Without a ripple
One of the largest pension funds for professionals in the Netherlands, the Doctors Pensions Fund Services (DPFS), recently outsourced the management of its assets from its in-house investment management team to external asset managers.
The transfer which involved the movement of €11bn of DPFS assets, was probably the largest transition of European pension assets in 2005 and provided a good example of the demands put upon transition management today.
John Minderides, the head of transition management for the EMEA region at JP Morgan, which managed the transition, says the transfer was notable for its complexity as well as its size.
“This was a hugely complex exercise, not just in terms of the volume of trading but also in terms of involving 30 different fund managers and involving asset allocation changes as well as fund manager changes.
“We were able to execute billions of dollars in bonds and equities without leakage of information, without
impact and with a result that has been very successful.”
The increasing volume and complexity of transition management business has attracted a growing number of players. Initially, transition management was the province of a handful of large buy side providers, notably Barclays Global Investors, State Street and Merrill Lynch Investment Managers. Their business was to service the asset gathering activities of fund managers who wanted to move large bodies of assets into pooled funds.
As the business developed, investment banks such as Goldman Sachs and Morgan Stanley moved the sell side into the business by developing portfolio trading to handle the execution of the large trades that transitions entailed. In the late 1990s they began to move into transition management on the buy side, reasoning that if they were already executing flows for the fund managers, they might as well handle the whole business themselves.
More recently custodian banks such as Bank of New York and Mellon have become involved. Like the portfolio traders, they reasoned that since they had large volumes assets in custody, with responsibilities for record keeping and other securities operations, they were well placed to become involved in transition management.
The changing nature of the transition management business has demanded different skillsets. Ten years ago, pensions funds were typically invested 80% in equities, usually in large equity index or pooled funds. As a result most transition management revolved round equities.
Today transitioning has developed from an equities business to a multi-asset business. This includes the transitioning of substantial bond portfolios, says Minderides. “The ability of transition managers to be able to handle lots of asset classes all at once is very important. Over the last few years there’s been a lot of net switching between equities and fixed income.”
The switch from equity to a multi-asset business has not always been easy, he says. “It has taken longer for the bond managers to play ball here because they work effectively in an over the counter market compared with equities and have not been as keen as equity managers about working with wish lists and transition managers.
“But what’s happened over the past three years is almost the mandatory appointment of transition managers by pension funds when they re-organise their assets. So bond managers have increasingly gotten involved, providing wish lists and accepting holdings.”
Multi-asset transitions may also require the use of derivatives. Simon Hutchinson, who is responsible for Northern Trust Global Investments (NTGI) transition management business across Europe, says being able to handle instruments such as exchange-traded derivatives during a transition is now part of the job. “ A good transition manager is someone who can utilise
all the tools that are out there. Clients may want to retain exposure throughout the whole transition. Using derivatives you can maintain market exposure while we get clients’ assets into their new structure as quickly as possible and manage them all the way through the process.
“You might use exchange traded derivatives to meet the client’s demand to maintain exposure through the transition. Or, if you are moving out of one asset class and into another, or from one benchmark into another, you might want to put on some derivative positions to manage that exposure. Then you can unwind those positions as you actually do the trade.”
One particular use of hedging in a transition is using currency forwards, he says. “If an asset manager on the new target side has been told to hedge all their currencies back to the client’s base currency, we, as a transition manager, can execute these trades for them at the time the assets are restructured.
“Otherwise what would happen is that we would do the transition, it would be unhedged and then the new manager would have to put the hedging on themselves. So obviously we can do that for them.”
Much of the work of transition manager is devoted to easing pension funds’ workload in this way. This in turn has raised pension funds acceptance of the need for transition managers. “Five years ago the people doing the transitions would have been the larger pension schemes and only the very big assignment would be transitioned,” says Hutchinson. “That has changed and clients are now hiring for smaller assignments.
“Pension funds have become aware of the difference between doing a transition with and without a transition manager. For example who is going to measure a fund’s performance between the time the old managers are fired and the new managers are hired? Who is going to identify opportunities for transferring assets between the old and new managers wherever possible? These are issues that pension funds have realised are big issues.”
Transition management, as a service, has also developed. Lachlan French, head of transition management at
State Street Bank Europe, identifies three areas where transition management has improved as a product over the past five years – cost, complexity and transparency.
“The cost of implementing transitions has fallen as we have applied more sophisticated risk management techniques to trading, thus reducing costs. Our internal liquidity pool has also grown as we have done more transitions. So in general the costs of transitions have come down,” he says.
“There is more demand for larger and complex transactions. Last year State Street did a deal involving £20bn of assets and 150 different accounts.
“There is also a drive to more concentrated, high alpha portfolios, which pose slightly different risk management and liquidity issues than the more balanced, lower tracking error type portfolios.” Transparency in client reporting has also become more important, he adds.
Investment consultants, particularly in the UK, have played a key role in introducing clients to transition managers and in raising awareness of transition issues,
John Conroy, a principal of PSolve, a UK based investment consultancy that is unusual in that it charges performance fees, says transition management is critical to its operations.
“When we take a decision to dismiss a manager and appoint another there’s always a movement of money going on. In terms of our proposition to clients that it will always be performance-related, net of fees, we can lose a lot of revenue if we transition money badly because that’s in the performance numbers.
“So there’s a huge incentive for us to know how to move money effectively. That means we must ensure that it works operationally and that it gets to B from A, but also in such a way that doesn’t involve paying lots of people to facilitate it.”
Successful transitioning also means ensuring that the benefits of the move justify the costs, he says. “We are constantly concerned with the trade off. Is it worth spending the money we’re spending moving money compared with the outcome that we’re looking for from the move? “
Moving money at your own pace is important, he says. Rushed transitions are usually costly. “Panic is the parent of cost. People who do things in this area regardless of market conditions simply to get from one position to another generally end up spending a whole bunch of money.”
The cost of not using a transition manager may be the most powerful argument in favour of employing one. One way of measuring the cost saving is to compare the trading costs that would be incurred with and without a transition manager.
Managers may charge only for trades they physically do in the market. Any other trades are therefore free. One such free trade is the in-kind transfer, when assets from the legacy portfolio are transferred in kind to the target portfolio.
Hutchinson of NTGI says the savings in trading costs from in-kind transfers can be significant. “We may find that with a transition of equities 15% to 30% of the assets can be moved from one portfolio to the other. So on those trades you don’t pay commission. And since you’re not trading in the market you will have reduced your market impact,” he says.
“If you didn’t have a transition manager you would have to pay someone
to sell all those assets and buy them again. So on that basis alone you’ve got a very clear measure of how much is being saved.”
Another free trade is internal crossing; that is, when the buy and sell lists of the legacy and target portfolios are crossed against assets in eligible pools of liquidity.
“If there’s an opportunity to cross with one of those funds, they’re free of commission. So again that’s money you’re not paying for trading in the market,” says Hutchinson.
The other key saving is in opportunity cost - the cost of being out of the market for the period of the transition. “If it is not using a transition manager, a pension fund will instruct its former managers to sell all their assets. That will take three days to settle. Somebody then has to reconcile them and then
all the cash is given to the new managers. So for five days the pension fund could be out of the market,” says Hutchinson.
The question of whether or not to use a transition manager has been largely answered, he says. Today it is rare for a transition of any size to be made without one. However the choice of transition manager remains.
The choice pension funds make depend to some extent on the business model they - and, more importantly, their consultants - prefer. Transition management has developed from a pure buy side operation, dominated by fund managers, to a mixture of buy side and sell side where there is a trading component.
This has created potential conflicts of interest, since the buying and selling activities of the transition manager’s trading desk could affect the price of the transitioned assets.
French at State Street says pension funds should look at three areas when choosing a transition manager – transparency, disclosure and alignment of interest. “With transition management, you are doing a one off major transaction very infrequently. So it’s got to be very clear to the client what the business model is – whether it’s a buy side firm or a sell side firm, whether it’s trading on an agency or principal basis, which tasks are performed internally and which re outsourced. All these areas should be disclosed to the client.
“Potential areas of conflict should be avoided at all costs. And the best way to manage conflicts of interest is not to have them in the first place.”
Minderides at JP Morgan says the combination of buy side and sell side experience benefits transition clients. “Obviously we’re a big trading house, but what that means for the client is that we can do the project management and the operational risk control as well as the trading and the seeking of liquidity, all of this in-house. The client has, in effect, got a one-stop shop where he knows no information is going to anybody else.”
Hutchinson of NTGI suggests that the fund manager provides the best business model. “We would say that when you’re hiring a transition manager, you’re hiring an interim fund manager, because you are asking them to manage those assets for the period in which they’re taking on those assets. So during that period we take on the responsibilities of a fund manager.”
The outcome of the transition, perhaps, is the best guide to which model to chose. One of the key issues of
transition management has been the measurement of its success – or failure. How can a pension fund be sure that
a transition has been managed
The answer depends on the measurement methodology managers use. Many managers use VWAP (Volume Weighted Average Price). Yet VWAP is not considered a complete measure. Although it measures a trade over a day it does not assess whether a transition has been a success overall. It is, in effect, a trading benchmark rather than a transition benchmark.
Implementation shortfall is seen as a broader and better measure since it compares what was supposed to happen on paper with what actually happened. This methodology has been encapsulated by the Russell’s T Standard, a template for calculating and presenting portfolio performance during a transition.
However, there is still disagreement about how this should be used. Minderides says, “Implementation shortfall is a very important measure. But transitions are essentially trading, and transaction cost analysis cannot be done with one benchmark. You need more than one to see whether a good job has been done.
“So while VWAP is not a measure of what the cost of the transition was it may be a reasonable measure of whether the implementation was done effectively.”
Minderides says a combination of implementation shortfall, VWAP and other benchmarks can provide a more accurate picture off the success of a transition. And as transitions grow in number complexity, such accuracy will become increasingly important.