Managing Transitions with Emerging Market Assets
Emerging market investments have experienced significant growth in recent years as evidenced by Figure 1 which provides an illustration of mutual fund flows since 2004. In step with this growth in flows, transition management has seen an increase in restructures involving this segment, both from investors moving into these markets as well as investors implementing fund manager changes within their emerging market allocation.
Investment structures matter
Pooled versus segregated: Investors either hold underlying securities in a segregated account with their custodian or they invest in a pooled vehicle, which offers access to a manager's expertise but with securities held in the name of the mutual fund. Transitioning assets held in pooled vehicles adds another leg to the restructure—and requires taking an "in-specie" slice of assets from the legacy fund to a transition account for restructuring and/or delivering a slice to the target fund. Because assets are registered in the name of the mutual fund instead of the underlying client, this introduces what is referred to as "change of beneficial ownership," or CBO. While most developed markets allow securities to transfer free of payment between accounts, many emerging markets do not. As a result, depending upon the fund, securities for some markets need to be liquidated or purchased directly by the outgoing or incoming fund managers in the market, thus reducing an element of the cost savings one would normally expect to achieve by transferring like assets in-kind. As a generalization, our experience typically sees this non-transferable market amount to be in the 20 percent to 30 percent range.
In order to implement a restructure, a transition manager needs a custodianbased account to stage the event and settle trades. Whereas in developed markets the custody account opening process is straightforward and relatively fast, some emerging markets require additional documentation. Account opening times vary by government; those markets taking the longest time include India (up to twelve weeks), Venezuela (ten to twelve weeks) and Taiwan (four weeks). The good news is that where an investor already holds segregated assets in their own name,opening a transition account for most markets is simple and efficient. Should a "documentation market" be included on the target side in a transition, the client and fund managers have a number of options:
- Postpone the restructure until accounts in all markets are open
- Implement the transition in a phased approach, employing futures or ETFs for the documentation market exposure until the account is ready
- Purchase depositary receipts or a developed market listed line of the specific stock
Naturally, discussions of any substitutions would involve the target fund manager and should be addressed in the planning stage of the event.
In addition to custody account documentation, some markets require that investor identification is submitted at the time of execution. The application process for investor IDs also takes time and will need to be handled in advance of the transition.
INVESTING AND IMPLEMENTING MANAGER CHANGES IN THESE MARKETS INTRODUCES A LAYER OF COMPLEXITY BEYOND NORMAL TRANSITION MANAGEMENT CHALLENGES.
As a result of the additional bureaucracy that comes with the inclusion of emerging markets assets, transition managers are seldom used when clients invested in pooled funds only change the managers but not the structure of their investments.
Ready, set, trade
Once all the boxes have been ticked— i.e., determined the restructure involves segregated securities, the custody accounts are open and investor IDs established— the transition manager assesses the execution requirements and designs a risk-minimizing trading strategy. In the first instance, it is critical that the transition manager understand the specific market nuances when designing the trading strategy. The following equity market examples illustrate the types of situations one encounters:
- An existing portfolio may hold a depositary receipt (ADR or GDR), whereas the target manager may request the local security. This could be an in-kind opportunity and a good transition manager would recognize that both securities are pointing to the same company and would then evaluate the costs of converting an ADR to local shares, versus trading both sides.
- Along the same lines, a target manager may request a specific foreign line Thai security, however Thai foreign lines can be thinly traded. In fact, a transition manager should consider liquidity of other associated instruments. Where a "foreign investor limit" has not been reached, the manager could purchase the more liquid local line and convert it to the foreign line required by the fund manager. Non-voting shares (NVDRs) of the same line may also be an acceptable substitute for the target asset manager and may trade more in line with local shares, thus reducing the cost of transactions.
As shown in these two examples, accurately assessing an emerging market event requires a significant amount of thought and consideration in simply evaluating the asset lists.
In addition to the various security choices and assessment of liquidity and timing, the transition manager evaluates any potential cost and risk reduction by including futures or ETFs. In general, when executing transitions, it is preferable to use the securities within the restructure to hedge exposure. For example, the transition manager would maintain correct market exposure by timing liquid purchases to accommodate illiquid sells. If futures are used, the transition manager should consider whether, for those relevant markets, locally listed (e.g., Taiwan's TAIEX) or foreign (e.g., SIMEX's MSCI Taiwan) contracts provide the better hedge. Another timing issue common with equity emerging market events is staggered cash settlement cycles. For instance, when selling and buying in India, transacting simultaneous sells and purchases in order to manage out of market risk will place the client in a cash overdraft situation. While it is a T+2 settlement market, cash for purchases is required on T+1 and the receipt of cash proceeds from sales does not occur until T+3. The transition manager must devise cash management strategies, as well investment exposure strategies, when transacting in these types of markets.
In addition to timing, settlement methodology also needs to be understood, as not all markets settle on a pure delivery versus payment basis.
As with all transitions, the transition manager should review the proposed trading strategy with the client. Local connections, execution capabilities and insight can smooth the trading process and minimize information leakage.
Trading emerging markets fixed income, by contrast, is fairly straightforward. Emerging market debt stock is increasing, sovereign debt for many countries trades electronically, and emerging market corporate securities can be quite liquid. Within transitions, we see around 60 percent of investments made in hard currencies and 40 percent in local currency, which helps to minimize challenges associated with local currencies and domestic settlement.1
A comment on style— active versus passive
In J.P. Morgan-managed transitions, there has been a trend toward highly concentrated actively managed portfolios. In fact, this trend is fairly independent of region, and alongside the typical developed versus emerging split have been a number of "global active" appointments where the portfolio has fewer than 200 names and includes both developed and emerging exposure. Larger, more concentrated positions can take longer to trade. Trading in line with volume, our firm's estimates suggest that 10 percent of a security's average daily volume (ADV) can trade with minimal market impact and can trade comfortably up to 20 percent ADV on a given day. Large, concentrated portfolios are typically less liquid and require multi-day trading and block liquidity sourcing. This has the knock-on affect of constantly re-evaluating current risk relative to the target exposures. The transition sells and buys need to be carefully coordinated to minimize the exposures that can occur with mismatched liquidity profiles.
Passive portfolios can be simpler in a transition for several reasons: (1) a greater number of securities typically required in indexed portfolios result in smaller, more liquid positions and (2) for some markets futures or ETFs with a low tracking error to the benchmark can be used to augment a trading strategy.
Cash is (still) king
Emerging markets introduce a number of challenges when it comes to cash management and currency transactions.
- Mismatched settlement—As noted briefly above, most of the developed world settles on a "T+3" basis and with the same cycle for buys versus sales; this is less standard within emerging markets. In a number of markets, purchases settle prior to sales, making it difficult to trade on a cash balanced basis without supplying cash for pre-funding.
- FX trade implementation—Many emerging market currencies are not freely traded, requiring custodians to execute via local agents. Whereas FX trading is normally an integral part of the transition process, managing currency risk alongside the underlying securities, in emerging markets the transition manager often focuses on the operational risk more than the market risk.
- Additional considerations—There are a number of country-specific rules and regulations to which one must adhere. In the same way that establishing a custody account can carry an increased administrative burden, some countries require specific documentation on cash transfers. Another common feature is that some countries require pre-funding of purchases. Furthermore, taxes can be introduced and changed, as was the case with Brazil's Financial Transaction Tax introduced in recent years.
Cash flow management is a core part of any transition; transition managers need to incorporate the market-specific requirements when designing the optimal trading strategy.
Forewarned is forearmed
Including emerging markets within an asset allocation strategy has become the norm. Accessing these markets through funds, ETPs and futures is straightforward and easy. Once the decision is taken to have a larger investment, and via segregated securities instead of mutual funds, advance planning and careful coordination with the help of a transition manager can minimize the risk and cost of initial implementations and future manager changes.
1 For a comprehensive review of emerging market debt, please see J.P. Morgan's "EM Rerates as an Asset Class: EM Fixed Income Passes a Second Stress Test," August 10, 2012, www.jpmorgan.com