Developing a transition strategy, coordinating all parties involved and executing the strategy efficiently is an effective way to cut drastically the overall cost of reallocating or transitioning assets within a fund.
Portfolio performance, the most appropriate measure, should gauge the success of the process. Measuring portfolio performance captures all costs associated with a transition and it is calculated by comparing the performance of the assets held during the transition to the performance of the target portfolio during the same period.
The key to a successful transition is developing a strategy focusing on the determinants of portfolio performance. The strategy must also be customised to meet the unique circumstances and constraints of the fund.
Maximising performance requires maintaining the appropriate exposure, minimising both portfolio and operational risks and finding liquidity.
Asset allocation is the largest influence on portfolio performance. One of the most important considerations is whether the assets held during the entire period are exposed to the appropriate asset classes.
If the desired exposure cannot be maintained through the simultaneous liquidation and purchase of securities, or if a transition includes a significant change in asset class exposure, a futures programme can achieve the desired exposure. In addition, maintaining the desired exposure requires close management of cash and currency due to the varying settlement periods of different markets and investment vehicles.
The second largest influence on performance is portfolio structure. Differences between the transition and target portfolio’s compositions (country weights, sector weights, etc) will produce a performance differential. We manage portfolio structure by constraining trades so that the portfolio’s characteristics don’t deviate from those of the target structure. This important control can easily be violated if you allow the markets to dictate which securities are traded, such as in a maximum crossing strategy.
Efficient trading is the final influence on performance results. This minimises costs associated with spreads and market impact by providing liquidity to the markets. Crossing is an effective method to reduce, if not eliminate, these costs, but it should not be seen as the sole solution if asset class exposure and portfolio structure are sacrificed as a result. Risk management tools are an integral part of developing these trading solutions.
A transition manager coordinates the transition plan between all parties involved. Trading activity during the transition period far exceeds everyday trading and this makes a good relationship with the custodian essential. Workload, efficient transfer of electronic data, exchange of trade delivery instructions, time constraints and processes are discussed in detail prior to the event. Effective planning and coordination prior to implementation is crucial.
During global transitions, securities are simultaneously purchased and sold in different accounts and in varying currencies. Coordination between broker and sub-custodian, currency conversion and cash delivery among accounts must be meticulously coordinated so that the correct currency is available to settle the correct trade in the correct account on the correct date. The transition manager and custodian must ensure this process is seamless.
Another vital relationship is between the transition manager and the old and new investment managers. Delivering the desired portfolio to the new investment manager as quickly as possible is key to a transition. Incorporating changes to the desired portfolio must be completed quickly and efficiently and must minimise unnecessary turnover. Prior to delivery, transfers and reconciliation need to be completed as soon as practical. Often the transition manager facilitates the process between the custodian and investment manager and providing effective coordination allows the new manager to get to work on the new portfolio.
Implementing the transition strategy follows a disciplined process involving several steps. The first step identifies securities in both the old and target portfolios and this is done prior to trading and subsequent to any modification to the target portfolio.
The second step requires an understanding of all components of cost, as well as their magnitudes, relationships and time dependence. The various costs are dependent on the markets where the securities are traded and on the portfolio characteristics (liquidity, tracking error, etc.). Explicit costs include commissions and taxes. Implicit costs, those varying with time, include market impact and opportunity costs. Market impact costs are unfavorable price movements due to a demand for liquidity; opportunity costs arise from not properly managing the portfolio structure throughout the transition . Because implicit costs exceed explicit costs, minimising the former is vital.
Market impact costs are a function of trading and are estimated using predictive models of the expected costs of trading securities in the open market. Market impact decreases with time because aggressive trading demands liquidity- the liquidity provider demands a better price. A more patient trade reduces impact costs either because it becomes a source of desired liquidity, or because a cross can be found that eliminates impact and spread entirely.
Opportunity costs are estimated using risk models that quantify the bets between the old and target portfolios. The greater the difference between the portfolios, the greater the likelihood of opportunity costs. Opportunity costs are proportional to time as the longer the portfolio contains bets relative to the target, the greater the chance of price movements.
In the third step an optimiser minimises total opportunity and impact costs. Executing this optimised trade list creates a portfolio more similar to the target portfolio (reduced tracking error) and one that is less susceptible to opportunity costs. This approach minimises opportunity costs, typically much greater than market impact, and allows a more patient approach for the remainder of the transition.
Searching for liquidity on internal and public crossing platforms reduces costs associated with open market trading. Crossing allows for a trade to be anonymously executed at a mid-point price. Although crossing cuts market impact, trades executed via a cross must meet the desired portfolio exposure and structure. Sacrificing desired exposure for the sake of a cross will result in unintended risks imposed on the portfolio.
The clearest measure of transition costs is the difference between actual portfolio performance and the target portfolio performance. This measure includes every relevant cost (impact, opportunity, commission, tax, etc.), and provides a comparison of the actual cost relative to the ideal situation – an immediate and costless event.
Adrian Jackson is director of transaction services at Frank Russell Company and Steve Dowling is manager, portfolio transitions at Frank Russell Securities