Between cup and lip
There’s nothing like a prolonged downturn in global equity markets to prompt institutional investors to start kicking the tyres and checking under the hood in an effort to determine whether their current investment strategy is in need of some fine-tuning.
Having invested heavily in equities in recent years, the fierce correction now gripping global markets has taken a heavy toll, and fund managers, insurance companies, European corporates and their pension funds are retreating amid heavy losses. With years of out-performance erased from the books and increasing pension fund deficits, investors are now focusing on rebalancing their investment portfolios to achieve their desired asset allocation. This increase in rebalancing activity is causing significant turnover within the fund management community.
With institutions desperately seeking to claw back value without incurring heavy costs and/or impacting fund performance, transition management services have come to the fore. A poorly managed portfolio restructuring, however minor, can lead to higher trading costs, compromised performance and other significant risks. Previous studies indicate that up to 2.7% of transitioned assets can be eaten up by costs during manager transitions.
In the UK, such is the level of concern that government-led initiatives, notably the Myners report, have thrown the spotlight onto pension fund trading costs and forced a reappraisal of the way banks and broker/dealers trade and the costs they pass on to their fund management customers.
By focusing on the management of risk, the transition manager can minimise such costs and improve overall investment performance. In the decade since it emerged as a discipline in its own right, transition management has evolved significantly – what started as an inefficient product has now become a highly sophisticated, technology driven offering.
In some respects, a transition is not so dissimilar from an outsourcing arrangement. Although it is carried out within a far more compressed timeframe, a restructuring or transition involves a high degree of project management, both in terms of planning and implementation. Expectations must be set and managed from the outset – if cost and risk of the portfolio is to be minimised, goals must be clearly delineated and locked down in advance and then every step of that pre-agreed process seen through to completion.
A traditional approach to a transition was to sell the assets within a plan and then deliver cash to the new manager to invest. This meant that the plan was not only out of the market for a short period but it also paid excessive commissions and fees. Given that these are the only visible costs, it is tempting to focus solely on them; however, these are typically the smallest costs in a transition.
As with an iceberg, what you can see above the waterline is only part of the story. Having researched the full range of costs involved in the average pension fund transition, consultant Mercers concluded that the average total was as high as 270 basis points, of which a mere 10-20% could be attributed to commissions and fees.
More important, are the less visible – and hence harder to quantify – indirect transaction costs. These costs include market impact, opportunity and operational which taken together are typically the largest contributor to the overall cost of transitioning a portfolio.
The major hidden costs of trading are market impact and opportunity cost – and these typically drive the performance of any transition. Using sophisticated pre-trade analysis coupled with portfolio and transaction modelling, transition managers are able to determine the optimal method to execute.
Crossing and swapping assets with others who are willing to exchange at middle market prices – whether via direct brokerages and crossing networks or other third parties – help minimise commission costs, stamp duty, spreads and market impact prior to hitting the market with trades. However, crossing can come at the expense of opportunity cost and should really form only part of a strategic approach.
Approaching the market, a transition manager will employ a variety of different trading techniques in an effort to complete the transition in a timely manner that limits risk and costs. It is also critical that a transition manager be able to provide the wide range of disciplines involved and be on hand to provide operational support. Such a ‘one-stop’ shop can encompass overall administration, custody, reporting and execution, be it in relation to forex, equities or bonds, as well as providing additional services such as cash management, derivative overlays, performance measurement and proprietary risk management tools.
A consolidated approach means that the client benefits from a single point of contact throughout the transition process in the shape of a dedicated transition coordinator. The coordinator is responsible for all activity between the plan and the fund managers and custodian, overseeing the transaction and making sure the transition plan is implemented according to schedule.
Keeping the whole process in-house also ensures that confidentiality is preserved, a particularly important consideration when it comes to major transitions. News of a large asset restructuring, be it changing a portfolio’s asset classes or rebalancing the domestic and international equity mix, can negatively impact the value of the securities the fund is looking to buy or sell. Similarly, if a particular fund manager has just been fired, other market participants will have an idea of which assets are subsequently going to be traded and may well seek to trade ahead of them.
Determining whether or not a transition has been successful has always been a concern to investors, particularly given the costs associated with them. Implementation shortfall, a measurement of portfolio performance from the time trading begins until the transaction is accomplished, is fast becoming the key benchmark by which the success of a transition is judged. Much work is taking place in Europe to standardise measures for transition managers, and implementation shortfall has the ability to provide an unambiguous measure of the total transaction costs involved.
With no end in sight to global market turbulence or to tightening of corporate purse strings, the role played by the transition manager looks set only to become more significant going forward.
Richard Warne is JPMorgan Investor Services’ global head of execution and investment products and head of securities lending for Europe, Middle East and Africa; Rob Barrett is head of transition management for Europe, Middle East and Africa