple concept portfolio implementation and execution is separated from investment idea generation and managed through a single platform via a centralised provider the CPM manager. The CPM manager implements trades put forward by the portfolio s underlying active managers, taking a whole-of-portfolio focus with an aim to minimise transaction costs and tax, while balancing the tracking error introduced relative to the underlying portfolio. We believe that CPM provides an interesting proposition for our institutional clients to improve their investment outcomes and obtain greater control over their investment portfolios, although we acknowledge it is difficult to determine an estimate for the potential cost savings. We therefore envisage this paper acting as a catalyst for further dialogue and investigation. In 2015, we will be carrying out research on the major providers of CPM services that are potentially available to Australian investors and will share the outcomes of this research with our clients.
Introduction The market structure of today is the outworking of several decades of iterative evolution years of adaptation of individual agents to meet the ever changing demands of the collective market, while attempting to make a profit. The end result is a structure in which there are multiple layers of service between the investment decision makers and their underlying investments. However, recent technological developments, most notably the advent of low cost communication and technology have reduced the need for a number of these middle men. Combined with a widespread increase in the level of sophistication of the end user of these services, this has fuelled an increased demand for visibility and accountability into all links in the investment value chain. As such, perhaps the time is right to consider a wide-scale restructuring of the broader market environment with the aim of improving outcomes for the end user the investor. CPM is one possible avenue to this end. This paper represents Towers Watson s first take on the concept of CPM, a portfolio management method that aims to create a better outcome through minimising tax and transaction costs. The typical approach to institutional investing is for the Board of Directors/Trustees/Investment Committee (the decision makers) to outsource the specifics and day to day investing activity to specialist fund managers. A traditional active equity portfolio consists of a number of managers, chosen by the decision makers to meet the institution s overall objectives. Under this framework, the specialist managers work independently to implement their mandated strategy. Communication between these managers is often minimal, or non-existent, which may lead to implementation inefficiencies at the overall portfolio level (for example, transactional expenses incurred in offsetting positions). But why does this have to be the case? Many investment managers consider implementation as a secondary concern; subordinate to their core focus of generating value-adding investment ideas. Accordingly, not every manager will have best-in-class implementation practices. Furthermore, having a number of managers each conducting what is essentially the same highly scalable function in parallel, is far from ideal. CPM aims to minimise inefficiencies by outsourcing portfolio implementation to a single manager whose sole focus is to perform the most efficient implementation. In this light, CPM can be considered as an additional level of specialisation the separation of investment ideas generation from implementation, with each being assigned to their respective best in class experts. Comparison of Traditional (left) and CPM (right) structures Traditional structure Manager 1 Manager 2 Manager 3 Idea generation Idea generation Idea generation CPM structure Manager 1 Manager 2 Manager 3 Idea generation Idea generation Idea generation Tax management and trade execution Tax management and trade execution Tax management and trade execution aggregation, tax management and trade execution 2 towerswatson.com
What do we mean by CPM? While there are a number of variants of CPM, in this paper we consider CPM at its highest level to be the aggregation of orders received from two or more individual active manager portfolios into a single model portfolio and subsequent consolidated implementation via a single execution platform. In this paper we note we are not considering strategies in which the CPM manager or the investor has discretion to selectively adjust aggregated manager portfolios (these approaches have historically been employed by some investors using emulation strategies 1 ). With this scope in mind, we identify the following avenues through which CPM can add value to an investor: Tax efficient implementation the CPM manager aims to improve after-tax outcomes by paying careful attention to capital gains positions and harvesting of franking credits. General cost savings and service provision the resultant specialisation brought about by CPM provides scope for economies of scale savings. Further, as CPM is effectively a form of passive management, these skills are highly leverageable and a good CPM manager should be able to act as a passive manager more broadly, and is also able to be a transition management service provider. Netting offsetting trades the overall portfolio exposures are consolidated, and trades are considered at a whole of portfolio level in order to avoid incurring unnecessary transaction costs and trades in opposite directions. The relative magnitude of each of these components will vary by investment type, as well as the individual circumstances (for example, tax status) of a given investor. That said, we would expect that for the majority of tax paying institutional investors Australian equity portfolios, tax efficient implementation is likely to be the most significant driver of added value. Indications from one provider of CPM services are that they anticipate approximately half of the benefit of CPM to relate to tax savings, a third to trading cost savings and the remainder to the benefits of netted trades. As a very rough indication, the expected ongoing costs of the CPM service provider may be of the order of 10-20% of the targeted gross cost savings. We now consider the three main cost saving benefits of CPM in turn. Taxation Tax-paying investors will be well aware of the material impact taxes can have on overall portfolio outcomes. An after-tax focus therefore warrants significant attention, but such an approach is rendered difficult without a portfolio wide view of tax positions. CPM offers a solution in this respect, particularly relevant when considered in the context of the benefits afforded to local investors under the unique Australian taxation environment 2. For example, in Australia, many investors are eligible for a discount on capital gains tax liabilities on equity (and selected other) investments which have been held for more than one year. Whilst an independent fund manager will only have visibility into the holdings in their own portfolio, the CPM manager can look across all holdings to select the most appropriate parcel of shares to sell, or even delay trades nearing the one year boundary to avoid unnecessary taxation. Another key feature unique to the Australian environment is the 45-day rule relating to an investor s eligibility to claim franking credits on dividends. The rule requires that an investor owns the shares for a continuous period of at least 45 days (including the ex-dividend date) in order to claim any franking credits associated with the dividend. The CPM manager is in a position to take these tax consequences into account at a portfolio wide level. Within the constraints of its mandate, a CPM manager has the discretion to delay trades to satisfy this eligibility requirement and therefore maximise franking credits. In doing so, the CPM manager balances the franking credit benefits against the tracking error relative to the paper portfolio. Whilst the benefits of CPM are straightforward to identify and relatively easily quantified, there are a number of issues that an investor must consider prior to its implementation. Many of these are implicit and/or secondary in nature (involving intangible effects and opportunity costs), but their collective impact is potentially significant. We touch on these later. 1 CPM is essentially a form of emulation strategy, although historically emulation strategies have tended to concentrate (i) more on lagging trade execution to increase the number of offsetting trades, (ii) less on efficient after-tax outcomes and (iii) have sometimes involved adjustments to aggregated managers portfolios (for instance by creating aggregated best ideas portfolios), with this last approach involving changes to how managers intellectual capital is employed for the investor and resulting questions on how this should be compensated. 2 Please refer to the Towers Watson paper After-Tax Investing in Australian Shares for a comprehensive analysis of the impact of tax on Australian equities (http://www. towerswatson.com/en-au/insights/ic-types/survey-research-results/2011/01/after-tax-investing-in-australian-shares). Centralised Management December 2014 3
Netting With the ability to process and execute trades centrally, CPM can minimise transaction costs by netting offsetting trades. Consider a portfolio of two active equity managers, A and B, with opposing views on stock X. Manager A decides to sell 1,000 shares of X while Manager B concurrently wishes to buy 900 shares of the same stock. At the total portfolio level, this results in the overall sale of 100 shares of X. Under a CPM framework, only one transaction with a volume of 100 shares would be processed (as opposed to two transactions, with a total volume of 1,900 shares), which serves to reduce transaction costs. CPM s capacity to add value through netting is heavily influenced by the prevailing cost of trading via traditional avenues, and the nature of the underlying portfolio (for example, number of managers, turnover and investment style). While we have not performed any analysis to quantify these netting benefits, we do hold some reservations about the frequency with which netting opportunities are likely to arise in a typical institutional investor s portfolio (although crossing opportunities between clients may serve to improve this). CPM managers vary their approach to the tradeoff between maximising netting opportunities with an increased window against the inherent tracking error introduced by the delayed implementation. Cost savings and additional service provision In addition to savings from netting, there are further possible economies of scale efficiencies that may arise organically under CPM. As implementation occurs via a single platform, in theory at least, reduced brokerage costs may be available. One way to think about the role of the CPM manager is that of a passive manager, managing to what is effectively an index comprised of the positions of the underlying active managers in the portfolio (we note that this reconstituted index could also include a market capitalisation index component, should the investor want some passive allocation). The CPM manager s job is to manage to this index in the most efficient and tax aware method possible, while balancing any tracking error that may be introduced relative to the paper portfolio. Furthermore, the additional level of visibility afforded by this single passive approach allows for a greater degree of oversight and control over the portfolio. An investor may for instance be able to more easily implement any portfolio tilts or screens to reflect their market views or beliefs. Finally, from time to time the fund may wish to transition assets from one underlying investment manager to another. This process is often undertaken via the employment of a specialist transition manager. As the CPM manager is afforded oversight of the entire portfolio, it is ideally placed to double as the investor s transition manager when such services are required. 4 towerswatson.com
Issues to consider While the benefits of a centralised approach to managing a portfolio are compelling in principle (albeit hard to quantify), there are a number of issues to consider before determining whether to move from current arrangements. Changing the status quo Widespread adoption of CPM represents a material change to the business model of many (most) agents in the investment industry. The status quo is a legacy of the industry s evolution, which has tended to favour the interests of brokers and other intermediary agents at the expense of asset owners. The advent of low-cost communication and information transfer meant that data is more readily available to the end user, and has therefore diminished the dependency on such middle men. Given the vested interests of many of the existing participants in maintaining the status quo, frictions exist which must be overcome if changes are to occur. The perceived benefits of quality brokerage Under the traditional framework, each investment manager has a relationship with one or more brokers to execute portfolio trades. The investment manager obtains access to broker research through the relationship, and trading costs are passed on to the investor. Under a CPM framework, given this broker-manager relationship is altered, the manager may lose access to these soft dollar benefits. Managers may then have to pay explicitly for research or restructure this process if the former, the manager may pass on additional costs to the end investor through increased management fees. Further, investment managers may believe that choice of broker is a potential source of value-add, giving them access to initial public offerings, placements and other investment opportunities they may not have otherwise been able to pursue. Under the current industry structure, this argument has some merit. Delayed implementation The CPM process, by design, requires an inherent delay in trade execution in order to capture the desired aggregation/netting opportunities and other efficiency gains. The actual time delay will vary depending on the CPM manager s approach, but would generally have to be at least one trading day to generate a material benefit from netting. CPM is therefore more suitable to some investment styles than others (detailed further on), and investors must weigh any alpha attributable to timing and prompt execution, and execution skill more generally for some of their investment managers, against the benefits generated under a CPM approach. For example, a way in which implementation may be restricted is that a model portfolio approach restricts a manager s ability to set maximum and minimum buy and sell prices to protect against adverse price movements when portfolios are being restructured. Despite this, with good communication between the CPM manager and the underlying managers, many of these issues can be managed and mitigated. A potentially diminished active manager universe Constructing a high quality multi-manager portfolio is in itself a difficult exercise. A further complication may arise as managers may refuse to participate in a CPM structure, effectively limiting the available manager universe, or have valid reasons for being excluded from the CPM structure, thereby limiting the effectiveness of the overall program. There are a number of reasons why a manager may be unwilling or reluctant to participate within a CPM framework, most notably: Loss of control of intellectual property a manager s biggest asset is their ideas. As such, they may be unwilling to provide their best ideas portfolio to a CPM manager, particularly when they are direct competitors to the CPM manager s other lines of business. Unwilling to change operational process a manager may not be willing to adapt their operational processes to fit within a CPM framework, especially for only a small proportion of their client base. Perceived fairness to all clients it can be argued that managers generate alpha from quality brokerage. Accordingly, they may argue that it is unfair that a CPM client benefits from this alpha, without the associated costs borne by other (non-cpm) clients. Perceived alpha/value add through trading managers may believe their implementation skill is a key strength (for example, for smaller, more illiquid investments, trading skills are arguably more important) and may therefore argue that this is a source of value-add to their clients. We note that this has the potential to be measured to determine whether these claims are valid. Centralised Management December 2014 5
Managers being unsuitable to fit in a CPM structure Despite the willingness of the manager to participate in the CPM structure, there may be other factors that render a manager unsuitable for inclusion. For example, manager styles involving higher turnover and subsequent shorter holding periods may be more heavily impacted by trading lags inherent in CPM. In an extreme case, a manager may have gone in and out of a position before the CPM has even processed the first trade. That said, managers who are unwilling or unsuitable to take part in CPM can always continue to be included in the portfolio, sitting alongside the CPM framework. We note here, that in order for CPM to be effective, a critical mass of participating portfolio FUM or managers (likely to be at least half of the portfolio) is required. Investors may consider this approach for managers in which they maintain a high level of conviction, although it is important to note that doing so brings added complexity to the overall structure. Will fund managers be less tax-aware? If fund managers are measured on the pre-tax performance of their paper portfolios there is a risk that their decisions become less cognisant about turnover and the potential beneficial and adverse tax consequences of their decisions than would otherwise be the case. A view mitigating this concern could be that most managers focus on successful stock selection and few effectively incorporate cost management and genuine tax awareness into their processes. Typically individual managers are unable to consider tax consequences from a whole of portfolio perspective. In our view this is quite a grey area, where it is very hard to empirically validate views one way or the other. How to attribute performance under a CPM structure The separation of idea generation from implementation can lead to differences between a manager s paper portfolio and the actual portfolio held by the client. In effect, the CPM manager implements the aggregated model portfolio with a tax-aware passive approach. Given that a CPM manager typically has some degree of freedom to deviate from the model portfolio, differences in performance are to be expected. In an ideal world, these differences would always result in a performance pick up, however this will obviously not always be the case. This raises a question around who is accountable for this performance differential. In cases where manager compensation includes a performance fee component, which portfolio is used to determine the fee and who is accountable for paying it? These kinds of complications must be clearly stipulated at the outset, with common agreement between the CPM manager and the underlying investment managers. An additional service provider and added complexity The services discussed so far require skills that cover index, index management, tax management and strong record keeping. While it may be possible for an investor to work with their custodian and index manager to deliver these services, this is likely to be stretching current skill sets, such that a specialist additional CPM manager may need to be employed. That said, a CPM manager may be able to incorporate passive management within the CPM structure. Employing a CPM manager carries with it similar considerations to an investor employing any other service provider. However, there are some differences to the nature of the monitoring required on behalf of the asset owner. Because of the operational nature of CPM, it is important to acknowledge the difficulty in assessing the quality of a CPM manager s implementation using quantitative measures. Actual costs and outcomes can be very transparent (for example, brokerage costs can be explicitly monitored and reported, rather than just being captured in performance outcomes) and these outcomes can be compared to a paper portfolio of what might have occurred if no CPM structure had been put in place. But there will be a number of critical assumptions in reporting on CPM savings achieved, meaning that the analysis will be more an educated estimate than a record of actual cost savings. Additionally, the focus of the monitoring shifts from an investment performance measurement to an assessment of its implementation efficiency that is, whether the CPM manager is executing as expected by monitoring the tracking error and outcomes relative to the theoretical paper portfolio. Similarly, assessing the skill of one CPM manager relative to another will be quite difficult via ex post outperformance measures. Accordingly, such assessments will likely need to be qualitative in nature, focusing on the core capabilities, processes and systems the manager has in place. Finally, it is also worth considering the added complexity burden placed on the investment managers themselves. Being part of a CPM framework involves a fundamental change in their operational processes, and doing so in a bespoke manner for a single client may add to internal costs, and/or introduce the possibility for errors. 6 towerswatson.com
Other considerations Conflicts of interest Fiduciaries will be well aware of the conflicts of interest that arise from a traditional principal-agent relationship and, over time, a number of measures have been developed to mitigate these. However, introducing a CPM framework brings with it new conflicts that need to be carefully monitored and managed. As touched upon earlier, managers (for good reason) will often closely guard their intellectual property that is, their portfolios and investment ideas and therefore be reluctant to share these with a third party. This is especially true when the third party is itself in the asset management business, and could potentially benefit from this information. Furthermore, in the situation where the CPM manager maintains its own products and separate client base (in addition to implementation only clients), conflicts may arise from the investor s perspective. A CPM client needs to be aware of the priority given to their transactions relative to the other trading activity conducted by other arms of the CPM manager s business. Setup costs and regulatory exposure The implementation of a CPM structure is a long-term decision, requiring non-trivial initial costs (such as legal, tax and other due diligence), with benefits generated incrementally through time. Investors must therefore be mindful of their exposure to regulatory risk, particularly in the taxation environment in Australia, and the impact these changes may have on the perceived benefits of CPM. Clearly this is very difficult to measure with any reasonable degree of accuracy and investors must make a qualitative assessment on a case by case basis. Voting of proxies Investment managers are often delegated authority to exercise active ownership of shares they hold on behalf of investors by participating in company votes on key business decisions. CPM strips the managers of this function, as shares are physically held by the CPM manager. To maintain best practice, the investor should ensure that an appropriately qualified party retains control of this function. Fund capacity management When participating in a CPM framework, a manager is likely to have reduced visibility or feel for the market impact of their investment decisions and in fact, cannot directly identify the extent to which their clients are trading off the paper portfolio they provide. While the latter point can be viewed as being a matter of trust and communication, the former point, particularly if CPM-based mandates become a significant proportion of a manager s assets under management/advice, is effectively a new risk introduced to the system. Conclusion By its very nature, CPM represents a fundamental change to the institutional investment landscape as it stands today. Accordingly, it is likely to face pushback from a number of market participants, most notably those whose business model is threatened by the emergence of CPM. We believe that CPM can provide tangible benefits to the asset owner; we do however hold some reservations about the magnitude of the benefits of such a structure quoted by CPM managers, and feel that this is an area that is ripe for further investigation and analysis. At the outset, it is difficult to determine conclusively whether an investor should pursue CPM, and further due diligence is required to ascertain whether the initial costs outweigh the possible long-term benefits. Further, while these benefits are relatively straightforward and tangible, CPM brings with it a number of important considerations secondary effects, opportunity costs and increases in overheads that are more subtle and subjective, the impacts of which are difficult to quantify but are equally significant. We do not envisage that CPM will be the optimal solution for all clients and, ultimately, its value potential will be driven by the characteristics of each investor s portfolio, objectives and beliefs. Towers Watson is committed to changing investment for the better, and we are supportive of industry developments that will result in an additional share of the value being captured by the asset owner. With this discussion paper, Towers Watson hopes to open up a broader dialogue with market participants, and form the catalyst for further exploration of the value proposition of this approach in more detail. In 2015, we will be carrying out research on the major providers of CPM services that are potentially available to Australian investors and will share the outcomes of this research with our clients. Centralised Management December 2014 7
About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 15,000 associates around the world, the company offers consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Learn more at www.towerswatson.com. Contact For further information please contact your Towers Watson Consultant: Melbourne 03 9655 5222 Sydney 02 9253 3333 The information in this publication is general information only and does not take into account your particular objectives, financial circumstances or needs. It is not personal advice. You should consider obtaining professional advice about your particular circumstances before making any financial or investment decisions based on the information contained in this document. Towers Watson Australia Pty Ltd ABN 45 002 415 349, AFSL 229921 Copyright 2014 Towers Watson. All rights reserved. towerswatson.com