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Passive shift a boon for transition management

Nicholas Bonn
Nicholas Bonn believes the passive investing wave has been good for State Street.

The shift to passive equity investment, particularly among public defined benefit plans, led to a spike in the use of transition management services in the first quarter, compared with both the fourth quarter and all of last year, with as much as 60% of activity attributable to the strategy shift, industry sources said.

Many clients held back on transitions in 2016 because of the U.S. election and uncertainty over potential central bank increases in interest rates, but sources said those clients began to make their moves toward passive management once 2017 began.

“We've definitely seen an uptick in transition management in the first quarter,” said Steven Glass, president and CEO of Zeno Consulting Group LLC, a Bethesda, Md., consultant to pension funds on trading issues. “A decent amount of transitions that we've been aware of have that passive aspect to them.”

“Active to passive has been the driver” for State Street Corp. (STT)'s transition management book of business, said Nicholas Bonn, Boston-based executive vice president of State Street Global Markets and global head of State Street's portfolio solutions business. “It's not a blip. The last couple years, there's been a high correlation of returns among assets. There's been little difference in stocks. In terms of returns, passive has beaten active handily, and that's been a big driver in active to passive.”

State Street has seen a consistent 40% of transition activity related to a shift to passive from active in the past year, while at Northern Trust Corp., transitions to passive management reached 61% of all activity in the first quarter compared to 25% in the fourth quarter and 30% in all of 2016.

“It'll be interesting to see the second-quarter numbers if that percentage remains consistent,” said Ben Jenkins, global head of transition management, Northern Trust, Chicago. “This is a big change for us, a big change in first-quarter transition activity. The first quarter usually tends to be larger than other quarters, but this shift has been larger. So it's interesting to see active to passive as a sign of what the (pension fund) industry is doing.”

Mr. Jenkins said a “large portion” of the first-quarter transitions to passive management came from public plans.

The transitions to passive management generally focused on large-cap equities and developed markets strategies, said Zlatko Martinic, managing director, head of transition management, Penserra Securities LLC, Orinda, Calif.

“That's not necessarily in the emerging markets space, where there are transferability issues, especially into commingled funds,” Mr. Martinic said. “But otherwise, there definitely is a shift going on. Still, when it comes to the sum of the observations, folks still like to make active plays in small caps and emerging markets equities. But large caps and EAFE are what's moving to passive.”

Year-to-date through June 6, 35% of transitions conducted by Penserra have been to passive strategies, compared to 20% in all of 2016.

Central bank focus

Along with delays in transitions spurred by the U.S. election, the actions of central banks have also had an effect, said Lance Vegna, managing director and global head of portfolio solutions, Cantor Fitzgerald LP, New York. “For the last few years, investors have been focused on how central banks, rather than fundamentals, have driven the market,” Mr. Vegna said.

“That has hurt active managers by making it more difficult to beat their benchmark index. As a result, investors have realized that and have moved more into passive, to avoid high fees and underperformance. Now, the (Federal Reserve) is once again speaking about balance sheet normalization, which could lead to the market trading on fundamentals, thereby fostering an environment in which active managers can perform better.”

Cantor was unable to provide data on the number of transitions it has made from active to passive on behalf of its clients.

Paul Sachs, Phila-delphia-based principal at asset servicing consultant Mercer Sentinel Group, the asset-servicing consulting business of Mercer LLC, said that beyond the U.S. election last year, many plan sponsors held off on transitions in the past two years.

“Is (the first-quarter boost) active to passive or because of pent-up demand by pension funds that have not done transitions?” Mr. Sachs said. “2015 was a relative slow year in transitions. We thought 2016 would be a gangbusters year because of pent-up demand, but it ended up being much less than anticipated. But January and February saw a lot of activity. Is that because pension funds decided to make their moves?”

Northern Trust did witness some slow going in the first quarter of 2016, Mr. Jenkins said, although the pace of transitions picked up later in the year. “It was very confusing for us,” Mr. Jenkins said. “We knew clients that wanted to make changes, but they were just holding back. But in the second quarter, the pace really grew. The first quarter 2016 was a pent-up quarter, but we saw that demand come back in later.”

Dovetailing with the increased demand for passive transitions has been moves among many public plans to internally manage those passive assets, Penserra's Mr. Martinic said. “Much like with the passive shift, you're seeing more plan sponsors have capabilities in-house. It's an extension of the active-to-passive shift. It's like a switch in the rail tracks. They're going in the direction of passive management, but instead of external management, they bring it in-house. Transition management is involved in that, most certainly. Either in-house or like any other change, (a plan sponsor) would hire a transition manager. It depends on the circumstances. If they can manage the transition internally, they'd bring their own teams on board. If they need help, they could come to us ... There are plans out there that look for a second set of eyes to validate what they do.”

Messrs. Vegna and Bonn as well as Connie Kreutzer, managing director and head of institutional sales at Penserra, expect active equity managers to make a comeback eventually — and that will be a boon to transition management as clients move some assets back into active to get alpha.

“Active managers are responding by coming up with new ways of discovering and using data to enhance fundamental analysis,” said Mr. Vegna. “If this translates into better active manager performance, you will see assets flow to these successful managers. The accelerating shift to passive and to those high-performing active managers will drive demand for high-quality transition management for quite some time.”

Mr. Bonn questioned whether passive management is “a forever thing. Do we eventually start to get to a more stock-picker's market where some managers show they can produce alpha? In the last few years, it's been a passive marketplace. Will it stay that way? I don't believe so.”

'Here to stay'

Ultimately, whether passive or active, transition management is “still really moving assets,” Ms. Kreutzer said. “I think it will revert (back to active management) sometime in the future, but not as much overall. Passive is here to stay.”

Although transition managers have benefited from the shift to passive investing, one traditional source of transition business — plan rebalancing of asset allocations — has declined, said State Street's Mr. Bonn. “Those are more valuable to us,” Mr. Bonn said. “We've seen less of those this year. That dampens our P&L (profit and loss statement). We've gone through this big post-election rally. I don't think a lot of pension funds' asset allocations have gone out of whack. Returns have been robust.”

Added Zeno's Mr. Glass, “I've talked to a lot of people who are excited about a little volatility in the marketplace. That might have explained the inaction before, but the market is seeing some volatility now, so those rebalancings could start up again.”

This article originally appeared in the June 12, 2017 print issue as, "Passive shift a boon for transition management".