Bo Abesamis cited pandemic-induced volatility as a key reason for the rise in ETF usage.
ETFs are becoming an increasingly useful tool for transition managers as more assets flow in.
Increased ETF use drives greater volume. High volume contributes to liquidity and, ultimately, to the utility of ETFs as tools in transition management, said Bo Abesamis, San Francisco-based executive vice president and the manager of Callan LLC’s trust, custody, securities lending and transition management consulting group.
“Actually, ETFs became even more prevalent as a solution, an accepted solution, for transition management because of the volatility emanating from COVID. When the markets became so volatile and people had to get the proper exposure, or rebalancing, ETFs had enough volume and liquidity to conduct transition management transactions,” Mr. Abesamis said.
He said transition management, at its core, is an act to preserve assets in transition over the short term and requires a discretionary level of care. ETFs can help a transition manager avoid cash drag, especially in a low-interest-rate environment, and achieve or maintain the client’s target asset allocation while moving a portfolio from the legacy manager to the target manager. Mr. Abesamis said ETFs can be “a very important toolkit” in volatile markets, particularly for clients who are unable to use derivatives or synthetic instruments, such as futures and swaps, to aid in portfolio alignment during the transition.
“However, not all ETFs are liquid,” Mr. Abesamis said. “You have to be very careful because not all asset classes or mandate styles are liquid enough. Even though there’s an ETF, it might not be liquid enough. And if it’s not liquid and there’s not much volume, and there’s no price discovery, then it doesn’t work. Then it doesn’t become a transition management toolkit.”
Mr. Abesamis said he also warns clients to avoid ETFs that are based on speculation.
“This is what I tell clients and transition managers to keep them honest. ... We don’t want an ETF that is driven by speculation because it will introduce an additional level of risk to the transition event. That happened last year. It manifested itself in the high-yield/credit space and in certain sophisticated equity strategies. We don’t want that. We want ETFs with large volume, liquid and utilized by ‘stable’ investors,” Mr. Abesamis said.
The liquidity of ETFs also gives transition managers the flexibility to optimize the timing of trades, said Grant Johnsey, a Chicago-based senior vice president in Northern Trust Corp.’s capital markets unit, which includes transition management, securities finance, global foreign exchange and brokerage services.
ETFs can be traded during the course of a day, over multiple days or weeks, in a time period that works best for the client’s needs, Mr. Johnsey said.
Similarly, he said, less-liquid asset classes, such as small-cap or microcap allocations, can be temporarily filled by ETFs during a transition, which saves time.
“Who’s ultimately better at managing this portfolio? The transition manager while we trade? Or get that portfolio into the hands of that small-cap manager specialist? I prefer the latter, and therefore we will use ETFs to finish the transition instead of potentially buying less liquid securities,” Mr. Johnsey said.
Global markets present additional complexities, he said, and ETFs can help transition managers mitigate tax impacts or change of ownership complications when transitioning a portfolio, particularly when working with international securities.
“There could be emerging markets involved, which would trigger potential change of ownership or tax implications. Even in Europe, where some of the European countries charge high transactional taxes, ETFs can help mitigate costs,” Mr. Johnsey said.
Taxes in countries such as the U.K., Ireland, France and Italy, for example, apply to all investors. However, transactional taxes are not assessed on ETF trades as they would be for local shares, he said, and some ETFs have tax exemptions. Even for those that do not have exemptions, the premium to buy an ETF that is widely traded is typically less than the full local tax and the premium will likely be recouped to an extent when sold, Mr. Johnsey said.
Going beyond placeholders, some institutional asset owners are choosing to hold ETFs created by the transition manager as a long-term part of the portfolio after a transition.
“We do see situations where the new target portfolio is an ETF. Perhaps the ETF reflects a new investment view or tactical bet, or perhaps the ETF is a placeholder during a new investment manager shift. Either way, the ETF we buy or create during the transition becomes a permanent or quasi-permanent component of their overall strategy. That’s also interesting because, in the past, a lot of the clients would want to go into an index fund because the fees are lower. But with an ETF, you can have more flexibility on when to sell and if you want to redeem for underlying securities,” Mr. Johnsey said.
The “custom basket” rule, announced by the Securities and Exchange Commission in September 2019, gave transition managers even more flexibility in constructing ETFs for more efficient client exits, he said. The transition manager can take the client’s shares of publicly held securities and, if the ETF fund manager is willing to create a custom basket, those shares can be converted into units of an ETF.
“My client is able to exit a less liquid, potentially more concentrated portfolio and get shares of an ETF that they can either hold or work out of over time or perhaps even get to the new asset manager to work out of as they as they deploy their new strategy,” Mr. Johnsey said.
