Once, pension plan sponsors and holders of assets who wanted to end a relationship with an underperforming asset manager or change an investment strategy had only to sell the relevant assets, deliver the cash to the new manager or managers and wait for the new securities to be purchased.
In effect, they handled such transitions themselves. But about two decades ago specialists known as transition managers quickly entered the game. Now they're back.
That's because the do-it-yourself approach worked just fine in a bull market when losses could be recouped quickly. It could still work when plan sponsors couldn't measure how much the change would cost and many transfers were simply from one manager to another, of fairly static sets of assets.
As plan sponsors began to change multiple fund managers and asset allocations simultaneously, however, transition managers began to quantify just how poorly a managed restructuring could lead to higher trading costs and lower performance.
Transition management experienced a slowdown in 2009 as pension funds reassessed their allocations and which managers to retain, dismiss or hire. But business is picking up this year as pension funds reassess the mixes of assets they hold, say transition managers. There are no standardized statistics.
Choosing the right transition manager is no easy task, however. Although many of the transition management specialists have signed the same T-Charter, an industry accepted document outlining the best practices, how they work transitions still differ. Their strategies and fees will depend on whether they are an agency or bulge-bracket broker-dealer, a pure asset manager, an asset manager affiliated with a custodian bank or even a consultant.
Asset managers insist they are favored by plan sponsors because they can take on a fiduciary role. "Plan sponsors are embracing the fiduciary model of doing business because it offers them a greater level of comfort they will receive the best advice on how to reduce the investment risk and costs of the transition," said Steve Kirschner, head of transition management for Russell Investments in Tacoma, Wash.
Taking on a fiduciary role means following either the Investment Company Act of 1940 or the Employee Retirement Income Security Act, which prevents Russell from favoring its own liquidity pools to maximize revenues. "Plan sponsors have to be comfortable that the broker-dealer doesn't have a proprietary trading desk which can make money off of the client's strategies," Kirschner said.
Custodian banks such as Northern Trust and State Street, which also manage index funds, can act as fiduciaries and move funds intended for index funds to their own. Broker-dealers, by contrast, typically match their clients' trades against orders on their books of business. These banks guarantee settlement, which will reduce operational risk involved when there are differences in settlement times between one type of asset class and another, such as bonds or stocks.
"If, for instance, assets are being moved from U.S. equities to U.S. mutual funds, there is a shift in the settlement cycle from three days to one day, and custodian banks will fund the money if the counterparty can't meet the settlement deadline," said Grant Johnsey, director of transition management for Northern Trust in Chicago.
But Kal Bassily, head of global transition management at ConvergEx Group in New York, points out that custodian banks now have dedicated teams to service transition managers. "The need for the plan sponsor to use the same custodian bank as its transition manager is now less than it once was,'' he said.
Moving money in transition into the index funds managed by the custodians results in no information leakage but can be risky during volatile periods. Also, such "indexers" typically delay trade executions, say brokerage firms.
As an agency-only firm, said Bassily, ConvergEx also doesn't take a position on any orders it handles. And as a broker-dealer it can more easily access multiple execution venues, including dark pools, more quickly and with far less information leakage than either an asset manager or custodian bank.
Plan sponsors now also want to understand what it is going to cost them and why.
"Transition management was once an operational challenge, but it has now become an exercise in cost and risk mitigation," said Northern Trust's Johnsey. "That means that plan sponsors are far more involved in the nitty-gritty strategy of just how the transition will take place, particularly if it involves the transition manager taking on the role of interim fund manager until a new one is appointed."
Sponsors are asking how long will it take to complete the transition, how derivatives will be used to reduce the risk involved with market downturns, currency and interest fluctuations and what risk metrics will be used. The longer the transition, the more likely the sponsor will also want daily or weekly risk and cost reports.
All transition managers use some form of "implementation shortfall" estimate, a calculation that compares the value that is retained in the target portfolio, when the transition is completed, to the value of the prior portfolio, before the transition began. But because there is some debate over which methodology is best, the plan sponsor needs to know which one was selected by the transition manager.
Plan sponsors are also beginning to engage measurement firms to validate the transition manager's reported performance. Inalytics reviews both the transition manager's pre-planned strategy and execution of that strategy and compares those results with what Inalytics calculates using the T-Charter's standards.
"A deviation [from expected results] may come from many factors including extreme market volatility, lack of hedging, and missed trading of equity, fixed income or foreign exchange," said Lisa Manuele, chief executive officer of Inalytics in North America.
Case in point: If the transition manager executes a foreign exchange transaction too late in either the business day or a day later it won't have sufficient local currency to settle a trade on time.
T-CHARTER FOR TRANSITION MANAGERS
The main principles of the voluntary code of conduct:
1. Disclose all sources of fees, such as commissions or mark-ups
2. Disclose potential conflicts of interest, such as pre-hedging
3. Use standardized method of measuring cost of transition (aka, the T-Standard)
SOURCE: MME Research