Transition Management Introduction Asset transitions are inevitable and necessary in managing an institutional investment program. They can also result in significant costs for a plan. An asset transition is defined as the movement of assets involving one or more investment managers among one or more asset classes. Transitions often involve electronic and open market trading that can expose a plan to significant costs and risks. An institutional investor needs to transition assets for a variety of reasons, including: Removing an incumbent manager Hiring a new or replacement manager Adjusting allocations to existing managers to rebalance portfolios within policy target ranges Changing asset allocation policy Because there are costs and risks associated with transitions, an institutional investor may find it prudent to use a transition manager. We explain the costs and risks related to transitions and detail the role a transition manager plays in minimizing these costs and risks for clients. Case for Transition Management Costs and risks in transitioning assets are due in large part to trading, market volatility, and managing exposures across multiple asset classes. A transition manager can be hired to mitigate these costs and risks, which is especially critical when sizeable assets are involved. We describe the various transition costs, the pretrade process of estimating these costs, the risks inherent in a transition, and the role of the transition manager. Transition Costs Just as investors evaluate investment managers performance relative to a benchmark, they need a way to evaluate the performance of a transition. The commonly accepted evaluation measure for transition managers is the implementation shortfall methodology, which quantifies the frictional costs of moving from one portfolio to another by comparing the return of the transition portfolio to the return of the target portfolio over the trading period. The return of the target portfolio represents the hypothetical return the portfolio would have earned had the assets been moved instantaneously and without cost, while the return of the transition portfolio is the actual change in value of the assets including all transition costs. Exhibit 1, on the following page, illustrates how to calculate the implementation shortfall for a transition completed in one day. The return of both portfolios is measured from the closing price on the night before the trade to the closing price on trade date. The implementation shortfall of - 0.10% (0.54% 0.64%) is the overall cost of the transition. 1
ransition Management Exhibit 1: Implementation Shortfall Calculation Return over 1 Day Period Transition Portfolio 0.54% Target Portfolio 0.64% Implementation Shortfall -0.10% The component costs of the implementation shortfall calculation include explicit and implicit costs. Explicit Costs The commissions a transition manager charges to manage the transition event for a client are the most significant portion of a transition s explicit costs. These charges are typically quoted in cents per share for U.S. stock trades and in basis points on the total value traded for non-u.s. stock or fixed income trades. Commission costs have dropped considerably over the past few years with improved technology and transparency. In addition, in early 2001, all U.S. stock markets changed from pricing securities in fractions to pricing them in decimals (decimalization), which not only lowered price changes, but also resulted in lower commissions. Moreover, transition managers can generally negotiate lower commission rates than traditional investment managers, given the volume of trades conducted and a focus on pure execution, which eliminates the need for research or other services obtained through soft dollars. While commission costs can vary depending on the size and complexity of a transition, Exhibit 2 represents a range of commission levels for the major asset classes based on our experience in assisting our clients with transitions. The lower commissions will generally apply to larger transitions. Exhibit 2: Commission Levels of EnnisKnupp Clients Asset Class U.S. Equity Fixed Income International Developed Equity Emerging Markets Equity Commission Rate 1 1.5 cents per share 4 6 bps 4 6 bps 10 12 bps 2
ransition Management ITG, an agency brokerage and technology firm that researches costs of trading and transitions, published a study in early 2008 that illustrates the recent decline in commission costs. Exhibit 3 shows the change in average trading commission costs in basis points over the past four years for equities in various regions. Exhibit 3: Change in Commission Levels 1 2004 (bps) 2008 (bps) % Change U.S. 14 7 50% U.K. 12 12 0 Europe ex-u.k. 15 10 33 Japan 11 7 36 Emerging Markets 29 20 31 Taxes are another type of explicit cost than can be incurred during a transition. Most countries charge a fee when buying or selling securities that ranges widely from a fraction of a basis point in the U.S. to 100 basis points (bps) depending on the country. Transition managers are aware of these fees and will seek to avoid them whenever possible. The use of derivatives can also result in marginal costs for the client. Implicit Costs While explicit costs are known in advance of a transition and can be quantified quite accurately, the most significant portion of the total costs incurred is the implicit costs, which include bid/ask spread, market impact, and opportunity cost. Exhibit 4 shows that these costs represent 80% 90% of the total costs incurred during a transition. 1 Source: ITG Global Trading Cost Review (Q1 2008). 3
ransition Management Exhibit 4: Average Distribution of Component Costs of Trading Commissions 18% Opportunity Cost 56% Spread/Market Impact 26% *Source - ITG: Plexus Plan Sponsor Group Bid/Ask Spread: The bid/ask spread is the difference between the price at which a dealer will buy a security (bid) and the price at which the dealer will sell a security (ask). The spread, which compensates the dealer for making a market in a particular security, is borne by the buyer of a security. A security with high liquidity in the market will have a much tighter bid/ask spread than a security with lower liquidity. In the fixed income market, where pricing often depends on the size of the position or lot, a small bond position or an uneven (odd lot) position compared to the normal unit of trading (round lot) will trade at a higher bid/ask spread. So will illiquid and lower-rated bonds. Market Impact: Market impact is the impact that trading has on the price of a security. The larger the position in a stock, measured in terms of percentage of average daily trading volume, the higher the market impact on its trading price. A higher percentage of average daily trading volume (generally over 10 20%, but the percentage can vary by security type) also indicates that a trade will likely take longer to trade than a position with a low percentage of average daily trading volume (generally below 10 20%). Opportunity Cost: Opportunity cost arises because various market factors can cause the target portfolio and transition portfolio to behave differently. Factors include market volatility, market news, and currency fluctuations. Other factors that can significantly increase opportunity cost are country, sector, and market capitalization imbalances between the transition portfolio and the target portfolio that may occur during the trading day. A transition manager seeks to minimize these imbalances as much as possible. Opportunity cost can be either positive or negative, depending on market activity during a transition event. Opportunity cost is estimated before a transition by calculating the daily historical tracking error between the legacy (terminated portfolio) and target portfolios. Pre-Trade Process A pre-trade provides an estimate of the mean expected cost of the transition and of the opportunity cost of the trade, expressed as a one standard deviation range around the mean expected cost. Assuming that costs are measured and estimated appropriately, we would expect the final outcome to 4
fall within this one standard deviation range twothirds of the time. Transition managers should also provide a qualitative assessment of the transition event that describes the trading strategy, profiles the characteristics of the portfolios, explains how risk will be managed, and indicates significant areas or concentrations of risk in the portfolio. Exhibit 5 compares a pre-trade cost estimate and the actual results for a $135 million transition from a U.S. mid-cap equity manager to an all-cap U.S. equity manager. The last column shows the final mean cost of the transition at 19 basis points with an opportunity cost of 36 bps, for a total cost of 55 bps. This falls within the one standard deviation range estimated by the pre-trade (between a cost of 57 bps and gain of 6 bps). The final cost was also at the lowest end of the range mainly due to a rally in U.S. equity markets as the transition manager bought U.S. equities. Exhibit 5: Pre-Trade Cost Comparison Pre-Trade Estimate Post-Trade Results $ Bps $ Bps Commission (118,047) (9) (88,406) (7) Taxes & Other Fees (2,000) (0) (2,008) (0) Spread (107,537) (8) (69,015) (5) Market Impact (114,289) (8) (100,754) (7) Mean Expected Cost (341,873) (25) (260,183) (19) Opportunity Costs +/-422,566 +/-31 (488,564) (36) Total Cost (764,439) 80,693 (57) 6 (748,747) (55) Risks Transitioning assets presents a variety of risks to institutional investors. Exposure risk is the risk that the transition portfolio will be over- or underweighted to a specific sector or region of the market or the market as a whole during the transition. Volatility during the trading day can negatively impact the transition portfolio if there are significant mis-weights. The transition manager coordinates the buys and sells with a goal of always remaining dollar-neutral during the trade. Exhibit 6 illustrates the importance of maintaining dollar neutrality during a transition, given daily market volatility. 5
ransition Management Exhibit 6: U.S. Stock Market Volatility 1996-Present (3/31/09) 80% 70% 70% 60% 50% 40% 30% 20% 10% 0% 13% 1% 26% 4% 31% 35% 46% 43% 50% 21% 33% 15% 12% 8% 7% 6% 19% 14% 14% 0% 0% 1% 199 199 199 199 200 200 200 200 200 200 200 200 200 200 (YTD 27% 7% 51% 29% 44% % Days with returns greater than +/- 1 % % Days with returns greater than +/- 2% Operational risk is inevitable, given the multiple moving parts involved in a transition. Transition managers offer specialists who are experts in, and are responsible for, coordinating all operational aspects of a transition to ensure that the appropriate paperwork is in place, that trade lists are received in a timely manner, that securities are delivered in a timely manner, and so on. The regulatory environments and a variety of global operational complexities including sub-custodian accounts, nontransferable securities, and different international holidays add complexity to international transitions. open at different times. For example, a transition that involves both the U.S. and Asia will experience a timing gap when the U.S. market is open and the Asian markets are closed. This risk can be mitigated by using futures as a hedge to maintain a dollar- neutral portfolio. Derivatives are an effective tool for transition managers to hedge exposure to a specific region, sector, or currency in an effort to reduce exposure, currency, or timing risk during a transition. Derivatives, especially non-exchange traded derivatives, do require additional paperwork for trading as well as an added cost. Currency risk is managed by trading currency forwards or other derivatives in order to manage a client s exposure to a currency or basket of currencies within the transition portfolio. Timing risk is a factor in international transitions, as it is not possible to maintain a dollar-neutral portfolio during a transition when markets are Role of a Transition Manager A transition manager has extensive trading capabilities, robust optimization and portfolio evaluation tools, and experienced strategists and traders who understand the various elements of a transition. The most sophisticated transition managers apply multi-factor optimization models that incorporate transaction costs, liquidity, trade volume, correlation, volatility, and other relevant information 6
to determine the most optimal way to complete a transition. Before implementing a transition, the transition manager should propose a comprehensive plan that describes the period for the transition event, the specific trading strategy, and the use of futures or other methods to maintain market exposure. Recall that opportunity cost accounts for over 50% of the trading costs associated with transitions. Therefore, one of the most important and challenging tasks for a transition manager is managing the tradeoff between the time to trade versus the related costs market impact and opportunity cost. Expanding the time to conduct a trade will reduce market impact costs, but will increase opportunity cost (and vice versa). Exhibit 7 illustrates the relation between time and market impact and opportunity cost Exhibit 7: Market Impact vs. Opportunity Cost 500 400 Bps 300 200 100 0 0.125 0.25 0.5 0.75 1 2 3 4 8 16 20 Market Impact Opportunity Cost *Source: Barclays Global Investors Days A more risk-averse or more time-constrained client may be willing to incur higher market impact costs in order to complete a transition more quickly. A less risk-averse or more time-flexible client may want to avoid significant market impact costs by trading more slowly at the risk of incurring a higher opportunity cost. A transition manager should understand a client s circumstances and primary objective before deciding on a final transition strategy. Given the material costs of a transition, especially a mismanaged transition, it is of utmost importance in selecting a transition manager to focus not just on the cost estimate described in the pre-trade forecast, but also on the qualitative aspects of a transition manager s capabilities. A number of groups have developed standards to help institutional investors evaluate transition managers. In October 2007, a group of leading transition managers released a basic set of principles called the T-Charter, which defines best practices for transition managers. The Pension Benefit Guaranty Corporation (PBGC) in 2008 released PBGC Transition Manager Standards, compiled with assistance from many of the industry s leading transition managers. These documents provide a comprehensive list of standards to serve as best market practice for transition managers. They also act as guides for institutional investors to compare 7
proposals and results of transition managers on a more qualitative basis. Both sets of standards address principles such as disclosure, confidentiality, conflicts of interest, transparency in reporting, cost estimation, trading strategy, and transition evaluation. One key distinction is that the agency-only manager acts as a fiduciary for clients. In the case of broker/dealers, they must not use their proprietary trading desks as a liquidity source and must establish stringent controls for managing the flow of transitionrelated information. Implementing a Transition There are differences between agency-only transition managers and broker/dealers. There are also a variety of liquidity sources available to a transition manager as it seeks to minimize cost and risk. Types of Transition Managers The two broad categories of transition managers are agency-only and principal or broker/dealer transition managers. The primary difference between the two is that an agency-only transition manager executes all transactions for its clients on a pure agency basis, meaning that it acts as a broker and does not commit capital to trades. Broker/dealers may have an agency-only solution (broker component), but they also can commit principal to complete a trade (dealer component), meaning they can buy securities that the client needs to sell. In this case there are potential conflicts of interest, as the organization is trading its own capital when it is implementing a principal trade. This is an important concern, and significant due diligence should be conducted to ensure that there are sufficient controls in place to minimize this potential conflict of interest. An agency-only transition manager does have the ability to source a principal trade (described below). An agency-only transition manager sources this from another broker/dealer and does not use its own capital to satisfy the trade. Many agency-only transition managers (excluding broker/dealers) belong to organizations that manage significant indexed assets, which enable them to cross transition management orders with their index flow. While broker/dealers do not have access to index flow, they do have sophisticated trading capabilities and access to algorithmic and general trading order flow, which provides significant liquidity for the transition management desk. Broker/dealers have historically been thought to have more significant trading expertise than the traditional agency-only transition managers; however, the proliferation of crossing networks and algorithmic trading in recent years has allowed the most sophisticated agency transition managers to acquire similar trading capabilities, which has helped to level the playing field. Liquidity Sources Transition managers can access a variety of liquidity sources for executing a transition. These include internal and external crossing networks, open market trading, and principal trades. The transition manager seeks to utilize a combination of liquidity sources in order to minimize cost and risk while executing a transition. Each of these sources is further explained below. 8
Internal Crossing Internal crossing refers to the ability of a transition manager to match transactions with internally managed index funds or current transition order flow. To cross with internally managed index funds (internal cross), a trade is input at the beginning of the trading day and then executed at the day s closing price. An internal cross does not incur commissions, bid/ask spread, or market impact cost, but because the trade is completed at the close, the security is exposed to a full day of price volatility, which can increase opportunity cost. For this reason, it is important that a transition manager does not simply enter the maximum amount of flow into the cross, but instead strategically decides from a cost and risk perspective the most optimal level of crossing and which securities to cross for the transition event. While the U.S. Department of Labor allows transition managers to cross Employee Retirement Income Security Act (ERISA) transition accounts with the flow from internally managed index funds, it does not allow ERISA clients to cross transition order flow with other ERISA transition flow. It does allow non-erisa clients (like foundations or endowments) to cross transition flow with other non-erisa transition clients. These crosses are also completed at the closing price and do not incur commissions, bid/ask spread, or market impact. Many of the largest transition managers have sufficient volume to take advantage of this additional source of liquidity. External Crossing Networks External crossing networks are developed and marketed by the security exchanges, broker/dealers, agency brokers, and hedge funds. While they are available in many varieties, the common feature of external crossing networks is that they fill trade orders anonymously without incurring market impact or bid/ask spread. The Securities and Exchange Commission defines crossing networks as systems that allow participants to enter unpriced orders, which are then executed with matching interest at a single price, typically derived from the primary public market for each crossed security. 2 There are more than 40 different external crossing networks today, expected to grow by 40% by 2010. 3 External crossing networks can be accessed directly by the trader or via a trading algorithm. Depending on the trading strategy, the algorithm allocates the order across various execution venues in order to achieve the optimal result. Most crosses are executed at the mid-point, but some crossing networks allow price negotiation between the two parties. Timing varies across the crossing networks; some cross continuously, and some at specific times during the day. Transition managers have continued to increase their access to these various crossing networks and employ experienced traders who understand each crossing network s unique structure, rules, and trade order flow. Open Market Trading Open market trades incur both market impact and bid/ask spread, as a trade is visible to all market participants. This can affect the execution price. As with external crossing networks, transition managers use algorithmic trading engines to execute trades in the open market. Trading directly with a broker can be an optimal choice during a transition if a trade can be completed more quickly and more cost-effectively. 2 SEC Concept Release, Regulation of Exchanges, 23 May 1997 (p.15). 3 Source: Barclays Global Investors (BGI). 9
Principal Trade With a principal trade a broker/dealer buys or sells for its own account and at its own risk rather than as an agent on behalf of a client. Transition managers will typically solicit principal bids from broker/dealers when a small basket of securities left at the end of a transition event represent a high percentage of average daily volume and thus, present a challenge to trade at a reasonable cost. While there is little transparency in a principal trade, and costs are higher, this may be the optimal way to complete the transition. A transition manager has the skills, expertise, and the quantitative tools to assist investors in minimizing the costs and risks of an asset transition. Investors evaluating a transition manager should not only analyze and compare the cost estimates, but also focus on the manager s qualitative offerings. Knowing how a transition manager analyzes the transition event and what assumptions are made in calculating the cost estimate and developing a clear understanding of a transition manager s portfolio management and trading capabilities will help investors to receive the highest-quality performance from a transition manager. Conclusion Asset transitions are complex transactions that may expose investors to significant costs and risks that can ultimately have a negative impact on the value of a plan. It is important that institutional investors understand the component costs of a transition as well as the likely risks to ensure that costs and risks are mitigated as much as possible. Kristin Doyle April 2009 10