Pension funds realize firing a money manager or a group of them can be expensive. They know there are plenty of trading costs and operational risks that accompany the implementation of new investment strategies, moving assets between investment managers. But no pension fund likes to get taken for a ride and overpay. Yet that is exactly what some pension funds feel has been happening-and some transition management pros agree. “We believe in our firm that the transition management community has not provided the solutions for plan sponsors,” says Hari Achuthan, head of strategy and sales for transition management at Credit Suisse.
Indeed, the Illinois Teachers’ Retirement System gave the transition management community failing grades three times in 2006. The $37 billion public fund then joined a growing list of pension funds that have stopped releasing information about the firing and hiring of managers.
The public only learns of a manager hire after the new portfolio is in place or successfully transitioned. So why would public pension plans shift from their long-held belief in transparency to total secrecy? The answer is the bane of any institutional trader, regardless of the size of the order: leakage.
Illinois Teachers’ declined to comment for this story, but a spokesperson for the plan confirmed Pensions & Investments’ reports of its leakage allegations: Traders in the marketplace were shooting against its sell and buy orders, particularly in the small-cap area. That helped to double the fund’s expected costs in three transitions last year worth $1.5 billion. Other plans also declined to comment or did not respond to Traders Magazine’s inquiries.
Like Wildfire
But one sellside trader describes what could easily be an axiom for the transition management business: “The more people who know about the trade, the greater the risk is that word will leak out that there is a big trade in the marketplace-and that will have an adverse affect on your transition.” Lance Vegna, head of transition management for the Americas for Credit Suisse, seconds that opinion: “Information can spread like wildfire.”
Transition managers are hired by pension funds to work on the funds’ behalf in the movement of assets between money management firms. They sell the fired managers’ portfolios and buy portfolios for the new managers. The goal is to transfer these assets efficiently and to trade the securities in the marketplace as inexpensively as possible. Transition managers are typically brokerage firms, ranging from bulge bracket shops like Goldman Sachs and Merrill Lynch to niche brokers; custodian banks such as State Street and Mellon; and big index players like Barclays and Northern Trust.
Transition management is big business. U.S. corporate and public funds oversee about $4 trillion in assets. Based on a typical range of asset allocation models, from 50 to 60 percent of that amount is invested in equities, or between $2 trillion and $2.4 trillion.
Big Trades
David Rothenberg, managing director of Russell Investment Services, a division of the Russell Investment Group, insists that many pension funds require their transition managers to act as fiduciaries. With a tremendous amount of assets involved in an individual transition-anywhere from $20 million to $500 million-pension funds want to ensure that their interests always come before those of the transition manager. A fiduciary will sometimes act as an investment adviser and invest a client’s assets.
Still, there is no centralized database that captures the dollar amount of all the transitions executed in a year. Many fly under the radar. One transition manager estimates that $900 billion in global assets, including fixed income, gets transitioned each year. However, others in the transition business say that figure stands on the low end. One transition pro cites a survey in Global Investor, a magazine covering institutional investors, which estimates that $2.1 trillion in global assets were transitioned in 2004.
Welcome to the uncertain world of transition management: an industry in which trading costs can be as little as 16 basis points or as ridiculously high as 10 percent of the portfolio, according to one transition horror story recounted by two separate sources.
Yet the costs of brokerage commissions can be the least of a client’s worries, say transition officials. It’s not too different from trading single stocks-just a more complex transaction. “Commissions are just the tip of the iceberg,” cautions Mark Keleher, president of Mellon Transition Management Services. The rest of the iceberg is implicit costs, which include market impact and the opportunity costs of missed trades.
This story looks at the process of portfolio transitions and offers some insights on leakage and other ways in which costs can be mitigated.
Round-Trip Trade
The three main reasons pension funds fire managers are poor performance, a change in a fund’s asset allocation or a rebalancing. A transition is typically a round-trip trade: the sale of the legacy, or fired manager’s, portfolio; and the purchase of the target, or new manager’s, portfolio. And costs can be significant.
According to Peter Weiler, director of global sales at trade-cost analysis vendor Abel Noser Corp., the total implementation costs for a transition include market impact costs, opportunity costs and commissions. The average cost for a large-cap portfolio is roughly 15 to 20 basis points, says Weiler, whose firm is also a broker involved in the transition management business. Transitioning mid-cap and small-cap portfolios cost about 40 basis points each.
Paul Sachs, a principal and senior consultant at Mercer Sentinel Group, offers a similar assessment of costs. He adds that costs can vary greatly because every portfolio is different and every transition has different levels of complexities, based in part on the number of managers involved.
Indeed, a 2005 study of 83 packaged or portfolio trades in the mid-cap category found that costs varied by more than 100 percent. They ranged from 67.2 basis points to 149.4 basis points, depending on the trading style employed.
One brokerage source involved in transitions says pension funds should not get bent out of shape if their pre-trade TCA numbers for an agency trade don’t match the transition’s actual cost. “You could get five different cost estimates from five different vendors,” he says. “It depends upon their methodology.” Others also point to the vagaries of the marketplace to explain why pre-trade numbers are simply “ballpark” figures: It is difficult to predict the future volatility and momentum of the market once the trading begins.
Pre-Trade Analysis
Thorough pre-trade analysis is key for any successful transition, says Steven Glass, director of pension services at Plexus Group, a consultancy division of broker ITG that measures the cost of trading. Once a pension fund has named its new manager, Glass meets with the fund and helps chart out an execution strategy, based on the characteristics of the legacy portfolio that will be sold and the characteristics of the target portfolio that will be purchased and handed over to the new manager. The objectives of the pension fund-including its risk tolerance, the urgency of completing the transition and its complexity-are factors in plotting that strategy.
Plexus, a registered investment adviser acting as a fiduciary, will typically help select the transition manager. Glass says that transition managers offer specific advantages, depending on the type of trade. Some are better at complex multi-manager transitions. Others offer a huge amount of flow and can readily cross stock. In some cases, a principal bid is what’s needed. “Not all transitions managers are created equal,” Glass says. “This isn’t a commodity business.”
One key question Plexus asks plan sponsors in the pre-transition analysis phase is how the plan measures a transition’s success-or simply put, what is its goal? Plans fall into three categories, according to Glass: Some plans care only about minimizing the asset loss to the fund and don’t care how long the transition takes; others consider it urgent to complete the transition because they have a financial responsibility to meet, and are less concerned about costs; and a third group is mostly concerned about a smooth transition, but still wants to complete the transition within a range of costs it considers reasonable.
Transitions, like all searches in the institutional money management game, start with a request for proposal (RFP). One public pension fund’s RFP found on the Internet asked for the transition manager to have a minimum of five years’ experience doing transitions. It also required the transition manager to have done at least 160 transitions worth a total of $80 billion in each of the last three years. Pre- and post-trade analysis were also high on the list of requirements.
Of course, some pension funds do their own transitions. The operational risk is the tricky part of any transition. “Trading is probably the easiest part,” says George Bodine, director of trading at General Motors Asset Management, which oversees investing for the $160 billion GM pension fund. GMAM does its own transitions. “All the heavy lifting takes place behind the scenes and in the setup,” Bodine says. Part of that includes making sure the stocks are all properly identified and in the system. The stocks in that account must then be matched up and harmonized with the custodian’s records.
Due to GMAM’s size and the complexity of the account, two of its custodians have three employees working full time right on the pension fund’s premises. Having knowledgeable custodians who are familiar with the account makes transitioning a portfolio a much easier task, Bodine says.
In any transition, crossing stocks that are in both the legacy and target portfolios is a huge advantage. Crossing not only avoids potential market impact, since there is no need to expose orders to the market, but also allows the portfolio to maintain its market exposure.
Cross Rate
For active large-cap portfolios, Bodine usually sees about 30 percent of the stocks match up in a transition, with 40 percent being the best one can reasonably expect. For small-cap portfolios, GMAM usually sees 10 to 15 percent match up in a transition.
During the transition process, the trading desk will balance its sells or buys with futures contracts, giving the pension fund the requisite market exposure. In these situations, GMAM’s normally quiet desk becomes busier and noisier. “There’s a lot of active communicating back and forth,” Bodine says.
Traders on the desk can also use their trading judgment, if they have reason to think they can time the market. They can increase or decrease their level of aggressiveness. That goes for most transitions the desk undertakes. “We’re not afraid to make a commitment,” Bodine says.
GMAM uses a variety of trading strategies, ranging from a guaranteed value-weighted average price, or VWAP, to agency trades and principal trades. The last is the most expensive.
Additionally, the desk can combine strategies. The desk can isolate stocks that are tougher to trade from a basket targeted for a principal bid, and then work those thinner names, while additionally benefiting from tighter pricing on the principal bid.
Costly Capital
Principal bids aren’t for everyone, says Mercer Sentinel’s Sachs. He believes that plan sponsors with active trading desks, like GM, are the only ones skilled enough to know whether a principal bid is the right choice. In his view, those without a desk should avoid principal bids.
Sachs says an agency trade is almost always a better strategy in a transition than a risk or principal bid. For one thing, agency trades are more transparent. For another, agency trades are a lot less expensive.
“Very few clients have circumstances where they need that risk transfer,” Sachs says, adding that he thinks a principal trade is necessary about 2 percent of the time. “Whenever you transfer risk, you pay a premium.”
Abel Noser’s Weiler says plans shouldn’t limit themselves, though. They can get a better handle on expected costs by soliciting both agency and principal bids, Weiler says. That will give them a range to compare their expected costs and may also provide a reality check to the agency estimate a transition manager is providing, he adds. The principal bid will almost always be more expensive than the agency estimate because of the element of risk and because it is a firm quote rather than an estimate of costs, Weiler says. The broker in the transition business quoted earlier agrees with this strategy.
Buysiders’ Opinion
Buyside traders say transition managers make the process more efficient, especially in complicated multi-manager transitions. Three out of four buyside traders contacted said they would rather get the portfolio than buy it themselves, although they prefer to-and often do-trade the less liquid names in a transition. One large money manager says it prefers to do the selling and buying for a transition. The firm has the same electronic trading tools as any broker, he says, but its interests are more closely aligned with the pension fund’s. The lower the transition costs, the greater the balance of the pension fund’s assets will be. The manager has an incentive to do a better job trading because it will receive a higher management fee, he says.
Glass, of Plexus, says the complexity of the transition is a critical factor in selecting the transition manager. “Trading 200 names is very different operationally from trading 2,000 names,” Glass says. “If you’re going from one manager to another, that’s fairly simple; but we’ve had transitions where there were 20 accounts, and that takes operational risk to a new level.”
John Despotopulos, head trader at $4 billion manager Lee Munder Investments, says transition managers have gained a bigger role in recent years in the small-cap arena, his company’s specialty. A few years ago, a small-cap transition would have been handled differently. The legacy manager would sell its small-cap portfolio and hand over the cash to the target manager, which would then put the money to work. Today, transition managers shepherd the process, making it more efficient, Despotopulos says. “It makes more sense to have a transition manager stand in the middle, especially when there are multiple managers involved.”
Tough Names
Lee Munder’s trading desk is still involved when a new account comes in. About 90 percent of the time, the trading desk will trade 20 percent of the new client’s portfolio. It usually trades those stocks because they are difficult names-and the desk is familiar with them and may know where the other side can be found. “It could be significant basis points we are adding,” Despotopulos says. The desk works with the transition manager in other ways, too. Despotopulos may give the transition manager limit orders on particular stocks. “We know our stocks,” he says, “and we feel no one would be better able to invest that money than we would.”
The desk at NWQ Investment Management takes a similar approach with new clients, according to Kirk Allen, head trader at the Los Angeles-based manager of $35 billion in equities. It also works about 20 percent of the portfolio itself. NWQ will, however, give the transition manager one day to see if it can cross the less liquid names it receives. “The transition managers have a tremendous amount of flow, and we want to leverage that crossing potential as much as we can,” Allen says.
There is also ongoing discussion and information sharing with the transition manager during the transition, since what the fund and manager do can impact one another. “Our approach has always been to be complementary to the transition managers,” Allen says.
Glass agrees that having the target manager handle the more illiquid names can be a good strategy. But it can also work against the plan sponsor, depending on the number of money managers involved in the transition. “If the market sees lots of activity in some common sectors or names, sometimes it is better if only one shop is handling that transition,” Glass says. “Otherwise, there could appear to be more selling activity and interest than really exists.” Glass points out these issues are discussed and decisions made during the pre-transition analysis.
Sloppiness & Leakage
Still, one global investment manager who requested anonymity will not allow a transition manager to trade a stock when it is building a new position. Of course, it only has that say when it is getting the client, not when it has lost one or been fired. The reasons behind this firm’s philosophy are two-fold: fear of leakage and potentially sloppy trading-either of which could wreak havoc on a stock’s price. Also, a transition manager’s and a money manager’s interests aren’t always 100 percent aligned. The transition manager could have different objectives than a portfolio manager, who may be more patient if a stock gets out of line, while a transition manager may have an urgent mandate to complete the trade rapidly. “I know there are post-trade reports,” says the trader, “but my sense is they just want to get the transition done and won’t give it the TLC we would.”
Here are some suggestions and explanations of issues that could impact the cost of a transition, as well as other insights that may cut down on leakage:
>> Transition managers sometimes provide low market-impact estimates to get business. They’ll say they expect a high percentage of the portfolio to cross, which would cut the pension fund’s execution costs.
>> If the trade is large or sensitive-anything over $250 million is considered a large transition-don’t go to multiple brokers. That lessens the number of market participants who know about a fund’s plans. A sellside trader in the transition business suggests no more than two bids for such transitions.
Here’s why: Losers of a transition mandate sometimes get involved in a transition after the fact. If they start to see certain sectors get active, they may realize the portfolio they lost out on is now hitting the marketplace. “They will remember what was in the trade, but not take the other side proprietarily,” the sellside trader explains. “But they might call a client and say, Listen, we think there’s a big transition going on and it’s going from large-cap growth to large-cap value.’ We hear this from our [buyside] clients all the time.”
>> Having dollar-balanced portfolios-such as selling $500 million of one portfolio and buying $500 million for a new one-is less of a cost indicator than knowing the correlation of the two equity portfolios, the trader adds. Transitioning between equity portfolios that are highly correlated, or within the same market cap, will be less expensive, for example, than transitioning from a small-cap to a large-cap portfolio, or vice versa, even if those portfolios are dollar-balanced.
>> Select a broker who won’t “flood the market” with indications of interest (IOIs) in a sensitive trade or name. Targeted IOIs may work, but the possibility remains that information will leak into the marketplace. Sometimes it is important to simply be an agent and not look to find a natural in certain stocks.
>> Don’t make active bets. Despite having a portfolio to be transitioned that is dollar- and sector-neutral, the transition manager may allow its sells or buys to outpace each other, and consequently makes an active bet on the market and loses the hedge that was built into the transition. Selling the liquid names before the illiquid ones will also give a portfolio transition liquidity skews. Losing neutrality “is probably the single most damaging tactic that a broker or a trader can make,” the sellside trader says. “While you might be right and hit a home run, the incremental risk on that portfolio is not worth it-and you’re creating a risk you never intended.” Brian Roberts, head of transition management for North America at Russell Investment Services, agrees. “You are potentially exposing that portfolio to a major move in the market,” he says. “Those market moves can add significant costs-hundreds of basis points-to a transition.”
