Difficult art of portfolio transitions
Transition management is a key process in the implementation of a new manager structure or any major shift in asset allocation. Poor management of the transition process can lead to a significant loss of performance.
This ‘implementation leakage’ or ‘investment gap’ is a major factor in the overall transition cost, which according to performance measurer The WM Company, can be as much as 2–3% of the fund for each major transition. Experts suggest that a carefully transitioned fund can reduce costs down to less than 100 basis points, plus the transition manager’s fees.
At times, a key part of the transition process is the use of a futures overlay. Financial futures allow a pension fund to reduce or increase its exposure to a particular asset class without having to buy or sell holdings in the asset concerned.
The impact of the futures contract, therefore, is to alter immediately the exposure of the fund to a particular asset allocation so that the transition manager can achieve and maintain the new benchmark while actually buying or selling the underlying securities. In this way the performance of the new benchmark can be measured from day one.
Without the futures overlay, part of the portfolio might be in cash as the transition team liquidates the unwanted securities and arranges to purchase the new stock. A cash position can work to the fund’s advantage, but where it is unintentional it introduces the risk of significant performance loss if the market moves upwards before the new purchases are made.
Research from Frank Russell Securities, part of the Frank Russell Company, indicates that most funds liquidate a major portion of their assets every three to four years and reinvest as new managers are hired. There are, of course, other reasons for a major overhaul - for example following an asset liability study, a merger or acquisition, a sizeable cash flow or a one-off event such as the introduction of European Monetary Union (Emu).
Frank Russell advises clients with total assets of over $1,000bn and manages $60bn worldwide. As part of its overall asset management service, the company’s internal derivatives group is responsible for the cash equitisation process to ensure funds are invested as fully as is practical.
This same derivatives team assists the global transition management operation. Troy Rucker, a portfolio transition manager with Russell, says “The most economical way to achieve a transition is to buy and sell stocks simultaneously but where this is not possible you could end up with a lag between buying and selling when a portion of the client’s portfolio is in cash.”
There are other reasons why you could end up in cash. Adrian Jackson, director of transaction services at Frank Russell says: “It may be impossible to match buying and selling – for example where you are moving in or out of pooled funds with different settlement dates.”
Russell managed 118 transitions worth £38.2bn (e63.5bn) in 1999 so the company is particularly aware of the market impact and opportunity costs that can undermine performance during the transition period. Trustees may be keen to see the transition achieved as quickly as possible but this can prove detrimental.One of the problems with quick transitions is that they can involve large orders executed over a short period of time so there may be insufficient liquidity to execute them at the prevailing prices. As a result, pension funds can be forced to buy at higher prices and sell at reduced prices.
Where these large orders are not handled with great care, information can leak out and push up the transaction costs even further. With a futures overlay in place the transition team does not have to force through sales and purchases and it is able to keep large transactions secret from the market where the news can affect the share price.
When faced with the alternative to the futures overlay – namely the risk of being in cash or of buying and selling at below optimum prices – Frank Russell finds that some trustees and plan sponsors are willing to pay the additional cost for the derivatives.
“If the client chooses a futures overlay, we explain how it will be instituted as well as quantify the costs in the agreement with the trustees,” Rucker says.
Miles O’Connor, head of business development at BGI in London, also stresses the importance of discussing the use of futures with the trustees. Even where the trustees appear willing, in a minority of cases the pension funds statement of investment principles will not allow the use of derivatives.
“We only ever use derivatives where the client gives permission. This is still one area where trustee bodies feel uncertain,” he says.
Like Frank Russell, BGI uses futures extensively in transitions as a mechanism to achieve a match with the new benchmarks. Once this is achieved the derivative position is gradually unwound as the physical holdings of stock build up.
As a major passive manager, the company has an extensive internal crossing networking and the futures contracts helps the company to match up natural buyers and sellers and therefore to capture the internal liquidity of BGI. Typically each year BGI might cross over 30% of its transactions across the globe internally, saving clients tens of millions of dollars.
However, derivatives are not always an option for the transition manager. O’Connor says, “We only ever use derivatives where the client gives permission. This is still an area where trustee bodies feel uncertain. Moreover, derivatives can only be used where a major change to the benchmark must be achieved. Some contracts only work in very large numbers of stocks.”
BGI’s futures requirements are drawn up by internal specialists and put out to tender among external brokers.
State Street’s transition team is located in London, Boston, Sydney and Tokyo. In 1999 the team transitioned over £60bn of assets across more than 400 portfolios. Martin Bednall, transition manager with State Street, explains how he might achieve a transition from UK to US equities. “The futures strategy would depend on the client’s requirements and the exact nature of the transition. Assuming the transition involved large-cap securities we would probably recommend selling FTSE 100 futures and buying S&P 500 futures at the outset so that the pension fund can capture the performance of the new benchmark immediately.
“Then as we liquidate the UK holdings and buy the US equities we unwind the futures contracts so that the benchmark is constantly matched.”
Organisations like State Street are able to handle huge transactions. So far in 2000 the largest mandate for State Street was the transition management of a £6bn fund through its specialist unit for portfolio reorganisation.
The company argues that large investment managers have two key advantages as transition managers – they have extensive in-house crossing networks and they can also use their bargaining power to reduce costs.