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September 30, 2004

The Time for Transitions

By Nina Mehta

Like many buyside traders these days, Jason Valdez has discretion over how he executes trades. He gets a list of buy and sell orders from a portfolio manager every morning, and then must figure out how to get best execution. But instead of trading for a traditional portfolio, Valdez works on a series of portfolios. Valdez is one of three traders in the transition management group at Frank Russell Securities, a subsidiary of Russell Investment Group, the consulting and financial services firm based in Tacoma, Washington.

Valdez and his colleagues sometimes execute trades for the parent company's mutual funds. But they primarily work on transition events that Frank Russell Securities has been hired to manage. A plan sponsor, for instance, may hire Russell to transition a portfolio from one manager to another, or to realign a portfolio according to a new investment policy. Russell handled 530 transition events in 2003, transitioning $185 billion in assets. In the first six months of this year, the firm handled 339 transition events, which represented $93.3 billion.

There are a number of large players in the growing transition management business, including State Street Global Markets, Deutsche Transition Management Group, and UBS Securities. Russell has a unique buyside' story. It is an agency-only shop and actually serves as an introducing broker. It therefore frequently executes through Wall Street brokers. "I can touch every broker dealer I have a relationship with," says Valdez.

Russell treats each transition - which could include U.S. equities, foreign equities, fixed income, foreign exchange, and derivatives - as a portfolio. For his piece of the puzzle, Valdez may be told to buy 300 stocks and sell the same number each day for a week. He may be asked to raise a certain dollar amount for cash management purposes - a critical aspect of transitioning big portfolios.

The longest transition Valdez has worked on took 12 days to complete. In that case, he transitioned a small-cap pension fund from one fund manager, who had been fired, to another manager hired to take over. Russell's biggest transition occurred in fall 2001. That's when it realigned the $25.4 billion U.S. equities portfolio for Ohio PERS pension fund. It took three months to execute. Ohio PERS was switching its benchmark from the S&P 1500 to the Russell 3000. Russell measures its performance based on implementation shortfall. Once Russell settles on a starting date for trading, the portfolio is valued as of the previous night's close.

"All my buys and sells will be evaluated against that benchmark," Valdez says. His trades aren't measured against VWAP or other relative benchmarks. In recent years Russell has made a case that an objective industry standard should be used for all transitions. This could improve cost analysis. And it could eliminate the incentive for traders to try to perform against the benchmark, which is used to measure them. "The benchmark is a fixed point in time I can't correct or change," says Valdez. "I have to do my best versus that benchmark."

Valdez acknowledges that the benchmark can be a double-edged sword. If he has a list to trade and the market is up five percent on the first morning of trading, he must still execute. "Hopefully I can trade in such a way that as the buys are moving away from the benchmark, the sells are doing better," he says. Like other buyside traders, Valdez and his colleagues can access multiple brokers, ECNs, and crossing systems. Depending on the trade, they execute positions themselves, or directly through floor brokers for listed stocks. The traders also have proprietary and sellside algorithmic trading tools to tailor strategies based on liquidity, volatility and other concerns.