Securities Services: Transitional, but not trivial
Most investors now recognise the advantages of specialist transition management. But Andrew Williams warns against the easy route of deploying one’s custodian to the task
The transition management industry has not had the best of times in recent years, with widely reported challenges across various providers, and some high-profile players making what might prove to be their final appearance. The growth in allocations to alternative assets and liability-driven investing, which are generally not on the wish list of most transition managers, and the increasing prevalence of defined contribution (DC) pension scheme transitions that mainly involve cash transfers, continue to pose a significant threat to the level of business available to transition management providers.
Not all providers are struggling, however, and steady demand has ensured that a range of players remain active on the worldwide transition management stage. Investors are still enjoying the choice offered by a competitive transition market comprised of experienced providers. Transition managers remain the protagonists of many transition events, and their range of additional services, by and large unused by institutional investors, extends to more than simply executing a basket of buy and sell orders.
Should investment managers deal with the transition themselves?
Even where target managers are being funded in cash, there is still the legacy portfolio liquidation to consider. For the majority of asset classes, the execution capabilities of transition managers exceed those of the investment manager, in terms of their purchasing power with market counterparties, the ability to cross trade with other clients of the firm, and their technological strength providing access to multiple sources of liquidity.
Another key differentiator of transition managers is in the quality of the reporting available. Investment managers, not unreasonably, are not geared up to provide the same level of reporting and cost analysis that transition managers are able to. In these times of increased scrutiny on all forms of costs and risks that investors face, the ability to analyse at a stock-specific level the costs incurred during a transition is extremely important.
The ability of the transition manager to manage market exposure through the use of futures and other derivatives remains under-utilised. While the management of mismatches in legacy and target allocations through the use of futures in transition events over a short period is well established, what is less well known is the ability of some transition management providers to use futures on behalf of clients over an extended time period.
Interim or beta transition management has a number of significant benefits. The advantages of rebalancing back to a central benchmark allocation to improve asset returns (essentially, selling high and buying low) is well documented. How to ensure that your asset allocation is managed closely against its target is, however, a different kettle of fish.
A futures overlay can manage market exposures in a timely and cost-effective way and has the benefit of also being operationally simple. Similarly, when a decision has been made to terminate a mandate, why should the investor have to wait several months before a new investment manager is appointed to manage the assets? During the period of mandate change-over, the assets will remain in the legacy portfolio even while the investor has decided to move on.
Interim transition management can take legacy active portfolios and turn them into a passive index-tracking portfolio, thus maintaining the desired asset exposure and removing the unwanted active positions. This can be done either through trading the physical securities into another basket of physical securities that replicate the index, or selling the legacy securities and purchasing index futures. In these days of dynamic decision-making, the delay of several weeks or months in moving away from a terminated investment manager’s portfolio seems peculiarly old-fashioned.
It is clear that transition managers still have a part to play in investor’s portfolios, but who to choose? This decision can come at the end of an investment strategy review and investment manager selection process, which in itself can be a time-consuming and laborious process. At this stage, the pension scheme’s custodian can be viewed as the easy solution – but is this default approach the most cost effective? Three questions need to be asked:
1. Are custodians likely to be the best transition manager, any more so than if they are likely to be the best asset manager?”
All the major custody banks have asset management departments, as well as distinct teams of people providing transition management services. Both these units offer specialist skills that are not correlated to those of a custodian, and the different departments compete in their own right against other firms within their respective sectors. Selecting a firm to act as a transition manager just because it has a strong custody capability can be as precarious as appointing an asset manager on the same basis.
2. If the custodian is the holder of the assets, surely it is best placed to co-ordinate a transfer of assets?
If there are any benefits, they are marginal and may be more than offset by the increased costs and risks that the trustees assume. Process integration between the transition manager and custodian, as well as custody-transaction-fee savings, are often cited by custodians as the key advantages. The most successful transition management teams will have a strong history of completing hundreds of asset transfers within the space of a few years and have extensive experience of working with all the major custodian banks. They are likely to be as familiar with the custodian’s operations as the custodian’s sister transition management team. Even where a waiver of custody fees during the transition is proposed, these costs are more often than not dwarfed by the total cost of the transition.
3. Would you normally select a service provider having undertaken little or no due diligence?
An asset transfer is an extremely important project for a fund if costs are going to be contained and risks managed. Obtaining more than one cost estimate should be the minimum level of due diligence undertaken. Even for transitions of €100-200m, differences in estimated total costs from different providers can run to hundreds of thousands of euros. Such comparative exercises do not mean that the custodian bank will not win a mandate, but if it does it is on merit, and enables trustees to demonstrate good governance.
Trustees may also feel that the one-off nature of many transition management assignments puts them at a disadvantage when it comes to monitoring a transition manager’s performance. The ability to express dissatisfaction and terminate the mandate is typically not an option once the transition is complete. Using an independent third party such as an investment intermediary enables the trustee to capitalise on the intermediary’s on-going relationship with the transition manager, presenting a much greater reputational risk to the provider if something were to go wrong.
Andrew Williams is an investments principal at Mercer Sentinel, specialising in transition manager research