The transition management business is hardly new, but the competitive pressures to stay ahead are becoming more intense and serving to differentiate many providers. A consistent squeeze on commission, decimalisation, and increasing fragmentation of the market liquidity (in the US) is making it “increasingly difficult for transition managers to compete profitably in a competitive landscape,” claims Ishan Manaktala, senior quantitative analyst and manager of Quantitative Services Group’s (QSG) transition analytics in Chicago.
“Changing pre- and post-trade benchmarks based on the actual performance, front running of a client trades, ‘zero’ commission trades are just some of the gimmicks that transition managers use,“ adds Mr Manaktala.
For those transition managers who “continue to reinvent with value propositions” such as quality pre- and post-trade analytics, sophisticated trading strategies and parceling techniques, and those that provide plan sponsors invaluable education on the true cost of a transition in the most lucid manner, will ultimately be “profitable and creditable in the long run”.
According to a QSG composite analysis of 21 billion orders and over $621bn (€520bn) in executed value conducted in 2005, the average liquidity charge of -17 basis points is “indicative of the persistence of price impact through a series of executions”.
The metric, which is especially beneficial for high velocity parceling strategies, is typical with transition trading and in executing less liquid stocks in substantial sizes. It not only increases liquidity charges but also increases the probability of adverse timing, says Mr Manaktala.
While the use of transition management services developed into something of a trend among pension funds in the early 1990s, resulting demand for such services fuelled growth in the number of new providers.
Today there are in the region of 20 providers of transition management services across four broad categories from ‘full service’ dedicated players with an ability to trade, clear and risk manage from legacy to target portfolios, and those who execute portfolio trades.
This number includes asset manager-type providers such as Merrill Lynch and State Street Global Advisors, custodian banks like the Bank of New York, as well as consultants such as Frank Russell.
High executioner
JPMorgan has successfully executed over 600 global transaction mandates worth over $100bn in traded assets. Under John Minderides, JPMorgan’s head of transition management, the bank provides a fully integrated global transition management service with professionals in London, New York, Sydney and Tokyo.
Last December, JPMorgan announced its largest transition brief to date in Europe – an €11.7bn mandate from the Dutch doctors’ pension fund. Two funds comprising predominantly government bonds were shifting from internal to external fund management – to be managed by 30 external managers. When fully complete, the restructuring was expected be one of the largest transition management transactions handled in Europe last year.
Jag Bains, head of transition management at Barclays Global Investors (BGI) in London, commenting in relation to the current clutch of service providers, says: “Whether they are all able to execute services to the same level is debatable. There has also been some margin compression in provider fees, which has probably been in the order of 10 to 15 per cent over the past two years. I would say, however, that the buyer needs to be aware.”
Tim Wilkinson, managing director, global head transition management at Citigroup Transaction Management (Citigroup), concurs that fees and margins have come under pressure and “are down”. But Citigroup has recently been able to successfully “expand margins a little based upon overall quality and comprehensiveness of service,” he reveals.
The TM team at Citigroup expects this trend to continue as more clients and their advisers broaden their knowledge and practical experience of transition management.
“Certain providers offer a partial transition service, which is priced accordingly, yet presented to look like something more substantive. While not all clients are driven purely by explicit costs, many are naturally drawn to certain low-cost proposals.” adds Mr Wilkinson.
“All too often, however, quality of service and transparency of total cost to the fund are compromised, and it is this that results in the fund incurring adverse transition performance impact,” he says.
Better choice is a by-product of additional providers, but can also result in greater confusion. The selection process of the transition manager therefore becomes critical, and clients and/or their advisers are encouraged by Mr Wilkinson to conduct an on-site evaluation of a potential transition manager.
Citigroup’s global head argues that in order to make a proper evaluation, areas such as the robustness of the operating platform and organisational structure; experience of project managers involved in portfolio risk; transition tools and systems (are they customised and fully integrated?); and, remuneration structures (how does the TM get paid and how much transparency is there?), should be examined.
Mr Bains contends that there is a “general recognition among the client base that that they are paying for a service and the price cannot necessarily go below a certain floor”, otherwise they risk receiving less than they think they have paid for.
Providing innovative and customised solutions to institutional investors certainly requires expertise, which makes selection of a suitable transition manager crucial. BGI has recently been seeing many more complex types of transitions – including liability-driven mandates, emerging markets in addition to building portfolios that have “higher tracking errors against the benchmark and those that contain more esoteric stocks”.
All this presents challenges with respect to sourcing liquidity. “The more sources the transition manager has to locate small caps or illiquid bonds, the better chance the manager has to produce a low-cost transition for the client,“
Mr Bains adds that in the UK equity market with the FTSE 100 and 250 (smaller companies) there is certainly a different liquidity profile.
“The top 20 to 30 names in the FTSE 100 are extremely liquid and bid/offer spreads are very tight – in the order of 5 basis points. In the mid FTSE 250 that starts to spread out to 25 basis points, and as you move into smaller companies you can be looking at anywhere between 70 and 100 basis points, ” he says.
Add to this that transition providers nowadays have more tools and technology at their disposal. Against a backdrop of greater liquidity in the global futures market, instruments such as single stock futures and exchange traded funds (ETFs) allow risk to be managed for emerging market-type pooled funds, which only open once or twice a month.
“Complexity has certainly increased, primarily as a result of the advent of absolute return asset managers within the typical fund’s line up of appointed managers,” says Mr Wilkinson.
“This renders the target portfolio – and sometimes also the legacy portfolio – much more illiquid than a traditional 3 per cent alpha-relative benchmarked portfolio. This in turn results in either an extensive – and largely undesirable – delay to the transition execution timeframe, or, it results in the increased use of synthetic solutions, deployed to replicate certain parts of the relevant portfolios, and handed over to the new manager in lieu of the exact model portfolio provided,” Mr Wilkinson adds.
But with the optimal solution being an increased use of derivative instruments, one needs an experienced transition management team with seamless and cost-effective access to the optimal synthetic solution.
An aggregation of historic studies on the area reveals that average transition costs have fallen from over 250 basis points in the 1980s to around 100 basis points through the 1990s – and as low as 45 basis points today, according to Citigroup’s Mr Wilkinson. Mr Bains at BGI says that “typical transitions” can cost between 20 to 30 basis points in terms of total costs borne by the client, based on a number of transactions that BGI has handled in the last few years. He acknowledges that a low volatility market environment has helped.
Transitional costs
Quantifiable and tangible costs incurred by a fund when changing managers were estimated at 2.7 per cent in a William Mercer survey (1996), while some have put the figure at near 5 per cent. An unmanaged transition between investment managers, could result in a client incurring costs up to 6 per cent in a few days, says Alex Johnstone, VP and European Product Manager at BNY Global Transition Management.
“However, the numbers will vary by type of asset transition, with single manager large-cap liquid transitions coming in typically well below 45 basis points, and multi-manager balanced mandate transitions or emerging market transitions potentially coming in somewhat higher,” adds Mr Wilkinson.
Citigroup believes that the “key is for the provider to deliver broadly in line with what it originally forecast [before transitioning], and to clearly explain the exogenous factors at work in circumstances where the result is above or below the forecast range.”
Transition costs are composed of direct (explicit) and indirect (implicit), the latter accounting for perhaps around 70 per cent of overall trading costs. Implicit costs are those lurking below the waterline and make up the bulk of costs – encompass market impact (where executing a certain size of trade can lead to a potentially detrimental drag on portfolio performance), and opportunity cost (delaying in execution) can swamp commissions and spreads.
Explicit costs are more easily discernible and therefore more measurable. Take for instance, commissions, taxes: a pension fund trustee can usually see immediately what these are from the contract note.
Minimising expenditure
Figures produced by Greenwich Associates and QSG (February 2005) based on the Russell 1000 large-cap universe indicate explicit costs at 14 basis points, while QSG’s analysis for Q1 2005 for implicit costs based on buy side institutional data put implicit costs at 64 basis points. Slicing or parceling the trade into the market can be a tactic to minimise such adverse situations, although there can be risk exposure and opportunity costs from not executing a trade sufficiently swiftly.
Mr Manaktala at QSG says: “A typical S&P 600 stock with over 200 fills [completed executions] is likely to have over 60 per cent probability of negative timing or opportunity cost.”
The size of transition management costs can certainly be affected by the asset classes involved in the transition management transaction. Mr Wilkinson notes: “Within fixed-income land, bid/offer spreads and liquidity are much better for government bonds than for these factors within the equity arena. For corporate bonds and other non-investment grade paper, however, bid/offer spreads and liquidty can be every bit and even more challenging from a cost-minimisation perspective than for equities.”
Hitting the optimal cost point entails finding a balance between executing too quickly, where the manager will incur high trading costs on the one hand, and executing too passively, where high opportunity costs may well be incurred. Transition managers invariably seek to lower costs by crossing transition portfolios with their wider liquidity pools.
Risk management is also a key cornerstone in transition management. Constant monitoring of potential market impact and opportunity costs, full service providers are able to effectively manage a transition and minimise what is referred to as ‘implementation shortfall’. This measures direct and indirect costs as it assumes an immediate and costless transition, but forces the transition manager to save all the costs and then justify costs incurred.
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