Centralised Portfolio Management Introduction In our previous paper (Centralised Portfolio Management, December 2014) we highlighted the importance of improving investment outcomes for members by considering ways to potentially minimise cost leakages. In this paper we further examine Centralised Portfolio Management (CPM), digging deeper into the potential benefits and risks of such an approach. In particular, we consider different approaches to CPM and compare them to other techniques that institutional investors could adopt. Key conclusions set out in this paper include: Not all CPM approaches are the same. Different providers adopt fundamentally different approaches to CPM and it is crucial to understand their approaches to determine what may be best for a particular fund. Not all cost savings are cost savings. Whilst the approaches of CPM providers are generally designed to reduce costs, some cost savings are dependent on fund circumstances, portfolio performance and rely on certain market conditions to achieve the desired results. Some of the cost savings are clear and explicit, whilst other savings introduce additional tracking error risks. Some benefits can be achieved through other means. Whilst CPM is most likely to deliver more tax and fee savings than any other approach examined in this paper, there are approaches that can result in material benefits but without introducing some additional risks or impacting managers best ideas. It is crucial to understand all of the consequences of CPM (including the impact on trading and operational risks) prior to considering implementing a strategy. Important disclaimers and definitions In writing this paper, we highlight that we are not tax advisers and part of the benefit of CPM relates to tax savings. Prior to implementing any solution, it is essential to consult with a suitably qualified and licensed tax adviser. We also highlight that this paper does not take into account the specific circumstances of any particular fund. In determining the most appropriate course of action with respect to CPM, it is very important to consider a fund s specific circumstances. We also highlight some definitions and alternative approaches that we refer to in this paper: Centralised Portfolio Management (CPM). The use of one organisation to determine and execute portfolio trades based on underlying portfolios provided by investment management organisations. After-tax performance measurement and benchmarking. The calculation of after-tax returns of individual investment managers and overall investment portfolios, compared with a customised after-tax benchmark. Propagation. A back-office/custodian function whereby underlying investment manager portfolios are effectively pooled for tax-lot purposes. For example, if Manager A sells a particular stock that is also owned by Manager B, then the cost base from the stock purchased by Manager B could potentially be used for capital gains tax purposes.
With the above disclaimers and definitions in mind, this paper outlines: Different CPM approaches Benefits of CPM approaches Key risks and issues to consider for CPM approaches Other approaches to consider Summary of approaches Conclusion, and Next steps. Different CPM approaches There are two broad types of CPM approaches that we cover as part of this paper: Delay of trades. This approach is often referred to as emulation and involves delaying trades (for example, by up to two weeks) and potentially not executing small trades and/or small positions at all. The key rationale for this approach is that for long term portfolios, small delays in trading are not expected to have a material impact on long-term performance but may result in tax or transaction cost savings. Implementation optimisation. This approach seeks to optimise a target portfolio based on the aggregate positions from underlying investment managers. The approach uses a range of techniques to reduce cost and tax by trading around a tracking error constraint (versus the target portfolio). In the next section, we outline some of the key benefits of the two main CPM approaches and highlight key differences between the two. We focus on those areas that can be quantified in order to bring to light the tangible benefits that CPM could bring to funds and their beneficiaries. Benefits of CPM approaches CPM aims to improve member outcomes through: Lower brokerage, and Improved tax outcomes. These are described below. Lower brokerage CPM providers can lower the level of brokerage incurred in the following ways: Execution-only brokerage model. CPM managers use an execution-only brokerage model and do not pay the higher rates that can sometimes be incurred by investment managers to gain access to broker research. For example, brokerage rates incurred by investment managers could be around 10-20bps (for full service brokerage), whereas execution-only brokerage rates are often 5bps or lower. Agency-only model for foreign exchange (FX) transactions. CPM providers adopt an agency only model for FX transactions so the broker is not in a position to gain additional profits from client trades. Therefore the sole aim is to execute on the best price possible. Offsetting trades. In some circumstances, one investment manager may be selling a particular stock, whilst another may be buying. Under this scenario, a CPM provider could net these trades so a lower level of trading is required. This would not be the case if investment managers were acting independently. Lower turnover. This could be due to offsetting trades (as discussed above) plus the CPM provider may decide to not transact if it is expected that the transaction would not have a material impact on the aggregate portfolio. Turnover is generally expected to be lower under the delay of trades approach compared with the implementation optimisation approach as the latter approach may implement additional trades in order to improve the risk and/or tax position of the portfolio. Improved tax outcomes Tax efficiencies can be achieved by CPM providers in the following ways: Better tax lot selection. By taking a more sophisticated approach to tax lot selection and using stocks purchased on behalf of one manager as the cost price for a stock sold on behalf of another manager, deferral of capital gains tax payments can be achieved. This may result in stocks that ordinarily would have been held for less than 12 months being held for greater than 12 months (thus introducing capital gains tax savings). It could also result in the deferral of tax if a higher cost base is used compared to what otherwise would have been the case. Deferring trades. Whilst preserving manager insights is of primary importance, a CPM provider could take the view that deferring a trade for a small period of time is in the best interest of the portfolio for example, to ensure a stock is held for at least 12 months (and therefore incur lower tax). Whilst this does introduce additional tracking error relative to the target portfolio, it could result in tax savings. This needs to be weighed up against the risk of under-performance while the trade is being deferred. Offsetting trades. In addition to savings on brokerage, offsetting trades can also reduce the amount of tax paid in any given year. This is because fewer gains may be realised (and therefore more tax deferred) and less trading could result in a higher proportion of stocks being held for greater than 12 months. 2 towerswatson.com
Buyback participation and franking credits. A CPM provider can ensure that an investor appropriately participates in buyback opportunities and that franking credits are not unnecessarily destroyed by the 45-day rule (which requires that shares are owned for a minimum period of 45 days before being eligible to receive franking credits). Additional optimisation strategies. An implementation optimisation CPM provider could undertake a range of strategies with the aim of improving portfolio outcomes. For example, a CPM provider could decide to sell a stock (based on a range of factors such as risk and tax) that did not precisely align with the sell decision of an underlying investment manager. If this stock was in a loss position, it could reduce the capital gains tax payable in the current financial year (that is, defer tax). By deferring tax, it will enable assets to remain invested within the portfolio and generate additional returns for the portfolio. For example, assuming a portfolio valued at $100, if $10 in gains in a particular year are deferred, assuming a tax rate of 15% and a portfolio return of 8%, this could add an additional 12bps of performance. The actual amount generated would be heavily dependent on the amount of deferred gains and the level of return achieved. We would expect that in periods of high dispersion of stock returns there may be greater opportunities to add value in this way. This is because there may be more stocks that could be realised at a loss, which could offset tax on realised gains. A similar approach could be achieved by using a tracking error tolerance to alter trades from investment managers. For example, a manager may wish to sell BHP shares however this may result in triggering a sale within 12 months of purchase. A CPM provider could instead sell Rio Tinto if this resulted in a better portfolio outcome and maintained similar portfolio characteristics. The trade-off of course is greater tracking error against the intended portfolio. We consider these optimisation strategies to be the key difference between the different types of CPM approaches with the delay of trades approach typically not implementing these strategies, while it is a key component of the implementation optimisation approach. Key risks and issues to consider for CPM approaches The key risks and issues to consider were set out in our first paper on Centralised Portfolio Management (December 2014). We won t repeat the detailed explanation of these risks/issues but, in summary, they include: Perceived benefit of quality brokerage Delayed implementation A potentially diminished active management universe (that is, not all investment managers are willing to participate) Managers being unsuitable to fit in a CPM structure Possible impact on the tax-awareness of investment managers Additional service provider and added complexity Conflicts of interest Setup costs and regulatory exposure Voting of proxies, and Fund capacity management. In addition to the above general risks/issues, we highlight several additional matters that may depend on the CPM approach adopted and an institutional investor s specific circumstances: Tracking error. Achieving performance above index is very difficult. CPM approaches typically introduce stock trading around an investment manager s best ideas which means that a manager s best ideas may not always be reflected in the underlying portfolio, at least not immediately. A client can dictate the tracking error constraint to the CPM manager and we would typically expect it to be up to 0.5% per annum. The higher the tracking error, the greater flexibility a CPM provider has to improve tax and other efficiency outcomes but the greater risk of under-performance against manager best ideas. Given that the total equity portfolios for institutional investors may have tracking error in the order of 1-2% per annum relative to a market cap benchmark, the introduction of 0.5% per annum tracking error (away from manager s best ideas) could result in a material impact on performance depending on the skill of underlying managers and prevailing market circumstances. Centralised Portfolio Management 3
Trading capabilities and approaches of underlying investment managers. Part of the value proposition for some investment managers relates to their approach and capabilities in trading. This should be assessed in detail to weigh up the potential value from CPM with the potential value that could be provided by underlying investment managers. Lagging of manager trades. Ordinarily, CPM providers typically receive portfolios at the end of a trading day for implementation the following day (that is, after managers are set in their stock positions). In normal market circumstances, this may not be a material issue but could have a material impact in momentum driven markets or when stocks gap up or down. Regulatory risk. Particularly with the implementation optimisation approach, a change to tax legislation (or interpretation of existing legislation by the Australian Tax Office) could potentially make CPM materially less appealing. Tax advice is required to ensure that institutional investors fully understand tax risks and benefits. Concentration of operational risks. Given that entire equity portfolios may become the responsibility of a single organisation under CPM, the potential impact of any adverse operational matters could be relatively large. Before undertaking this approach it would therefore be critical to undertake operational due diligence on potential CPM providers to determine operational risks and their likelihood of occurring. Fewer benefits for pension sections and non tax paying institutions. Since a material part of the benefits of CPM relate to capital gains tax savings, pension options and untaxed entities are unlikely to receive the same level of benefit compared with taxed entities. For superannuation funds, if pension assets are not segregated from accumulation assets then pension members could potentially be worse off under a CPM approach if decisions are made solely for the benefit of accumulation members. Other approaches to consider It is important to note that CPM is not the only way to achieve many of the implementation benefits previously described. Should trustees and/or their delegated bodies be uncomfortable with the above risks, other approaches to improve after tax and fee outcomes could be adopted. Other approaches may not deliver the same level of tax and fee savings as CPM but they would have fewer (or no) tracking error risks and may result in less disruption to the existing portfolio structure. These approaches include: Encouraging greater transparency around brokerage. This could potentially involve moving to a situation that is more transparent around execution costs and research costs. Where clear value is not demonstrated from brokerage arrangements, alternative approaches could be encouraged. For FX transactions, an agency-only model could also be adopted without using a CPM provider. Propagation by the custodian. Whilst we have not reviewed this approach in detail or assessed any practical constraints, this approach could potentially result in tax savings to a superannuation fund under certain portfolio and market circumstances. We understand that the majority of custodians in Australia offer this service though not all clients have adopted it (which we understand may be due to the different tax positions of clients or potentially the additional cost of the service). After-tax performance measurement and benchmarking. This would align investment manager behaviour with the desired results of fund members and some of the techniques used by a CPM provider could be used by individual managers. However, this may not lead to the same level of tax savings compared with a CPM approach as an investment manager would typically not have access to the tax position of the overall portfolio and the approach relies on the investment manager having the requisite tax expertise and systems. The advantage though is that investment manager insights would be fully preserved. There are a number of organisations that can undertake this service. Greater awareness of tax positions. To partially resolve the issue with after-tax performance measurement of the underlying investment manager (that is, that investment managers do not have oversight of the fund s overall tax position), a fund could implement a system whereby investment managers can be made aware of portfolio-level tax circumstances prior to trading so they are fully aware of the impact of any trades (there are providers in the market offering this service). Again, this approach has some limitations (for example, potential timing issues) but we believe is worthy of consideration alongside all of the options discussed. 4 towerswatson.com
Summary of approaches To illustrate the benefits of CPM and to contrast these with alternative approaches, we have attempted to quantify the potential benefits by providing an illustrative example of savings that could potentially be made for an accumulation section of a typical superannuation fund. We highlight that the figures should be considered illustrative only and results could vary significantly across funds and across market conditions. They should not be considered as estimates for any particular fund. Lower Brokerage Delay of trades approach CPM estimate of cost savings (per annum) Implementation optimisation How savings are achieved Stock trading 5-10bps 1 0-10bps 2 Execution-only model plus potentially lower turnover. The delay of trades approach is expected to result in lower turnover hence potentially greater savings FX trading 0-15bps 3 0-15bps 3 Agency-only model. Savings would be nil for an Australian equities portfolio Lower Tax Other ways to achieve (or partially achieve) savings Greater transparency of brokerage arrangements Potentially greater use of execution-only trades Lower brokerage from investment managers Agency-only model for FX trading Franking credits including buyback participation Capital Gains Tax better tax lot selection Capital Gains Tax other savings Negligible 4 Negligible 4 Monitoring 45-day rule and assessing buybacks Variable but we understand could potentially be up to 25bps 5 in some market and portfolio conditions 10bps 6 Variable but we understand could potentially be up to 25bps 5 in some market and portfolio conditions Variable but potentially the largest impact on estimated benefits. Therefore, it is not unreasonable that potential benefits could be 30bps 7 or above Matching sales from one manager with purchases from another for the purposes of tax calculations Permanent gains, for example, deferring trades so that gains ordinarily realised within 12 months would be realised after 12 months Deferred gains, for example, for the implementation optimisation approach, selling stocks that are in loss positions to offset realised gains Total 8 15-30bps 20-60bps 10-30bps Use of Investment Management Agreements with after-tax measurement and/or incentives Propagation at the custodian level Undertake the same approach at manager level It could also be undertaken at the portfolio level provided a fund had the systems in place to ensure that individual managers are aware of the portfolio-level tax implications for any trades that they may make Potential tracking error (from desired portfolio) 0.5% 9 (though can be defined by the fund) 0.5% (though can be defined by the fund) 0.0% 1. Assumes turnover reduces from around 50% pa to 30% per annum and brokerage rates reduce from 15-20bps to 5bps. 2. Assumes turnover is around 40-60% and brokerage rates reduce from 15-20bps to 5bps. 3. FX savings can be highly variable depending on how FX is currently managed. For Australian equities, there would be no additional savings but for international equities, savings could be material. 4. We would not expect material benefits from franking credit management as high quality investment managers are typically reasonably proficient at preserving franking credits (45-day rule) and buyback participation (for segregated mandates). This ignores any strategies of tilting portfolios to explicitly achieve a higher level of franking credits. 5. Based on conversations with a range of market participants. 6. Assuming a portfolio of $100, if $1 of gains could be moved from a short gain to a long gain, it would result in approximately 5bps in savings. If a further $3 could be deferred, and assuming a portfolio return of 8%, this could result in an addition 4bps of savings (assuming 15% tax rate). 7. In addition to the techniques discussed in 6., approaches such as realisation of losses to offset realised gains could result in further cost savings. This will vary from year to year and fund to fund so determining a robust number is problematic. The number above has been inferred from example analysis calculated for particular funds over a particular period. 8. Will depend on a fund s specific circumstances and assumes that the existing portfolio currently has very limited tax awareness and market circumstances are reasonably favourable. Excludes the potential impact of propagation. 9. Can vary significantly over time. Centralised Portfolio Management 5
Conclusion At a high level, the benefits of CPM appear appealing but we believe that trustees and/or their delegated bodies should ensure they fully understand all of the consequences and risks of CPM prior to pursuing such an approach. Our general view is that CPM should be assessed as part of a range of potential after tax and fee solutions that could reduce cost leakages (refer to Other approaches to consider ). We suspect that CPM could be suitable for some funds but may not be appropriate for others. For very large funds that are going down the path of internalisation of investment functions, internal CPM could also be considered. Next steps We would typically suggest that a fund undertake the following steps to assist in determining the appropriateness of CPM: 1. Investigate ways to potentially improve the after tax and fee performance of the portfolio (including quantifying the potential costs and benefits), such as: a. Understand the strategies that existing investment managers use to improve after tax and fee performance b. Ascertain the actual brokerage costs of underlying managers and investigate their trading approaches c. Investigate whether the approach to FX trading could be improved d. Determine whether the fund s custodian can undertake propagation and the costs and benefits of doing so e. Determine whether underlying investment managers should be measured on a customised after tax and fee basis (in order to change their behaviour to focus on after tax and fee returns) f. Determine whether underlying managers can undertake pre-trade reviews to determine tax implications at the portfolio level 2. Compare the costs, risks and potential benefits of the other approaches with the costs, risks and potential benefits of a CPM approach. 3. Seek feedback from existing managers as to any issues they anticipate with respect to CPM and whether they would be willing to participate. This should include setting out (in detail) what safeguards (and requirements) would be implemented as part of CPM. 4. Understand the level of tracking error within equity portfolios and ascertain what level of tracking error could be appropriate for a CPM manager. 5. Determine whether accumulation and pension assets would need to be segregated and the costs and practicalities of doing so. 6. Seek tax advice from a suitably qualified and experienced tax professional. 7. Undertake operational due diligence of any proposed CPM provider. We expect that the above steps should highlight the most appropriate approach for a particular fund and whether any benefits of CPM would be worthwhile. We would be pleased to assist funds with their analysis. 6 towerswatson.com
Contact If you would like to discuss any of the areas covered in more detail, please contact your usual Towers Watson consultant or: Paul Taylor Senior Investment Consultant +61 3 9655 5120 paul.taylor@towerswatson.com Ben Trollip Investment Consultant +61 2 9253 3179 ben.trollip@towerswatson.com 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 16,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Learn more at towerswatson.com 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 TW-AU-15-43909. July 2015 Copyright 2015 Towers Watson. All rights reserved. towerswatson.com /company/towerswatson @towerswatson /towerswatson