FT Mandate: The trend among institutional investors towards hiring transition managers has grown considerably over the last few years. What are the reasons behind this growth?
Mellon Transition Management Services: Total returns are a function of investment returns minus implementation costs. In the recent low return environment, more and more institutional investors recognise that whilst they can’t control returns, they can control costs through an efficient implementation process. Alpha is hard to harvest and institutional investors may risk a year’s worth of excess returns in a few days if a transition is managed poorly. In addition to the cost savings, a transition manager aims to reduce the operational hurdles that pension schemes encounter during a transition. In our experience, once a client has used us they tend to engage us again for future transitions.
FTM: What types of events are driving this increased demand?
MTMS: The simplest and most common transitions are shifts in asset portfolios stemming from changes in investment managers. These changes are driven by performance considerations and, more recently, changes in the asset allocation to more effectively match liabilities. These new asset allocations can be much more complex effectively increasing the cost and risk of the transition. In general, the more complex the transition, the more value transition managers can create for the client.
FTM: The ultimate goal of transition management is to reduce costs and minimise risks for clients. What are the main challenges in trying to achieve this?
MTMS: The business of transition management is much more than a simple execution of trading lists, with the two main challenges relating to portfolio performance and project performance.
 Wim de Ruijter, MTMS | Portfolio performance poses a challenge because the markets are dynamic and have limited liquidity. The market risk in the transition is not static but continuously changing. We design a trading strategy that systematically reduces the risk in the transition, which along with the residual risk, is continuously monitored throughout the transition. By adopting this approach a change in the risk can be quickly accommodated by a change in execution strategy. |
The project performance of a transition requires impeccable organisation from the transition manager along with a clear project plan and all-inclusive communication matrices. We see it as our responsibility to remove the majority of the operational burden from the client. In the event something goes wrong, the transition manager should assume responsibility and communicate and execute the appropriate solution.
FTM: Fixed income transitions present unique challenges for managers. What are those and how do they differ from equity transitions?
MTMS: Transition management focuses on making shifts in asset portfolios as efficiently as possible. Transactional efficiencies are clearly not the hallmark of fixed income instruments. For this reason, many schemes and consultancies conclude that there is little room for a transition manager to play when bonds are involved. Naturally, we do not necessarily share that view.
In terms of general differences between debt and equity transitions, the number of fixed income securities is far larger than equity securities. In addition, there are important distinctions in how these securities are traded. Equities tend to be exchange-traded instruments with negotiated commissions and a high degree of price transparency. Bonds, on the other hand, are more likely to trade over-the-counter in a spread-driven market with limited (but improving) price transparency.
Due to the size and fragmented nature of the bond universe bond investors face challenges that their equity counterparts are not likely to encounter. In part, fixed income portfolio managers will build portfolios based on specific investment characteristics rather than specific names in mind.
With a vast universe of securities available, a bond manager will typically be more interested in a general class of credit, sector, or maturity rather than the relative investment meriting one specific holding. This flexibility enables the bond manager to consider a wide range of bonds, which he or she might be willing to accept as substitute holdings in the event that a given bond is not available due to poor liquidity. This presents obvious potential problems for the transition manager who, when purchasing a list on behalf of a newly hired target manager, must go back and forth between the kitchen and the table with an ever-changing menu. In many instances a transition manager may resort to handling a risk-controlled liquidation of a legacy list with cash proceeds deliverable to the target bond manager. In such a situation the transition manager may recommend constructing a duration hedge to cover exposures between trade date and ultimate re-investment date with the new manager.
The use of crossing networks to complete fixed income transitions is not widespread, unlike in equity transitions. In many cases, bond prices aren’t quoted often enough to obtain a neutral crossing price. In addition, transition related crossing can be a numbers game. A transition manager is much more likely to find a match on one of the stocks in the MSCI World than one of the 7,000+ bonds in the Lehman Aggregate.
With all the differences aside, investors should note that transitions driven by asset allocation changes expose assets to risks across asset classes. A centralised intermediary like a transition manager is much better positioned to address aggregate risks than multiple managers operating independently of one another.
Undeniably, transition managers must recognise certain structural limitations when it comes to asset shifts involving fixed income. Nevertheless, it is the very lack of price transparency inherent in the bond market which can make it so critical to have a specialist on hand who will act as a fiduciary during any restructuring.
FTM: The use of crossing networks to complete equity transitions is widespread. What are the differences between external and internal crossing networks and what are their benefits?
MTMS: Some transition managers, like us, can source liquidity through both internal crossing and external crossing. Our internal crosses are performed using a proprietary crossing system. The internal cross takes advantage of the trading flow generated by Mellon’s assets under management that are eligible to participate in such crossing opportunities. External crosses utilise networks such as ITG’s POSIT® which electronically and anonymously match institutional buyers and sellers.
Although crossing offers several advantages in transition management, it also holds many risks if used improperly. The most prominent disadvantage of crossing is the low percentage of orders submitted that are actually filled. Most industry fill rate estimates are between 10 and 20 per cent. Thus, approximately 80 per cent of all orders submitted for crossing cannot be matched with a counter-party trade and must be taken to a primary exchange. Missed orders can translate into opportunity costs. While an order is waiting to be filled on a crossing network, the market price of the security is moving up or down. Opportunity cost is the difference between the price that an institutional investor would have received if he had taken the order directly to the market and the price he received after being delayed by an unfilled crossing order. If a transition manager is obliged to wait for an extended period of time for crossing opportunities, an unnecessary risk is placed on the institutional investor in exchange for providing liquidity to an external party.
Potential for information leakage is another crossing risk that needs to be addressed when selecting a transition manager. Crossing network participants with unfilled orders can assume that the order will be soon taken to an exchange. For example, a third-party that sees a large buy order for a stock go unfilled on an external crossing network could purchase that stock and wait for the unfilled portion of that crossing order to be taken to an exchange. An institutional investor with large crossing orders can be forced to pay a higher price or sell at a lower price than necessary because other parties anticipating the institutional investor’s order can drive prices up or down countering the institutional investor’s interests.
Another problem associated with crossing relates to the risk control process. In general, it is the most liquid stocks that will cross but some of these stocks may have attractive risk reduction characteristics. If this is the case, maximising crossing can lead to high residual portfolio risk and higher opportunity costs. This is one of the reasons why there is a low correlation between high crossing rates and low implementation shortfall.
We see crossing as a primary source of liquidity but use it carefully as part of the risk management process.
FTM: What are the main criteria institutional investors need to take into account when choosing a transition manager?
MTMS: Due to the complex nature of transitions, there is no simple analytical way to evaluate transition management companies. Typically, transition managers will estimate the cost of the event prior to a transition. However, these estimates are only as good as the market impact and risk models being used and crucially, the estimates of the input variables such as volatility.
We advise clients to temper the quantitative inputs with the qualitative aspects of the analysis. While preservation of asset value is critical during the transition, it is sometimes the intangible elements that make or break the success of the transition. If a transition manager does not or cannot handle and coordinate all of the operational, custody, portfolio management, trading, and trade settlement issues, the client faces undue risk and unnecessary expense.
Another fundamental consideration relates to fiduciary responsibility. As transitions mark a period when assets are in flux, it is critical to ensure that a specialist takes responsibility for ensuring that all the eggs are transported securely from one basket to another. Hiring a transition manager with fiduciary oversight can help protect the investor as they migrate from asset set A to asset set B. The investor however, should be aware that not all transition managers meet these criteria. When acting as a fiduciary, there is a checklist of the things that the transition manager should do (like be in a position to support proxy voting and corporate action resolution) and things they should not do, such as pre-hedging.
Evaluating a transition manager is complex; a number of fundamental questions should be asked:
- Do they have a dedicated transition team or will they be using the resources of multiple departments to execute the transition?
- Do they have specialist settlement and risk systems built specifically for transitions?
- What is the business model of the transition manager? Do they charge a fee or do they profit in some other way from the transition?
- What is their track record with your type of institution?
- Do they possess real market risk management knowledge and experience and the tools to use this expertise during the transition?
- Does the transition manager have the capacity to undertake your transition and will your transition be given the focus required?
IN ASSOCIATION WITH
Mellon Transition Management Services
Mellon Transition Management Services has a strong track record, having completed more than $50bn in transition assignments since its inception in September 2001. It provides premier global transition management services to institutional clients, focusing on reducing transition costs by minimising market impact and maximising market liquidity in a risk-controlled environment. Supported by state-of-the-art trading and analytic systems, a dedicated portfolio management team oversees the transition process from pre-trade planning to post-trade analysis..
