Transition. Management

Transcription

1 R o u n d ta b l e Sponsored by I nstitutions primarily use transition managers to minimize costs and risks when changing investment managers. And in 2009, transition activity is on the rise. After being beat up by the markets last year, people saw the failings in their current managers. Many are revising the risk profiles of their funds and going into various types of bonds. I think transition managers are going to be busy in the next while based on what I see coming to our shop, says Robert Bevan, Senior Consultant, Toronto Asset Consulting Service Group, Towers Perrin. Robert Bevan was the moderator for a roundtable discussion held on October 1, 2009, at the Benefits Canada Toronto offices. Participants included Eric Bolduc, Head of Transition Services, Brockhouse Cooper; Mario Choueiri, CFA, Transition Project Manager, Brockhouse Cooper; Troy Rucker, Chief Operating Officer for Implementation Services, Russell Investments; Travis Bagley, CFA, Head of Fixed Income Transitions, Russell Investments and Paul Sachs, Principal and Transition Specialist, Mercer Sentinel Group. Many people aren t quite sure what transition managers do, how they work or how they make money. The participants reflected on how the industry has evolved, how it s structured and what the expanded role of transition managers is today. They also discussed current issues affecting the industry such as transparency, responsibility and fiduciary capacity.

2 Company profiles For more than 25 years, Russell Investments has helped clients manage risk and investment performance when restructuring their portfolios or asset classes. Their in-house capabilities include specialist equity, fixed income, currency management and futures teams. Brockhouse Cooper has been assisting institutional clients to implement portfolio changes for more than 25 years and has provided comprehensive transition management services since Their transition management experience covers the spectrum of institutional investment mandates and projects range from fund liquidations to complete plan restructurings. Roundtable participants Robert Bevan Senior Consultant, Toronto Asset Consulting Service Group, Towers Perrin Troy Rucker Chief Operating Officer for Implementation Services, Russell Investments Travis Bagley, CFA Head of Fixed Income Transitions, Russell Investments Mario Choueiri, CFA Transition Project Manager, Brockhouse Cooper Eric Bolduc Head of Transition Services, Brockhouse Cooper Paul Sachs Principal and Transition Specialist, Mercer Sentinel Group

3 How did the transition management industry develop? Troy Rucker: Years ago, when plan sponsors wanted to make a manager change, it was an operational or administrative exercise. Often it entailed the old manager liquidating the assets to cash, then the sponsor or custodian transferring the cash to a new manager who would purchase the new portfolio. With unintended cash exposure to the portfolio, large performance deviations sometimes occurred. For example, a portfolio worth $100 million at the onset, and handled as outlined above, could be worth $98 million when the performance clock started for the new manager. If the markets were relatively flat, clients wondered where the multiple percentage points of value went unintended portfolio exposures, unnecessary transaction costs? That s been the key issue that we ve seen drive the industry: clients want to minimize performance deviations versus benchmark, while fulfilling proper due diligence and fiduciary duties. Transition management has morphed from an administrative function to a valuable investment management exercise. Mario Choueiri: It is important to note that the performance gap was not just from commissions or transition revenue. It arose mostly from the opportunity costs. Given the past tendency to liquidate to cash and then hand over the cash to the new manager, the assets suffered from a lack of market exposure and consequently experienced severe cash drag. Furthermore, there was essentially a dead zone where neither the legacy manager nor the target manager was held accountable for this performance gap. Transition management addressed the need for someone to manage the process, minimize costs and risks and provide accountability for the overall process. What are the benefits of hiring a transition manager? Mario Choueiri: Plan sponsors use transition managers for cost and risk management as well as project management and single-party accountability. 3 Eric Bolduc: The value of a transition manager increases with the complexity of the transition. For example, if you re going from a liquid US$50 million largecap portfolio to another US$50 million large-cap portfolio, the transitions can be executed in very little time without great risks. There are greater risks with complex transitions involving multiple asset classes, multiple portfolios or many counterparties. That s where the experience of transition managers and the project management skills really come into effect. Robert Bevan What are the various business models of transition managers? Travis Bagley: There are three primary models in transition management. One is the broker/dealer model, which many investment banks use. The second is the custodial model, which is highly focused on crossing, or internalizing order flow, and is primarily set up for index-type products. The third is an investment advisor model. How are fees charged within the various business models? How does your firm charge clients? Travis Bagley: The most common way is through explicit agency brokerage fees, which we do for most of our clients. We also offer flat fees, investment management fees. What s important is that these fees are entirely transparent to the client. There are no additional costs or revenue streams coming from areas that the client is unaware of. And that s extremely important in the business we re in because there are opportunities to generate revenue and severely disadvantage a client portfolio in non-transparent ways. Eric Bolduc: Brockhouse Cooper acts on an agency basis on all asset classes, generating commissions on trades executed in the marketplace. We charge a transparent agency rate that s fully disclosed ahead of time in our pre-transition estimate. What are the various costs invoked during a transition? Paul Sachs: The first costs are explicit costs such as commissions and taxes. The second are implicit costs, which include factors such as bid-ask spreads, market impact and currency spreads. The third is opportunity costs how the markets move for or against you. Impact is a cost created by your traders actions, but stocks or bonds can move against you while you re in the middle of a transition: these opportunity costs are the largest potential source of risk to clients. If someone is trying to find a transition manager, they want someone with a very clear, transparent model. What do they want to avoid? Eric Bolduc: There s a principal-based model. You can go for a risk bid to various large global brokers who price your transaction and make a bid. This is less common today, but there are principal elements of the industry that are not as well disclosed as one would think. Equities are becoming more transparent than ever, but asset classes like fixed income and foreign exchange have grey areas of making money. When we present pretransition cost analysis to our clients, it s often apples and oranges against estimates from other providers. We want our clients to be aware that they re getting an agency bid, not a mixed bid with some elements that are on an agency basis and others on a principal basis. Mario Choueiri: I ll give you a recent example we had for a pre-trade analysis. The client was comparing two bids and asked why the two bids were so different. We

4 Events that lead to hiring a transition manager Most commonly, plan sponsors hire a transition management team when they are unhappy with their investment manager s performance. Today, investment committees are more intolerant of underperforming managers. In the past, they would have waited for the selection process to be completed, says Choueiri. Now, more investment committees are forcing administrators and plan sponsors to fire a manager immediately, creating a need for a temporary manager. Temporary asset management is something more plan sponsors are starting to look at, says Bolduc. We have a manager search business at our firm, but often clients want to fire a manager and don t have the replacement yet. Clients use our services to help smooth that passage to a new manager. It s a great solution, especially when the client feels that the risk of remaining with their current manager justifies an immediate remedy. Plan sponsors also turn to transition managers when there is an asset allocation shift, or a restructuring or rebalancing of the fund due to changes in the benchmarks. Occasionally, changes to the personnel on the investment management team trigger a desire for sponsors to change the manager. Finally, transition managers do liquidations for clients when a plan needs cash or they wrap up plans. wanted to break down the bids and compare them, but were having a hard time given that the other provider was not disclosing their foreign exchange fee/commission. The other provider simply told the client that they would handle the foreign exchange transactions. We believe that plan sponsors are entitled to know what their transition provider is making and what it s costing the plan to do foreign exchange transactions. This lack of transparency is a very important issue in the industry right now. The different models and lack of disclosure are causing difficulty for plan sponsors when comparing pre-trade estimates and even post-trade analysis from different providers. Brockhouse & Cooper, you trade bonds on an agency basis. Those are usually principal transactions. How do you deal with those on an agency basis? Eric Bolduc: From a risk management perspective, it s similar to equities in that we look at the portfolio and isolate the risks. Risk in domestic fixed income mandates is primarily derived from duration, credit quality and liquidity of issues. In executing the trades, we work with multiple dealers. Our goal is to minimize the bidask spreads on the fixed income securities we trade. A transition manager s goal should be to manage portfolio risk while canvassing the market for the best price. If you give a list of specific bonds to one dealer, you won t pay commissions, but the cost will be embedded in the price of the securities. What is the industry doing to address the issue of transparency? Mario Choueiri: IIROC, the regulatory body in Canada, has targeted fixed income transactions as being problematic and has put out proposals to enhance transparency and fair pricing because some clients, more particularly retail ones, were at a disadvantage in that they didn t have access to different quotes for bonds. Whenever these clients used a dealer to execute a trade they had no idea what the spreads were and were subject to possible abuse. Transition Travis Bagley Travis Bagley: On the fixed income side, in comparison to where it was 10 years ago, the industry has made some strides towards transparency. The electronic platforms that are now available allow managers to get a real-time market on a screen for liquid Canadian bonds and other global bonds. You can see realtime quotes from multiple dealers at one time to find the best market. Although it still lags behind the equity market, the industry is making strides towards more electronic trading and transparency. And more electronic trading is beneficial for clients because it will squeeze bid-ask spreads and lower costs. We ve identified a few issues principal bids and transparency that plan sponsors should be aware of. Are there any other areas of concern? Travis Bagley: In any transition there is tremendous potential value in the information of the lists of securities to be traded. It s part of the transition manager s job to protect the client and minimize information leakage. Information players in the market will pay to get that information. When you consider some of the crossing behaviour that happens, you can see why transition lists would be very valuable in terms of soliciting more order flow into particular shops. Take for example a large transition of small-cap equities; the information on what will be traded is extremely valuable due to the trading impact and the ability to move prices and sway markets. 4

5 Information players can take advantage of this information, which is detrimental to the plan doing the transition. Troy Rucker: Any information leakage that could potentially cause an impact on the client s assets is a very serious issue. When you look at those various business models of an agency firm, of an advisory model think about how the investment advisory industry works. That provider is responsible for the performance of those assets, so they re going to do everything in their power to make sure information leakage does not happen, to make sure they re tapping all sources of liquidity in the marketplace, to make sure they maintain proper portfolio structure. It s our duty to make sure we insulate our clients from any adverse effects of information leakage. 5 How do you protect a client s portfolio information during the pre-trade estimate process? Eric Bolduc: Money used to be made for some broker/dealers when they would shop lists ahead of time. Firms have been cited for pre-hedging, effectively shopping out a list ahead of time to various counterparties. Brockhouse Cooper has never participated in any of that kind of activity and this is supported by our very clean track record with regulators. As a firm policy, we do not disclose any order information to counterparties. We ve built strong relationships with plan sponsors in Canada by acting with integrity and protecting their portfolio information. Paul Sachs: We mask the portfolio information so that the client s actual confidential information is not released to any party. We replace 40% of the value of the portfolio by using trading analytic software to ensure that the masked portfolio has the same trading characteristics as the client s actual portfolio. We use the masked portfolio in our cost and risk discovery process because it gives specific information to the transition managers. If you go to a transition manager and say, Assume these characteristics, everyone will interpret assumptions differently. When you get four pre-trade estimates back, you won t be able to make a valid comparison. With the masked portfolio, we re not trying to predict the cost of the actual transition, we re trying to use a common yardstick to compare the providers. What are some of the challenges that you encounter with the pretrade estimate process? Troy Rucker: We ve seen the comparison of pre-trade estimates be an extremely difficult and sometimes misleading exercise. When you look at the trend of commissions over the last decade, before more transparency was created in the transition management industry, most providers would just compete on price. It was often a commission race until a peak, years ago, where some providers would quote at or near zero commissions. I think that was a bit of a reality check for pension plans to realize that nothing in life is free, that you re buying investment management services and there s a fee associated with that. I think that s provided a bit more balance to the commission structure, but the transition industry still has far to go in terms of increasing transparency for clients. Paul Sachs: As recently as 2007, I evaluated a transition management contract that essentially asserted that the transition would be done at no cost to the client with no market impact. It was designed to do a principal transaction for the entire transition. That s the big difference between agency trading and principal trading. Agency trading is disclosed you re selling to a third party, your broker is acting as an agent and getting a disclosed commission. In a principal transaction, the transition manager is acting as a counterparty, a dealer; they re committing their own capital and there s no transparency around price. Because of the lack of transparency, there is no way to know how much they would make on the transition. Both Russell and Brockhouse are in an environment where people will try to evaluate them based on commissions. The interesting thing is that explicit commissions are generally about 25% of total transition cost, in the range of 20% to 35% for the average transition. Commissions are the tail. Impact, spreads and opportunity cost are really the dog, the big issues. Eric Bolduc: Commissions are not the only issue. Calculating the estimated market impact, opportunity costs and even bidask spreads can be done differently by different providers. Often times, a low pretransition estimate will win the business incentivizing providers to produce low and unrealistic estimates. Clients would sometimes come to us and say they ve got this really great deal on the implementation shortfall estimate from another provider, much lower than ours. These same clients have frequently come back to us after they ve received their post-transition analysis and said, You know what? Your pre-transition estimate was a lot closer to what actually happened. Eric Bolduc Market impact is going to be what it s going to be regardless of who has estimated it and what methodology they ve used, so how does it help distinguish a firm? Paul Sachs: We don t agree with the premise. The impact a firm estimates is a function of their strategy and trading capabilities. Firm X might do all open market trading. Firm Y might do 20% internal crossing, 30% external crossing but only 50% in the open market. The general assumption is that open market trading is the most expensive way to trade. So the reasonable question to ask as you evaluate

6 a proposal is whether the assumptions of 20% internal crossing and 30% external crossing are reasonable expectations for that firm or are they vastly over-inflating their ability to get it done in that fashion. Transition managers are also differentiated by their ability to control risk during the transition. If you don t control your exposures during the transition, then opportunity costs, which are potentially the largest factor, can have really serious negative effects. How did the financial crisis affect the business of transition management? Travis Bagley: We saw a number of transition managers exit the industry because it wasn t core to their business. We saw a contraction in 2008 and we ve seen consolidation, mostly in the investment banks. We re starting to see some of those players re-emerge, starting up shop again within other investment banks. Troy Rucker I ve heard it said like this: Before the financial crisis, there was an original set of providers long ago that were in the transition management business. The financial crisis came and the original set are still here, while the others came and went. If you re going to start a relationship with a transition manager, you want a transition manager who s been around, who has the experience and the capabilities, but also one who s going to be around in the future so you don t have to go through the process of renegotiating your panel of transition managers with every downturn in the market. Mario Choueiri: The financial crisis brought a new twist in terms of considerations for plan sponsors. For lack of a better term, let s call it transition manager counterparty risk. Given the slew of departures, voluntary and involuntary, of providers in the transition management business, plan sponsors now have to consider long-term viability and commitment of its providers. Let s suppose, for instance, someone had a stable of five transition providers before the crisis. After the crisis, that stable may have been depleted to one provider, thereby forcing the plan sponsor, through no fault of their own, to go through a whole new selection process. Or what happens to the plan sponsor who was using Lehman Brothers the day it declared bankruptcy? Plan sponsors now have to think about this counterparty risk when choosing a transition management provider. One of the largest factors in determining the cost of a transaction is the extent to which you put stocks into the open market as opposed to crossing them. How important are internal crosses? Eric Bolduc: In theory, crossing should lower the market impact of trading. Therefore, randomly crossing assets into a portfolio may seem tempting; however, it can significantly increase risk. Assets that are readily available for crossing tend to be the most liquid, which in themselves tend to be the assets in a transition that increase correlation between the legacy and target. Therefore, crossing should only be done when it reduces the risk to the client. Troy Rucker: Russell doesn t internalize order flow, or internally cross ; rather, any cross executed is done at an independently determined market price and is clearly auditable. While there are potential benefits to the reduced transaction costs that Eric mentioned, we feel there s also some inherent conflict in the challenge of maximizing crossing versus maintaining proper portfolio structure. When a provider has the ability to cross internally, they re a bit at odds. Should they try to maximize that internal order flow, which may provide benefit to their firm? Is that in the best interest of the client? Finally, how are these conflicts managed if the provider has this type of capability? Paul Sachs: Both Russell and Brockhouse have just put forth client-oriented methods of managing internal crosses, which are unconflicted. Both are trying to do the best for the client and they both importantly pointed out that crossing without risk management is very dangerous in that there is a risk of adverse selection, where you actually inject risk into the transition. How do you manage external crosses? Eric Bolduc: We have an extensive list of institutional clients that have trading flow that we cross against. It s important to assess whether crossing adds value to the process. Is it reducing the tracking error to the target portfolio? Often we see potential crossing opportunities, but because of the nature of the trade, we ll pass on it if it s going to throw off the sectors or country exposure. Traditionally, we ve found crossing to be very helpful in the Canadian small-cap space, which can be very illiquid. Illiquid trades that are crossed add value by eliminating the potential market impact. Troy Rucker: We ve built and invested heavily in a global multi-venue execution platform so we can tap any and all liquidity pools in the market including various crossing networks that are external and have independent market pricing and transparency. How do you assess the risk/reward and costs associated with the various crossing strategies? Eric Bolduc: Crossing has to be a balance between managing the benefit of reducing your market impact costs and balancing your opportunity cost risk. For example, if you had the chance to cross your entire legacy portfolio to cash, reducing market impact costs, but could not hedge the cash to the target managers portfolio characteristics, then you re leaving yourself open to opportunity cost risk, which can be substantial. 6

7 What type of derivatives do you commonly use and for what purposes? Travis Bagley: Most of the derivatives we use are futures and currency forward contracts. Because of the typical timelines for transitions, exchange-traded futures are generally easier for clients to set up and implement than swaps. Currency forward contracts are highly liquid currency management tools. Managing currency risk using currency forwards during a transition helps clients minimize opportunity costs when moving assets between geographies. of reducing market impact. Today, there are various dark pool models, including some models that have principal trading participants. In addition, certain dark pools send Indications of Interest (IOI) to seek out liquidity. As a result, there can be trade-offs between finding liquidity and information leakage. In Canada, there are two dark pools: MATCH Now (buy-side and sell-side) and Liquidnet (buy-side). Mario Choueiri Travis Bagley: The traders on our desks focus a lot on these pools, analyzing them, understanding them not only how they work, but which types of trades work best in the different execution venues. Because of how much we trade in a short time, our trading desks have to be experts in these liquidity pools. The increased use of dark pools, particularly in Canada, has changed the market dramatically over the last five years. With dark pools for Canadian equities, we ve seen smaller trades size and increased execution frequency trading, and therefore less trading on the exchange. What risks in particular do you manage with futures? Eric Bolduc: The goal of futures and forward contracts is to minimize your tracking error in the target portfolio. Travis Bagley: Generally, futures allow us to manage beta exposures that may be missing in a legacy portfolio. For instance, if I have a pooled fund with a settlement cycle on the sell side that doesn t match up with the buy side, I may use futures to maintain exposure to the market while I m waiting for cash to be delivered. We often use derivatives for this purpose. Troy Rucker: Large asset allocation shifts whether going from equity to fixed income, or within equity space for example, going from large-cap to smallcap may come with high trading costs. But because of the liquidity of futures contracts, you could typically make that asset allocation shift rather quickly at the onset, then more patiently work through the rest of the transition. That s part of the cost benefit analysis we perform. Some clients have a very tight transition timeline and derivatives may help us to adjust the asset allocation or portfolio structure quickly and reduce the overall performance cost of the event. What is a dark pool of liquidity? Eric Bolduc: The traditional dark pool is an anonymous crossing network that can be accessed by buy-side and sellside participants. Trades in traditional dark pools are often executed at half the bid-ask spread, so it s an attractive way How are dark pools used in transition management? Eric Bolduc: In transition management, part of our execution strategy will be to source dark pools for hidden liquidity in order to reduce the market impact on orders. In addition, orders with potential higher market impact can be placed passively into a dark pool to increase the likelihood of finding a cross. Attributes of a good transition manager What precautions must be taken when using dark pools? Eric Bolduc: Using dark pools does not guarantee that orders will be executed. As a result, if a trader misuses these tools, this can leave unexecuted orders at risk of adverse price movements. With research, experience and advanced trading tools, transition managers know where to route orders, how long to leave them in dark pools and when it s time to adjust the trading strategy. If you put a trade into a dark pool and it doesn t get executed, the price changes, the markets can move against you. With research and experience, you ll know where to route orders, how long to leave them in a dark pool and when it s time to change your strategy. Mario Choueiri: There s a risk that a trader can game the system because there are Portfolio transitions are often complex assignments involving multiple managers, global mandates or various asset classes, says Rucker. The following are some of the capabilities that a dedicated, experienced and successful transition manager will possess: Dedicated team a global, dedicated team working solely on transition activity Execution capabilities unbiased access to all market centres, crossing networks, exchanges and other electronic trading venues Conflict-free a business model that is fully aligned with the client, a transparent revenue model with no conflicting interests and full investment advisory fiduciary oversight 7

8 no minimum size limits to the orders. For example, someone can put in an order for 100 shares on a whole list of stocks and fish out the institutional flow to get an idea of what s going on. That is valuable information, arising from information leakage and can be used against the plan sponsor s transition. Therefore, serious attention should be given to this risk when using dark pools. What are the various performance benchmarks used in transition management? Troy Rucker: Implementation shortfall is the overwhelming benchmark of choice in the transition management industry. We view the T-Standard as the primary methodology for calculating implementation shortfall. The use of T-Standard implementation shortfall benefits clients because they have a consistent metric to analyze the investment performance during their transition. The T-Standard captures all performance impact and costs, both implicit and explicit, and is modelled after accepted standards used in the broader investment management industry. Mario Choueiri: Implementation shortfall is highly recommended and the most widely used benchmark. Other less common benchmarks are explicit costs and VWAP (volume-weighted average price). Upon a client s request, Brockhouse Cooper can also provide a performance analysis against a customized benchmark, such as market on close (MOC). How important is the voluntary T-Standard to the future of the transition industry? Travis Bagley: It s an important step toward bringing transition management to the same transparency and consistency expected in more traditional forms of asset management. In 2003, Russell Investments was very involved in the industry process to establish the T-Standard. It was developed to help investors measure the performance of portfolios during a transition. T-Standard reporting is consistent with implementation shortfall and CFA Institute performance standards. How is the transition management industry regulated? How is your firm regulated? Mario Choueiri: The transition management industry, in and of itself, is not regulated. Rather, it is the provider s appropriate regulatory body that oversees its activities. This regulation will depend on the business model used by the provider to deliver transition management services. For example, asset managers offering transition management are regulated by their appropriate securities commissions. Brockhouse Cooper, as a broker, is a member of IIROC (Canada) and FINRA (U.S.). We always exercise the duty of care, diligence and skill that a prudent transition manager should exercise. Transition Is fiduciary responsibility in transition management necessary? Troy Rucker: Yes. Russell s typical practice is to contract as an investment advisor and act as fiduciary of the fund, providing full alignment of interest and ensuring all decisions are unbiased and in the fund s best interest. We approach transitions as short-term investment management assignments and look to maximize the fund s risk-adjusted performance. Mario Choueiri: It depends largely on the transition manager s business model. When the provider uses principal trades as part of the execution strategy, fiduciary responsibility becomes more relevant. Fiduciary duty, in essence, requires a provider to always act in the best interest of a client. This issue comes into play when conflicting considerations are present in a decision with respect to a transition project for the client for example, principal equity trades, internal crosses, foreign exchange or fixed income transactions where there isn t full disclosure of revenues or there is potential for information leakage. Although we do offer fiduciary oversight to clients who specifically request it, Brockhouse Cooper is agency-only and provides full transparency on all revenues earned (including foreign exchange and fixed income transactions); therefore, there are no conflicting considerations that would entice us away from always acting in a client s best interest. 8