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The transition of trust

Over the last decade there has been extraordinary growth in the demand for transition management, the process by which a fund is restructured in order to implement a new investment strategy. This growth has inevitably attracted new players into the sector. But whilst this has created more competition and tighter margins, it has also led to a bewildering range of different provider types which render the selection of the right transition manager by trustees an increasingly challenging proposition
To an extent the industry’s success has created a virtuous circle of growth. As investors have attained greater awareness of the savings and operational benefits offered by transition managers and trustees found that moving mandates could be cost-effective and worry-free, they inevitably became more comfortable in making those moves and the use of transition managers grew exponentially. An increasing emphasis on asset liability matching and risk budgeting as well as the ongoing shift of assets to specialist managers has also fuelled growth. These trends have been exaggerated by the downturn in the market, which illuminated portfolio underperformance, whilst increased competition and diminishing returns have lead to a keener focus on cost.
All trustees want the same things from a transition: smooth migration to the new structure, proactive management of portfolio and operational risk, confidentiality, minimum market impact, transparency of reporting and, above all, a competitive price.
Of course all transition managers claim to be competitive, but the devil, as ever, is in the detail. The biggest issue is in ascertaining the true - as opposed to stated - cost of a transition which can be somewhat opaque. Whilst taxes, fees and commissions are perfectly visible, the opportunity costs, market impact and spreads paid can vary, sometimes alarmingly, from manager to manager and transaction to transaction. Moreover by being creative with the measurement process and choice of benchmark these true costs can be hidden. Worse still the choice of measurement technique is likely to effect the implementation process; selecting the wrong benchmark will virtually guarantee the wrong trading strategy which will increase the true cost of the transition. But, faced with such a nuanced decision, how is the trustee to know which is the right benchmark, who has the best trading strategy and which transition manager he should choose?
There are some basic credentials that can be established. The ability to cross orderflow away from the market has been long established as a good way of eliminating market impact and spread costs. The ability to cross is dependant on the pool of assets that can be crossed against and in transition management this is a function of the size of the transition management business and the value and type of assets under management. Beyond this, credentials get somewhat more qualitative but it is important for the investor to review samples of client reporting as well as identifying key steps within the risk management process.
Nevertheless, despite the guidance afforded by volume of assets and process, trustees remain confused by the real costs and charges of restructuring funds and sceptical of the claims of unique risk management expertise. Indeed many trustees, who are primarily seeking peace of mind, still suspect transition management is more of an art than a science. Perhaps it is no surprise then that they are increasingly looking beyond presentation to try and distinguish between rival managers.

The primary, almost inescapable negative, is the transition manager’s conflict of interest. Many managers are conflicted by other in-house business streams. These range from, at the sharp end, proprietary trading and corporate relationships to, at half a remove, everyone’s fundamental need to make money. But this is axiomatic. Everyone understands that these firms are in business to make money. The real issue lies not only in the amount of money charged, but in how transparently it is charged and reported.
Although it would appear self-evident that any transition manager with its own principal trading book would have an inalienable conflict of interest, these conflicts of interest are not quite as clearcut as the uninitiated might assume. Last year one UK based firm was was fined by the FSA for ‘pre-hedging’ - trading securities on its own account that were likely to be included in a programme trade - without disclosing this fact to their client.
Following this some firms wrote to their clients outlining their policies on pre-hedging. One firm announced that they would never pre-hedge while another argued that no-one who knew about the programme trade would deal in the securities involved after the placing of the order and before completion without the client’s prior agreement. However they went on to say that they would pre-hedge between providing a quote for the business and winning the order. It seems extraordinary that anyone might feel able to justify this process of pre-hedging since any trading activity is likely to impact the prices of the securities involved and in this case the choice of trading activity is likely to be influenced by the information received as part of providing a price of the trade.
In the light of this ongoing debate, the point to be made about conflicts of interest is that even where things appear to be black and white that is rarely the case. It is a grey area, indeed a series of overlapping grey areas, that leave the transitioning trustee no clearer about whom he should be dealing with. So, faced with claim and counter-claim, he has little choice but to rely on his instincts and decide whom he trusts.
Whilst trust is ultimately a matter for individual conscience, there is one trend the trustee should bear in mind. The rise in corporate cash flows - the S&P 500 has over $500bn in cash and a fifth of the companies in the FTSE 100 have announced share buybacks or special dividends - has undermined the investment banks primary lending activities. This, allied to diminished M&A opportunities, have led many to seek alternative income streams. Most have used their balance sheets to expand their principal trading activities so aggressively it has become a colloquialism to describe the big investment banks as little more than hedge funds. Inevitably this trend away from client services towards proprietary trading has been accompanied by a not always subtle shift in the traditional client/ broker relationship: partnership has been replaced by profitability and service by a more adversarial stance. There is a certain honesty to it, but it doesn’t necessarily lead to trust.
Lachlan French is Head of Transition Management, State Street Europe

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