Transition Management in difficult markets
Surveying the wreckage of their portfolios, investors are seeking out new ways of investing that puts huge pressure on fund managers and various risk management techniques. Transition management, whereby professional firms handle all aspects of a change of portfolio or asset manager, is a boom area.
A transition involves moving out of a current investment structure and into a new one. Such a decision can be driven by a variety of factors, including changes in the investment structure, liability profile, asset mix and class, investment providers and mandate. Unlike regular trading, a transition involves a substantial number of trades to be traded within a short period of time.
The main reason for hiring a transition manager, says Andrew Williams of investment consultants Mercer in a paper published in November, is to organise and co-ordinate the transition process and effectively provide a smoother transition for the investor by minimising risk and controlling cost. “Transition managers are usually able to transition portfolios at a lower overall cost than the incumbent or target investment manager completing the transition internally,” he says
Justin Balogh, senior managing director and head of securities trading in Asia-Pacific for State Street Global Markets, comments: “Recent market volatility has seen institutional investors focus on two streams of thinking; they have been prompted to either undertake a review of the core strategic asset allocation in light of how financial markets have changed, or if they wish to maintain their current strategic asset allocation, they have been investing time in seeking to understand the best means to rebalance back to it. It is true for every investor now that current asset allocations
have moved considerably away from strategic policy weights.”
BNY Global Transition Management, a subsidiary of global agency brokerage BNY Convergex Group, attained record growth in its business during July 2008. The number of transitions executed during the month grew by more than 50% and the principal amount of the assets transitioned more than doubled compared to the same period a year before. BNY said transition activity surged throughout the US, the UK, Middle East, Asia and Europe. Growth was recorded in both the number and type of new clients coming to market, the dollar value of assets transitioned, and the level of complexity of the portfolio compositions.
Current market volatility - where daily moves of 5% have become commonplace - is colouring the transition management market. Kal Bassily, head of global transition management at BNY Convergex, says: “Asset owners are not used to reallocating assets in times of economic turbulence. However, the markets have been exceptionally volatile for almost a year and while at the beginning of the year asset owners were postponing transitions because of the volatility, they are now going ahead and transitioning their portfolios.”
Volatility has also increased market impact, says Bassily. “There is an emphasis on the provider side to be creative in how to trade, source liquidity and explore non-displayed liquidity. Transition managers must leverage all types of liquidity management technologies. They also have to be very nimble and quick in going to the open market and executing in different venues.”
Simon Hutchinson, head of transition management international at Northern Trust
Global Investments, agrees that transition management is a more difficult process
during volatile markets, particularly on the trading side. “Our experience is that asset owners are moving much faster between an initial enquiry about a transition to granting the assignment,” he says.
“The levels at which markets are moving is out of line with historical trends. In the past, a move of 1-2% would have been considered quite big, but in September alone you had market moves of 5-10% in a day. These unprecedented movements are making transitions potentially more expensive. However, the volatility has highlighted the importance of using a professional transition manager, who can manage operational risk and make sure things happen when they are meant to, ensure exposures are well balanced between different asset classes and are monitored throughout the assignment.” Williams identifies five costs associated with transitions: commission, taxes, bid/ask spread, market impact and opportunity (the latter two being indirect costs).
In all these cases transition managers can help keep costs down. For example, transition managers, because of the large volumes of trades they carry out each day, are generally able to achieve extremely competitive commission rates. They can also use their scale to reduce bid/ask spreads.
The minimising of market impact is due to trading skills, says Williams. Trading desks at transition management firms are more familiar with trading very large blocks of securities on a daily basis in the market, compared to investment managers’
trading desks, which are less experienced in trading large volumes of securities, he says. Transition managers also will ensure that the new asset exposures will be obtained as quickly and efficiently as possible. “It is at times difficult to manage the legacy exposure with different asset classes and keeping them in line with the target exposure. The opportunity to sell unwanted legacy assets and purchase target assets simultaneously at fair prices can leave a transition exposed to significant opportunity costs, especially in volatile markets. If these types of risks are not managed properly and adeptly, losses can occur,” says Williams.
“Transition managers can minimise exposures by utilising various derivative instruments such as basic future contracts, as well as sophisticated trading techniques such as algorithmic trading, to dampen volatility in the potential transition cost.”
State Street’s Balogh says, “Portfolio risk management has always been a key differentiator of service providers in this product space, however this issue has become salient to institutional clients in markets that are displaying unprecedented volatility. We’re working with clients higher up in the process however, right from the portfolio construction and investment policy decision making stage through to execution and transition.
Portfolio construction decisions that were formed in the past are being tested by periods of extreme market turbulence and as a result we have received a significant number of calls from clients who are seeking advice and research input. We receive many requests for insight with respect to regime-dependent risk management techniques; that is to say, considering portfolio construction and risk measurement for both turbulent and non-turbulent market environments. Clients want to know how their portfolio is likely to behave and what their risk exposure is in varying market conditions.
The last few months has tested conventional thinking on risk management. “These decisions are then flowing down into restructuring or transition events. Insight on managing portfolio risk is the first question being asked. Service providers, who can demonstrate clearer, quantitative approaches to managing portfolio risk during a restructuring, are more likely to be awarded mandates in the current environment.”
Sydney-based Michael Jackett-Simpson, head of the transition management team, Asia at Citi says it is still early days for transition management in Asia and it is a relatively new concept for most asset owners. “However, Asia cannot be classified as a single market so the situation is very different around the region,” he says.One of the key drivers of the transition management business in the region is that legislation and regulators are opening up markets to allow for more offshore investment by pension funds.
“There is a growing need for transition managers to help local pension funds to diversify and restructure their portfolios,” he says. “The credit crisis has slowed transition moves because costs are now much higher compared with before the crisis started and bid-offer spreads in equities are increasing.”
During the past 18 months the use of transition managers has grown however. “More pension funds are appointing transition managers, often just to validate
the concept of a portfolio or manager change. We expect the market to pick up during 2009, as markets begin to stabilise.”
Bassily agrees there has been an increase in the use of transition managers in Asia Pacific, which is unrelated to market volatility. “First, wealth accumulation has been a major factor. In different markets across the region, sovereign wealth funds, government pension funds and reserves of central banks have grown steadily. This growth is always an indicator of an uptick in transition management activity. Also,
transition management is being driven by regulation and legislation in the region. Asset owners are increasingly able to allocate some of their investments outside their home countries, across equities and bonds. They need transition managers to help them invest in non-home currency instruments - for many this will be the first time they have invested outside of their home country and the first time they will use transition managers.”
Northern Trust’s Hutchinson says the Asia-Pacific region “looks a little like Europe did a number of years ago”. Asset owners are changing their asset allocations to be more global, as regulations in different countries allow for more offshore investment. “Moving to a global equities portfolio requires a level of co-ordination that is best provided by a transition manager,” he says.
Transition management has always been about risk management and protection of the asset value of the client’s portfolio, says Jackett-Simpson. “The credit crisis has not changed this - transition managers still must do detailed pre-trade analysis
in order to understand what is in the portfolio and the market conditions so they can formulate a strategy.” What has changed slightly, he says, is that some transition clients are in more communication during a transition. “Market moves of 2-5% are now quite common, so transition managers have to manage clients’ expectations because with such volatility, the range of outcomes is much wider than during less turbulent times. Transition managers have to ensure that clients’ expectations
are appropriately set before any trading is conducted.”
Hutchinson agrees: “During volatile markets it is particularly important to ensure that clients understand the potential highs and lows of a transition’s outcome. Transition managers must give clients more colour about what they believe will happen, but also what might happen.”