In its most basic definition, a transition is the implementation of an investment decision driven by one of several different factors. These can include a change of investment manager due to performance, the addition of an asset class, a shift in asset allocation or a change of risk profile in the investment portfolio.
However, there are a number of complexities to consider when executing a transition to help fully maximise its value.
Kal Bassily discusses the elements of what makes a transition and a transition manager a success – careful planning, global experience combined with regional knowledge, in-house execution and sophisticated proprietary technology.
The seeds of a good transition are sown at the planning stage. Can you explain the pitfalls that good planning circumvents?
You’re exactly right. It’s during the pre- trade planning phase that the transition manager meets with the asset owner to understand the goals and parameters of the transition and, importantly, asks all the necessary questions to ensure a smooth and successful transition.
What questions the transition manager asks the client at this stage is crucial and is the reason why it is critical to use a manager with significant experience in a wide variety of transitions. For example, if the manager fails to enquire about issues like custody structure or the duration within which the transition must be implemented, it can create problems down the line. You don’t want to discover at the last minute that the legacy assets are coming out of a comingled fund, as that can delay a transition, with considerable costs, or – worse still – scupper the transition entirely.
The pre-trade planning stage is also where the manager learns of the constraints under which the transition must be carried out. The client may need to remain cash neutral throughout the whole transition portfolio. Or, in the case of a pension fund, the client may be prohibited by the investment mandate from using derivative instruments.
An experienced transition manager knows that the prohibition of derivatives requires large-scale adjustments in the planning of the transition. If a client is shifting from a G7 sovereign debt portfolio into an MSCI emerging markets equity portfolio, for example, there could be a daily cost of 120bps in terms of tracking error. Without a full understanding of the asset owner’s constraints, a transition manager might attempt to use a futures overlay to dampen volatility, especially since, with emerging market equities on one side, the transition will be spread over several days.
If the manager knows that the trading strategy cannot use futures to manage the risk then the strategy can be built around this constraint carefully. This is a process that takes time. Again, this is not something you want to learn at the last minute or the transition will be significantly less effective.
Is there a reporting element to the transition that must be considered?
Absolutely. Communication around this has become especially important in the growing area of transitions conducted for multi-managers, where transition managers will be employed to move assets between sub-advisors.
Here, it is very important that the transition manager is aware of the NAV calculation requirements. Where the multi-manager has to strike a daily NAV to report to shareholders, for example, the transition manager must set up protocols between it and the fund accounting agency of the multi-manager early in the process. Sometimes this agent is the custodian but often it is the multi-manager itself.
Either way, the transition manager must research how best to achieve connectivity via a one-off protocol that allows it to instruct the fund accounting agent upon execution via SWIFT. This should be done on a daily basis, and must allow for any time delay created by the differing jurisdiction of the multi-manager. Failures or errors around NAV reporting will not only have an impact on the service quality provided to major fund shareholders; increasingly, NAV reporting is a regulatory requirement.
Having experience in this space is essential. It will allow the transition manager to ask the right questions at the right stage of the process, in order to support comprehensive planning. If the transition goes ideally in terms of trading and implementation shortfall but the NAV is not produced to the required specifications, then we consider that the transition has failed.
It is also crucial to use a manager with extensive back office experience on a global basis and who can understand the peculiarities of the custody regimes across the world. For this reason, at ConvergEx we employ staff whose careers have been spent working on the operations side of a custodian bank.
How important are statistical models at pre-trade in preparing a successful transition?
At the pre-trade analysis, clients look to their transition managers to apply a proprietary suite of analytics that estimates the total costs of a transition. These will include evaluating the liquidity profile and the overall risk profile of the transition event.
When it comes to risk, models play a vital role. But every model has its limits and they work best when there are experienced traders on hand to interpret them.
To understand why, consider the workings of the regression models. These multi-factor analyses, which work on historical data, typically form the foundation of any pre-trade model. But the models frequently do not give accurate predictions when it comes to the more esoteric asset classes, such as those in frontier markets, where the data set is small or unreliable. This is even the case in some emerging markets that behave very differently to the deep and established markets of, for example, large-cap US equities.
Often the mathematical models will underestimate the market impact of a large trade’s volume. A manager embarking on a transition armed only with the predictions of the model will begin execution with an excessively optimistic view of this element.
This is where the input of experienced traders becomes vital. The trader may say ‘an order of this size in XYZ small Russian stock, will move the market, not by the 50bps that the model predicts, but rather by 250bps’.
This becomes especially valuable when you consider that the stock-specific risks encountered in frontier markets (and certain emerging markets) can be very hard to hedge. This means adjusting is much harder to do ‘on the hoof’ when you are surprised by the market impact effect mid-execution.
At ConvergEx, when we are planning a transition we will always survey our traders for their input. Because we have professionals with specialisation across the asset mix, we can canvas an experienced view on execution for every part of the transition.
How can clients best mitigate the risk of information leakage in their transition?
The primary risk of information leakage arises from the outsourcing of transition executions. The greater the degree to which a transition manager can keep the working of transition orders inhouse, the lower the risk of leakage. This is why transition managers with access to a wide range of in-house execution capabilities often make the best transition managers.
At ConvergEx, for example, we have order-working and execution capabilities across a vast number of markets. Our transition clients can therefore enjoy the resource of all of these trading and execution venues while worrying less about the risk of leakage than can come from accessing diverse pools of liquidity. Importantly, we also have no ‘at risk’ proprietary trading operation so our transition clients don’t have to worry about us impacting market prices by trading at risk against their transition orders.
Contrast this with a manager that outsources some or all of the execution to unaffiliated broker-dealers on the Street. These dealers that now enjoy access to this order information are not contracting parties with the asset owner – they have less motivation to safeguard the information they receive.
Does in-house execution make transitions more responsive during execution? How?
This is an important point. It is quicker and easier for a transition manager to adjust the execution strategy in response to market events when the working of an order is performed in-house.
For example, let’s consider a transition involving a basket of European equities. Before the US market opens, the US Labor Department announces an unexpected fall in the job numbers and there is subsequently a shift in the market during the remaining trading period in Europe. With in-house order working, the transition manager needs only to communicate directly with the transition manager’s own traders to prepare a response. In this case, it might be executed quicker if they feel the market will soon rally and the transition client is a net buyer.
It’s easy to see how having a conversation with a third party would take longer and would be tougher to initiate.
How does automatic execution aid transition quality?
The benefits of keeping the trading decisions in-house obviously increase where transition managers have more sophisticated execution capabilities. ConvergEx, for example, has a large electronic and program trading business. We run numerous algorithms and two dark pools in-house, which we have built ourselves. Again, because we have no ‘at risk’ proprietary trading operation, everything we build is available to our asset management clients – nothing is off limits. And the programs run by the algorithms are highly specific, depending on the type of execution.
We have even developed our own algorithm, specifically to support transitions. A transition optimiser TOPx, has a crucial dynamic element to it, which few execution brokers can offer. When the global trading desk is executing a leg of the transition via an execution venue, such as a dark pool, TOPx adjusts its behaviour in real time. As fills come into the order management systems of the desk, TOPx tapers the execution strategy accordingly.
Compare that to a transition manager who outsources execution. There, the order is given up to an outside broker and with it is surrendered some control over is handled.