Moment of transition

Transition managers have faced a triple whammy as the credit crunch increased cost pressures, counterparty risk aversion and illiquidity forcing many to rethink non-core businesses.

Concentration of talent and strength in fewer, more stable players is arguably another forward step for an industry already working to improve its reputation. Following the T-Charter's success, attention has turned to performance measurement, where weak due-diligence continues to challenge pension funds.

"Two years ago transition managers, of varying quality, numbered about 20," said Inalytics chief executive Rick Di Mascio. "That has halved as some peripheral and some very credible players have left."

Investment banks in particular have been exiting transition management, traditionally a natural complement to their trading capabilities. UBS, RBS, Citigroup and Lehmans all shut or scaled back operations in recent months after initially entering the market to capture additional trading flow.

"Transition management wasn't core to many investment banks' businesses," explained Mercer Sentinel Group's European director, Ben Gunnee. "Many were forced to re-examine bottom lines and cut less-profitable areas.

Simultaneously, illiquidity and high volatility meant pension funds postponed restructuring portfolios. Uncertainty about market direction and future asset allocation exacerbated this inertia. Transition flow, therefore, declined significantly, further pressurising costs.

According to Di Mascio: "Pension funds are now looking to providers who can implement portfolio changes in a very difficult environment, requiring significant access to trade flow and excellent management."

Manager performance
One advantage of the tougher environment is that it has helped pension funds to distinguish between good and bad transition managers. In previously benign markets most providers could perform reasonably well.

"When things got tough," Gunnee said, "it really showed the quality of providers' technical development and market know-how, demonstrating which were long-term players with the underlying strength and performance. It has cleaned the decks as, largely, it was those lacking strong value propositions that have left the industry."

As well as delaying transitions, State Street's senior managing director and head of EMEA portfolio solutions group Edward Pennings, argued one-stop-shop investment bank models became increasingly unpopular as concerns about counterparty risk caused a flight to the relative safety of fiduciary agency providers.

Investment banks, while very strong at executing transitions, may have suffered as pension funds, spooked by market turbulence and uncertainty, placed greater emphasis on management expertise.
"This may be harsh, but it is not untrue," argued Pennings. "Some stronger agency providers have, however, been able to attract excellent ex-investment banking talent whose strengths are often in trading. This is an essential skill, making survivors' offerings even stronger."

John Minderides, global head of JP Morgan's transition management business, defended the investment banking model. "The investment banking model is still a good one. The problem with some investment banks was that they ran their businesses within silos, so it was hard to see the benefits of TM to the firm as a whole," he says.

Di Mascio agreed the shake-up had increased the concentration of talent: "The experience is now in stronger, more stable homes," he said.

However, the demise of some investment bank models has reduced choice for pension funds, who benefitted from a higher degree of visibility and control. "The lack of third parties reduces the risk of lack of connectivity during the process," Gunnee argued.

Minderides warns: "It is quite easy for clients to believe they are going to get a better service out of asset managers, but are asset managers actually delivering better service?"
For survivors, at least, things appeared rosy. Many have invested to meet the increased capacity needs of less competition and an influx of pent-up demand.

"The strong got stronger as those who survived have found they are getting an even bigger piece of the pie," Pennings said. "There may still be one or two providers in the process of rethinking their commitment, but overall there is still enough competition for pension funds to choose from. Eight months ago the top providers were probably doing 90% of transitions anyway so, in effect, the industry has just focused on those who were more committed. They are subsequently better able to invest and improve their future service."

A cautious approach
Pension funds, however, still need to exercise considerable caution when appointing transition managers given uncertainty around short and long-term asset allocation, strategy and manager selection. In addition, dislocation in fixed income markets markedly increased trading costs during the last nine months.

"There has been some reversion as markets stabilised," BGI's head of transition management in Europe Lachlan French said, "But the environment of increasing costs and fast-moving asset prices underlines the importance of managing costs and moving quickly."

Managers' ability to understand and think through trading strategies in different scenarios has become paramount.

According to Gunnee: "Even the best transition strategy is nothing without good execution. Managers must be able to adapt and alter trading as markets move. They have to be on top of developments and have processes and technology for implementing changes quickly."

But, while the need for greater understanding of transitions increased, pension funds faced a significant knowledge gap. Individual funds perform transitions relatively infrequently, particularly in individual asset classes. Markets and providers have likely changed between projects.

While some schemes have ongoing relationships with managers, transactions are usually awarded on a per-project basis, resulting in a lack of accumulated or ‘legacy' knowledge.

"Trustees either forget what they learned from previous transitions or the experience isn't relevant," Di Mascio said. "This is an inherent problem."

Some larger funds have developed manager panels with whom they have established relationships. "When the fund requests bids," Di Mascio says, "The managers have a vested interest in taking a serious and honest approach. It makes sense for everyone."

Introducing the T-Charter
In 2007, the T-Charter was developed to overcome legacy knowledge gaps. It introduced a widely-embraced code of conduct for transition managers.

Previously, managers used different assumptions, methods and terminology to arrive at pre-trade estimates. Comparing bids required considerable further examination and understanding by schemes. The code standardised pre-trade estimates and post-trade reporting, allowing comparisons to be more easily drawn. It effectively removed a layer of analysis, improving due-diligence.

However, pension funds still need in-depth understanding, French warned, as so many factors beyond managers' control can affect final results. "Particularly in volatile, rapidly-changing markets, pre-trade estimates can look very different from one day to the next and will vary significantly depending on the time period of the underlying volatility and volume data."

Pre-trade estimates account for various different explicit and implicit costs, such as tax commissions and bid-ask spreads. An ‘opportunity' cost is also included, measuring the impact of trading time-lags by comparing the existing and target portfolio performances. Volatility and other market factors can result in actual costs varying considerably from pre-trade estimates.

Managers' performance is currently measured by looking at actual versus estimated costs. Pre-trade estimates are, however, given to within one standard deviation, allowing a 30% margin-of-error each way.

"The current system is not adequate," Gunnee said. "Overnight gap risk and the ability for a transition manager to specify the range of opportunity costs makes it difficult to judge if the manager has done a good job, which is further complicated by the lack of an independent measurement."

Pension funds are also not able to check the likely accuracy of pre-trade estimates given an absence of performance statistics. "Lack of legacy knowledge coupled with no track record data is a dangerous cocktail," Di Mascio explained.

"It is logical to create an industry-wide database to compare results," he added. "In most other areas of investment, schemes conduct due-diligence by reviewing track record. The lack of data for transition management means due-diligence is relatively weak compared to other governance processes."

Record of achievement
Discussion has begun regarding a performance database to differentiate between managers and disadvantage those who under-bid to win business.

The debate focuses, again, on the causes of the knowledge gap: no two transactions are the same; each manager would have to conduct a significant amount of activity in each asset class; and variables outside of managers' control affect the eventual outcome.

According to Pennings: "If a manager did a significant number of transitions a year the data would be very interesting, but its relevance would be questionable if a manager only did ten transactions all in different asset classes.

"Furthermore," he added, "Recent transitions would likely produce wider standard deviations than a year ago versus pre-trade estimates given extreme volatility. If a transition was slightly over cost, the manager may still have produced an excellent result, but could have been unlucky with the opportunity cost."

Gunnee argued, however, the real skill of managers, lay in minimising the opportunity cost and getting the existing portfolio to perform as close as possible to the target portfolio's benchmark return. "Having ant industry-wide performance database for transition management would be fairly complex, but is essential for the evolution of transition management," he said.

Transition managers seemed to unanimously agree a database would be positive. "This is a good initiative," Pennings said, "but further debate is probably necessary about how to compare like for like and ensure all data gets included."

If a database were introduced, schemes would still need to do considerable due-diligence on those statistics in order to ensure a correct interpretation.

"There has been a cleaning-up of the transition management industry and the survivors are those who view it as core to their business, have and continue to invest in growing and improving their offerings and are therefore doing the lions-share of the work," Pennings concluded.

"It is, however, still very important for pension funds to fully understand the process, carry out detailed due-diligence and carefully examine managers' businesses and risk models."