Times change

The role of the transition manager is diverse and ever changing – it has to be to match the increasingly complex world of investment. In recent months, market turmoil has thrown a spanner in the workings of financial markets, while the eruption of new investment vehicles – such as 130/30 funds and liability-driven investments – have altogether increased the complexity of investment strategies.

In light of these obstacles, has transition management become more difficult for schemes to implement? And what impact, if any, has the recent market volatility had on the process?

Complex dealings
The increasing complexity of contemporary investment strategies is actually something transition managers should relish rather than fear. Switching asset allocation or changing a fund manager can be a very convoluted process, in which case it is more likely that those with fiduciary responsibility will choose to appoint a transition manager.

BlackRock’s managing director of transition management Peter Walker believes that the current investment climate does make life more demanding for transition managers.

He says: “It does throw up some more challenges, because transition managers have to continually evolve and develop their techniques to deliver strategies to handle the more sophisticated implementations.”

However, this is by no means to the detriment of the transitional process.

Walker notes: “Certainly for a pension fund the increasing complexity means it needs more strategic advice and resources to help make the changes and right decisions, so I think it increases the opportunities for transition managers.”

State Street Global Markets’ managing director and head of portfolio solutions group Ed Pennings agrees that new strategies have made the transition management role more complex, but thinks it ultimately comes down to picking the right man for the right job.

Pennings says: “It is more complicated for the transition manager, but if the scheme hires the right manager in a fiduciary capacity it shouldn’t make a difference for the scheme. The outsourcing of the whole function, to take on the operational risk, and all the work that comes with it, is just a matter of picking the right transition manager who can handle all those complex strategies.”

Russell Implementation Services’ managing director David Rothenberg thinks schemes have upped the ante when it comes to what they expect from transition managers. However, if a transition manager is equipped to deal with the intricacies of the operation then they can add value to a scheme.

He says: “I do not think transition management has become more complicated for schemes but they have raised the bar for what they expect of their transition managers. You will find transition managers, who have built infrastructure and business models that can handle more complex assignments, are finding that they can provide more value back to schemes.”

Not only are transition managers required to handle the process of realigning assets based on the decision of those with fiduciary control, they are also expected to have a firm grasp on being a fund manager and be able to project manage as well.

Pennings elaborates: “You need to have trading skills to execute the orders, but you also need to have fund management and operational skills because, in essence, you become an interim fund manager. Combining these skills is what makes a successful transition manager and if you don’t have the skills, the operational risk becomes too big.”

Walker believes the way trustees approach appointing a transition manager has also adapted to suit investment strategy complexity.

He says: “In the past it was about just presenting a proposal for a transition manager to respond and quote on, now it is about clients discussing a range of alternatives with the transition manager before they elect their final strategy.

“Trustees need to take into account the cost of implementing those changes and the implications of the changes they are making.”

Balancing act
During the implementation process a trade-off often exists between trading quickly to minimise the risk of reduced exposure to a market and avoiding moving the market by buying too many stocks at one time. How do transition managers balance this trade-off?

The use of multifaceted optimisation tools aids the trade-off process, as Barclays Global Investors’ transition strategist David Edgar explains: “The optimisation tools help trade in a way so that the risk is reduced more quickly and is done in such a way that you are not impacting the market.”

One such tool, used by BGI, is a multi-period optimiser (MPO), which structures trade flow by ranking stocks in terms of their risk and liquidity. It also flags up anything risky and illiquid that needs to be eliminated quickly.

Similarly, as Rothenberg affirms, consultants such as Russell who offer transition management services also use optimisation tools to achieve this trade-off.

He says: “We have access to alternative trading systems, exchange traded systems, brokers and broker networks and with that we look at the liquidity of the market place and run a series of optimisations using both proprietary and third-party software and model what the expected costs and time plans would be.”

Edgar adds: “The market impact will be lower if you take longer to trade a security – by selling in smaller tranches – but if you take longer your risk level increases because you are exposing yourselves to risk for a longer period.

“We assess what the market impact is if you trade over different time periods and what would happen to the risk over that time period. We work out the combination that gives the lowest possible cost for optimum risk. Using tools like the multi-period optimiser we can achieve this in a quantitatively rigorous manner.”

Being able to access multiple sources of liquidity is also integral to effective transition management and something optimisation tools seek to find. Edgar explains it is important to have a reliable liquidity pool to tap into when markets kick up anomalies.

Edgar says: “Fundamentally, trading is about sourcing liquidity. The more places you can go to find that liquidity the less of an impact you are going to have on the market.”

Obviously, there are occasions when certain operational constraints impinge transition management processes. For starters, it can take several months for everything to be agreed and a transition manager’s job does not really begin until the decision has been made by whoever shoulders the fiduciary responsibility. Even then, signing the job over to the manager can take time.

A consequence stemming from this interim period is a fund being “out of market”, which, in simple terms, refers to the interlude between buying and selling when a fund is not invested in assets and exposed to changes in the markets (the time gap between buying in Japan and selling in Europe, for example).

If a drastic event occurred during this time causing the market to plunge and Japan to open up then that would spell trouble because of the out of market exposure. In this situation, a fund is often sitting on cash.

Edgar explains: “If you do not have a transition manager you may sell shares from manager A and buy shares from manager B. This process might result in a couple of days delay for the assets to settle, the cash to be transferred and target securities to be purchased.

“This situation can result in out of market exposure as, during those two days, the assets of B might become more expensive while you are in cash.”

“What a transition manager is looking to do is minimise time out of market and cover that market exposure using derivatives such as futures.”

Pennings adds: “What you never want to do is sell a legacy portfolio first, sit in cash and then buy the target portfolio.

Normally a risk framework is put together in the planning stage aiming to always be cash neutral – i.e. matching buys and sells so if there are market moves you are not exposed to being out of the market.”

Pennings also believes a way of avoiding being out of market too long is to reduce risk and exposure using futures.
He continues: “Out of market is something you can avoid, for example, through the use of a futures overlay to get the market exposure.

“It is not always ideal exposure because there is often a tracking error between a future and an underlying portfolio, unless you have a portfolio that a future is based on like an S&P500, for example.”

Furthermore, Pennings suggests: “Using currency hedges is a very cheap way of hedging the risk, say, for example, if you move from a US portfolio to a European portfolio there is a currency implication you can hedge out very quickly and that is how we deal with out of market risk.”

Managing volatility
Did the recent market volatility have an impact on transitional activity?

In terms of volume of transitional activity it would seem not but the volatility did target certain asset classes – namely fixed income bonds – which lead to a drying up of liquidity.

This effect has particularly taken hold in bonds, as Edgar observes.

He says: “In the last two months, particularly in the credit markets, we have seen liquidity dry up considerably. In these sorts of market conditions having access to a wide variety of liquidity sources is more important than ever.”

Pennings agrees, but says at the height of the credit crunch he did witness a cautious approach to some transitions, with particularly the complex ones being delayed.

A common stance by certain clients has been to sit back and observe what is happening over the coming weeks before committing to heavily-involved transactions.

Pennings adds: “The biggest issue was the drying up of liquidity in certain fixed income instruments. The additional difficulty was to ensure getting the pricing right, so I think it was prudent for some transitions to be postponed until there was a bit of rest in the market again.”

Walker also thinks volatility has caused some managers to air caution: “Over the last two months we have been in discussion with lots of clients about alternative strategies or whether they should even do their transition in the current market environment. It is very important for clients to engage with their transition manager and for the transition manager to share with the client the benefit of their experience and analysis.

“In the last two months equities have been more expensive to deal because they are more volatile, bonds are notionally more expensive to deal but practically very difficult to deal because there hasn’t been much liquidity in the credit markets in the last two months.”

Sometimes, however, the unpredictability of markets leads to events that cannot be pre-empted by transition managers, no matter how many tools or strategies are used.

A bold transition decision can pay off generously, as was the case when Boots’ pension scheme moved £2.3bn assets from 75pc equities to 100pc bonds at the turn of the millennium.

Edgar recalls: “Historically there have been instances when people have taken very bold approaches.

“For example, the Boots pension scheme when they switched all their equities to bonds and got their timing completely right – after that switch the equity market plummeted. Given the long-term nature of pension schemes, that kind of a decision is likely to have a major impact on the scheme over the next 50 years.”

T-Day
With the T-Charter looming on the horizon, the future of how transition management is implemented looks set to change. Having been toiled over for several years, it now seems the industry-approved code of best practice could be just round the corner – perhaps even signed off in the next few weeks.

Walker explains the need for such a code.

He says: “One of the unusual aspects of transition management is that you have asset managers, broker dealers, custodians and consultants all offering the service so it is very difficult for clients to make a comparison across that spectrum.”

“The T-Charter is a code of best practice to help clients better understand the process and educate them to inform their decisions. It is 100pc for the client.”

After such a long wait, however, will it be well received by an industry that is all for adhering to governance and best practice?

The answer is a resounding “yes” but the fact it will have no legislative power makes it potentially difficult to keep in check.
Pennings, for one, does not want to see a code that everyone acknowledges is present but not everyone adheres to.

He says: “We would like to see a T-Charter with teeth in it that actually holds organisations accountable and is enforceable. We strongly support the principles behind the T-Charter and are actively working to ensure the charter meets these principles. Our focus remains to ensure that it achieves the highest possible standards, not the lowest common denominator.”

Russell has been involved in the process since the very beginning and Rothenberg believes that time will tell if the T-Charter is a successful addition.

He says: “We are going to have to wait and see whether the hopes of a voluntary code of conduct deliver upon the hopes
and expectations that have been laid out to people.”