An unmanaged or poorly managed portfolio transition can at its worst combine opportunity costs, market impact and commissions to produce breathtaking costs. You needn’t look far for horror stories. A recent article in the US quoted the transaction cost company Plexus as saying one of the transitions it monitored has cost a total of 11%. Back a little further and the WM Company published findings that the average cost for a number of local authority funds in the UK to transfer from a balanced to a core satellite approach was 270 basis points.
These are isolated and extreme cases but it is now accepted that a poorly managed transition can be unnecessarily expensive. Publication of the Myners report has only served to raise further the already rising profile of transition management. Any transition manager at the leading providers – Merrill Lynch, BGI, Legal & General, State Street and Frank Russell along with the investment banks Goldman Sachs, Morgan Stanley, Credit Suisse and Deutsche – will testify that it is a good business to be in at the moment. But, as business intensifies, so does the need to measure the performance of various managers.
To date, the problem facing pension funds and institutions eager to employ the services of a transition manager is a lack of any means of comparing relative performance. Rick Di Mascio’s Inalytics based in Croydon, south of London, one of the few transition management measurement businesses, hopes to change this.
Normally, when an institution employs a transition manager, it asks them to do the reporting. “You get the situation where managers are reporting on their own performance and increasingly the evidence is that pension funds are saying that they would like some independent verification that these costs have been properly reported. It’s particularly important during a transition when you might have the equivalent of two years’ transactions in a two-year period,” he says.
Di Mascio says in the past six months there has been a consensus that implementation shortfall – market impact, opportunity costs and fixed charges – has become the preferred way of measuring performance. Six months ago only a couple of transition managers were applying the full shortfall treatment. Until recently, most used VWAP, or volume-weighted average price, as a means of comparison.
In practice it’s a method with numerous limitations, the main problem being that it compares trades with the volume-weighted average. For a large trade, so common with transitions, you can literally represent the market for the day and therefore you’re comparing yourself with yourself. It also compares the price with the daily average so, in theory, certain trades may look favourable up against the daily average but fare poorly against the equivalent price, for example, the previous week.
Another shortcoming is that it only measures completed trades and ignores those left on the order book. Given that these are often the trickiest, not to say the most expensive, it appears wrong to exclude them. The approach of Inalytics is to measure implementation shortfall, which captures both the individual trade and the effect of any outstanding trades.
According to Rick Boomgaardt, head of transition management at Credit Suisse First Boston, implementation shortfall represents the total cost of a transition and is a more adequate measure. “Execution versus VWAP doesn’t give you the whole picture of what the total cost is,” he says. Most transition managers now subscribe to some form of implementation shortfall. The next goal is to standardise its calculation, something Daniel Wiener, head of the securities division at State Street, says is long overdue.
Each transition manager measures performance slightly differently and such an approach appears non-sensical in an industry where business is often won on the basis of pre trade estimates of the overall cost. In other words, it’s a situation where the manager is providing both the bid and the post trade measurement. “If we’re producing an independent validation of the final cost, it means there’s an independent check and one with particular reference to the pre-trade estimate,” says Di Mascio.
If research published in October by Frank Russell – under the abysmal title “Slouching trader, hidden drag on performance” – is to be believed, the comparison is valid. By analysing transitions between the third quarter of 1999 and the first quarter of this year by more that 100 pension funds based in the UK, Europe, North America and Australia, it concluded that the eventual cost works out an average 99 basis points more than the original estimate.
Frank Russell is sketchy about the precise data but some pactitioners among the broking fraternity tend to quote for transitions solely on the basis of direct or explicit costs. Those that use implementation shortfall as an estimate of the price of a transition say the discrepency is due to the implicit costs.
Merrill Lynch has always used implementation shortfall to quote for transitions and Michael Marks, joint head of the transiton management team, says that consequently in their experience total post-transition costs have been in line with estimates. “We wouldn’t even expect total costs on a straightforward transition to be one hundred basis points so to be out by a hundred is quite something.”
Whatever the shortcomings of Frank Russell’s research, it raises awareness of the potential magnitude of implicit costs. The message appears to be getting through to institutional investors. In the UK, funds are now more that willing to employ a transition manager and the interest from funds in the Netherlands is increasing.
Di Mascio believes the business has changed dramatically in the past 18 months to become recognised as a specialist service. “Transition managers have done an excellent job of demonstrating that the process of change does require professional project management and exceptional dealing skills and therefore the client base has become much more comfortable with appointing a transition manager almost as a course of event if they are deploying a big change.”

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