Assessing the work of transition managers can seem a daunting task, given the complexity of transition events and components of the service provided. An accurate appraisal requires a nuanced approach to measuring performance and qualitative consideration of project management.
Fundamentally, all transitions should be judged by the criteria that are important to the individual institutional investor client. This means that even at the earliest stage of the process, before an appointment has been made, discussions take place between the client and potential transition managers that will shape the strategy of the transition.
“It all comes down to communication,” said Chris Adolph, head of transition management, Emea, Russell Investments. “Right at the start, if the client makes it clear what is important to them and we set out how we are going to manage the process, it makes the evaluation process at the end that much more straightforward. The whole process is geared around making sure there are no surprises.”
In the early stages the transition manager works as an advisory role, which develops once the appointment is made and lasts the entire lifecycle of the transition.
Justine Anderson, global co-head of transition management at BlackRock, said: “The important thing is that even at the very early stage you have to be a close partner to your client. We have an ongoing dialogue with the client, even during the analytics stage, to assess the scenarios that may make sense for the client. That only works if there is two-way communication.”
These early discussions will result in a pre-trade analysis documents. These are designed to capture as accurately as possible a strategy, or range of strategies, that matches the preferences of the client. It covers both trading strategies and operational arrangements, which for many clients may be just as important for the success of the transition.
“We view the pre-trade as a tool for the client to make the right decision on strategy, not as a way to present the lowest cost number,” said Anderson. “It’s about working with the client and finding the optimal strategy. The clients that compare strategies rather than numbers are typically the ones that are most satisfied with the result in the end. The biggest mistake a client can make is simply to compare numbers.”
Nick Hogwood, head of implementation, transition management, Emea, BlackRock, added: “There will always be a series of trade-offs between cost and risk, or cost and immediacy. There is not necessarily a right or wrong answer – our job is to outline the options, the pros and cons, and help the client choose the optimal strategy.”
While the strategy is of central importance, costs are clearly very important. Transition managers submit pre-trade cost estimates, based on the client’s data and transition manger’s strategy but are subject to market conditions.
Graham Dixon, director of transitions at Inalytics, said that clients with a panel of transition managers have an advantage as they can compare multiple cost and risk estimates. “Best practice is to give all of the panel members the same information,” he said, adding that the actual portfolio data can be amended at this stage to protect confidentiality.
The pre-trade analysis remains an important document throughout the transition as it forms the basis of whether performance is ultimately deemed a success. “The big thing we tell clients is that you don’t want the transition manager to be the owner of the benchmark – you should not just accept a cost estimate. What deems it a success or a failure should be owned by the client.”
He noted that this is another advantage of obtaining multiple pre-trade estimates. “There is a temptation, if you are not in competition, to put in an overly prudent cost estimation – so you have a greater chance of looking good against the benchmark after the event.”
During the transition
By the time the transition actually takes place, very little should be left in doubt. The strategy should cover every foreseeable scenario, with pre-agreed contingencies built-in for unforeseeable events. The level of communication will be tailored to the needs of the client; an end-of-day statement is considered to be the minimum and many will want intra-day communication.
“Clients should definitely have a clear expectation of what they are going to receive. There should be open and clear communication of progress and performance – not just the numbers but also the operational aspects,” said Hogwood.
The pre-trade analysis is based on expected market conditions, which can of course change during the actual transition. This can range from a mild deviation, such as a tightening of liquidity, to a market-shaking terrorist attack or even a full-blown market crisis. This means trading costs can increase so it is essential to agree beforehand how to proceed under the full range of circumstances.
“Some clients will want to be involved in decisions, others say they engaged us to use our professional judgement and, knowing their objectives, do what is reasonable during the transition,” said David Goodman, division director at Macquarie Group.
“There needs to have been a conversation about their preferences regarding potentially incurring larger opportunity costs, from taking longer amount of time to trade, versus the lower market impact from slowing the pace of trading during the more expensive times.”
Common problems include market-related issues, such as temporary volatility or illiquidity, as well as operational and stakeholder management elements. It is usual for the transition manager to have a pre-agreed amount of leeway to make decisions.
“It comes down to expectation management,” said Hogwood. “There are things you can foresee and those you can’t. Part of the planning protocol is to agree at which points a transition manager should consult the client and ask permission to change the strategy.”
News relating to a specific stock may result in challenging trading conditions but should not require the transition to be halted, while any events that fundamentally effect the functioning of markets are another matter. “Those are definitely the scenarios where you escalate and talk to the client and agree a path forward,” he adds.
After the transition has occurred the post trade-analysis will be conducted in the context of the pre-trade analysis, both in terms of performance and project management.
Performance will be measured in terms of the implementation shortfall. “It is a fair, verifiable measure of the performance costs of a transition. It is 100% replicable,” said Goodman. “The significant change over the last couple of years is that clients expect an independent third party to validate the process, to calculate the implementation shortfall, and also go back and ask the valid question of what the pre-trade should have been.”
The industry-standard setting T-Charter lays out a template for cost estimates. “That template is pretty good,” said Inalytics’ Dixon. “If all of the boxes are ticked for the pre-trade cost estimate you can take the post-trade template and compare like-with-like. “With that information, you can do an attribution at the end and say whether it was a fair estimate or identify things for which you should make an allowance.”
The attribution stage is very important – a badly-managed transition could appear successful if market conditions were favourable and a well-manged one could miss the estimate through no fault of the provider.
“Market movement is often the biggest component of cost – it you are one-sided
The report also assesses how effective the strategies set out in the pre-transition analysis. Adolph said: “If you put on hundreds of millions in futures trades there should be something stating what you did, why you did it, whether it was successful or not, and if not why not.”
Once the mathematical measures are agreed the conversation can move on to what actually happened during the transition. “More and more work is done communicating the story of the transition,” Goodman said. The transition manager may identify three or four large events and explain the decisions that they took. “For example, this could be accessing liquidity through crossing or using index futures to hedge – did they add or subtract value?”
Clients will also want to see whether the processes that were established at the outset were actually followed. “Poor project management can cause costs and delays that are not captured in the implementation shortfall,” said Goodman.
“Clients are looking for more dimensions. They want to be able to assess whether the transition manager did a good job given the markets they were operating in. They want a lot of granularity and visibility into the underlying decisions, especially those that were different to the expectation at the pre-trade.”
The transition manager needs to be able to show to the client that at each stage the decisions they took at the time were objectively reasonable.
“Performance is important – but other things contribute to its success or otherwise,” said McGroaty. “Were there failed trades, overdrafts or other operational difficulties? Were the custodian and assets managers happy? Was it delivered on time? You might have great performance but if you have got these things wrong they might overshadow the performance.”
Inalytics, which is involved throughout some of the most complicated transitions, does a formal post-mortem with the client and transition manager after every exercise. “Performance is just one dimension of deeming a transition a successful. Clearly, there are all sorts of non-quantitative aspects that are absolutely vital to the smooth running of a transition,” said Dixon.
He said project manager’s role is essential as that person coordinates the custodian, other record-keepers, outgoing and incoming asset managers, the client and their advisers. “The project manager sits in the centre and how well they respond to events during the transition is absolutely vital,” said Dixon.
“If you have got the right project manager and s/he is surrounded by the right team, you are really in a good place. It is an area of competitive advantage. Sometimes we actually prefer individuals within organisations. It is equally as important as performance.”
CASE STUDY: Maintaining market exposure
A transition undertaken by Russell Investments on behalf of Nestle’s pension scheme shows how a transition manager can add value even while raising cash from an equity portfolio
Nestle’s corporate pension scheme needed to liquidate a European small cap equity component of a broader European equity fund on the platform. The aim, at the strategic European equity fund level, was to facilitate the 100% redemption from two European small cap portfolios at a specific month end to cover some immediate cash flow requirements.
The small cap exposure was a tactical bet within a broader European equity fund and one that the client wanted to maintain as long as possible. However, the liquidity profile of the small cap securities held meant that they could not all be sold into the month-end pricing point of the fund.
Nestle needed a transition manager that could design a strategy that ensured all securities would be liquidated by month-end, while maintaining exposure to the small cap element as long as possible, and ensuring the fund was fully invested if some of the liquidations had to commence well before month end.
Russell Investments analysed each of the portfolios and designed strategies that would keep the small cap exposure in place as long as possible. Where trading needed to commence prior to month-end (to ensure all securities were liquidated), in order to avoid any out-of-market risk all cash raised would be equitised with EuroStoxx 50 futures.
The redemptions were being made in euros, but it was recommended that any non-euro cash raised during the month be left in the local currency as the underlying currency exposures of each of the portfolios were a good proxy for the overall strategic benchmark. Keeping the local currency exposure helped to further reduce the overall tracking error relative to the strategic benchmark.
Russell Investments modelled trading by dividing the portfolio holdings into liquidity groupings and then devised a trading strategy to sell only the least liquid names first. Trading progress would then be tracked through to month end.
The transitions for both portfolios exceeded expectations:
- Full liquidation was achieved in the desired time frame
- The small cap bias and market exposure were maintained for as long as possible, minimising performance short-fall
- Patient and opportunistic approach to trading in the liquidations resulted in a small market impact even in highly illiquid names
- The actual costs were lower than the pre-transition estimates
“The best of all worlds outcome, importantly contained within the one standard deviation range of expectations, was most satisfactory,” said the spokesperson for Nestlé Capital Advisers. “Russell Investments demonstrated flexibility to engage on timing, strategy, simulations with futures and FX forwards and estimated liquidity of positions, such that the most appropriate strategy could be recommended for approval.”