Assets are often on the move. Every time an asset moves there are costs and risks involved.
What is a Transition?
An investor’s investment strategy may need to be enhanced by changing the long-term Strategic Asset Allocation (SAA) i.e. the mix between equities, bonds, property and cash or taking advantage of short-term market trends and thus changing the Tactical Asset Allocation (TAA). Market movements could have caused the asset allocation to move away from its strategic targets or optimal mix and thus rebalancing may need to be implemented to reinstate the ideal long term asset mix. Another example is where the investor may need to terminate an investment manager and appointed a new investment manager and such a decision also leads to a transition.
Independent of the reason, each of the above situations will require assets to move either from one mix of asset classes to a different mix of asset classes or from one investment manager to another or potentially even to simply change the mandate of an existing investment manager. This change of state does not occur immediately and much like the caterpillar goes through a transition phase to turn into a butterfly, the assets of an investor goes through a transition phase (or transition for short) in order to change from the old state (the legacy) into the new state (the target).
Changes that may result in a transition:
- Changing the long-term Strategic Asset Allocation (SAA);
- Changing the short-term Tactical Asset Allocation (TAA);
- Rebalancing back to the SAA;
- Terminating or appointing investment managers;
- Changing an investment manager’s mandate;
- Facilitating large contributions or withdrawals;
- Changing the structure of an investor i.e. as an example, moving from defined benefit to defined contribution;
- Movements of members between low, medium and high risk Life Stage / Risk Profiled solutions;
- Taking profits from one investment manager and buying into the dips when market valuations are lower;
- Rebalancing a Liability Driven Investment (LDI) strategy i.e. taking profits from the Growth assets and allocating such to the de-risking assets;
- Changes due to the merger of retirement funds;
- Major changes to investment strategy or objectives.
What is Transition Management?
The concept of a transition is simple, but the management of a transition is not easy. Strategy is easy, implementation is hard and complex.
Let’s discuss one of the examples noted before in more depth. A transition would be required where an institutional investor decides to terminate one investment manager and appoint another. The underlying investment portfolios of these two investment managers are usually different. The one investment manager may hold MTN, SAB and Naspers whereas the other holds Implats, Standard Bank and Sasol. The investment portfolio will therefore have to transition from the old (or legacy) portfolio of MTN, SAB and Naspers into the new (or target) portfolio of Implats, Standard Bank and Sasol. It is key that such a transition is conducted as cost effectively and as transparently as possible whilst managing all the risks in the process.
How will this transition be effected? Should the investor hand over the portfolio as is to the newly appointed investment manager and start monitoring performance immediately? Should the investor potentially provide the investment manager with a “performance measurement holiday” i.e. the investment manager will only be monitored and measured once the portfolio is in line with his ideal portfolio? How much time will this take and what cost will the retirement fund occur along the way? Alternatively, should the terminated investment manager start aligning the portfolio on behalf of the newly appointed investment manager? Will the newly appointed investment manager be willing to share his ideal / model portfolio with the terminated investment manager? Maybe the terminated investment manager should just sell all the assets and transfer cash to the newly appointed investment manager…but what if some of the assets overlap and the same assets are then sold and then bought back again?
As you can imagine, it could be a very gray area to know where the responsibilities of the terminated investment manager ends and where the responsibilities of the newly appointed investment manager begins.
Transition Management is the transparent and cost effective project management of this transition phase to ensure a central point of communication to all stakeholders, the non-slip operational management of moving the assets from one place to another and the tight control and management of costs (direct and indirect) as well as risks relating to the transition of the assets. It’s a specialist function so don’t just think one of your investment managers can just do it. Do your homework and make an informed decision to ensure the process is well managed, fully transparent and cost effective.
According to our own experience of conducting transitions over the past 15 years and a survey conducted by Global Investor, the most important consideration when selecting a Transition Manager is the ability to manage costs.
In our previous GraySwan article “The effects of cost-drag on investment performance” we explain the importance of cost management. Just as performance compounds over time to your advantage, so too can costs (causing the lack of performance) compound over time to any investor’s detriment. Cost-drag, which is the loss in performance due to costs, can put a retirement fund on its back foot after a poorly managed transition, which may take years to recover in the current low return environment.
Costs incurred during a transition can be broken down into direct costs (such as brokerage, taxes and levies) and indirect costs (such as opportunity, implementation and market impact costs). Although direct costs are important to manage, the often forgotten and hidden indirect costs can be the majority of the cost of a transition to the fund.
Investors should therefore keep a keen eye on implementation shortfall which is a measure of total transition costs including both direct and indirect costs. In another article in our series of transition management articles we will expand on the details of calculating the implementation shortfall. Suffice to say for the moment, it is the difference in performance of the actual portfolio and the performance of the new portfolio had the investor been able to change his portfolio immediately at no cost.
Most investment managers can calculate their own transition costs but will typically not be able to provide a fully transparent and documented process outlining all the different costs of the total transition and how the costs were managed and minimised. The Transition Manager provides the required transparency of the entire transition process.
Parties involved in the Investment Process
There are many different parties involved in the transition process.
Strengths and Weaknesses of Different Parties
Each of these parties have a role to play during a transition, but each have their strengths and weaknesses. The Transition Manager pulls all of the parties together, manages the entire process and ensures all lose ends are tied post the transition i.e. reporting the results to the fund, the administrator and the auditors.
|Investor||Investment Manager||Fund Custodian||Stockbroker||Transition Manager|
|Costs||Able to manage direct costs, but generally don’t have systems|
and strategies to manage indirect costs.
|Usually requests a “performance measurement holiday” while effecting a transition. Costs incurred are not always reported on in a manner which provides the investor with adeqaute insight|
into the success of the transition.
|Enables effective movement of assets from different accounts and ensures settlement of trades and cash movement.|
are usually per
|Ensures trades are carried out at best execution and|
that individual trades are planned in terms
of timing, liquidity and market
|Has a complete portfolio overview and focuses on both direct and indirect costs. Costs are reduced by using specialist strategies and
best of breed stockbrokers.
|Transitions are done infrequently and therefore the fund generally does not have|
the specialist Transition Management skills in-house.
|Capable of the transition of their individual portion of the transition but will not have an overall fund view to man-|
age risk taking into account the overall fund asset allocation and benchmark.
|Specialists in the administration of corporate actions, movement of|
scrip and cash and settle- ment of trades.
Not focused on managing the overall fund risk.
|Specialists in trading stocks, finding liquidity and reducing mar- ket impact costs but generally|
not focused on managing overall fund risk taking into account the overall fund asset allocation and benchmark.
|Specialists in overall fund risk manage-
ment and project management reducing gray areas and making sure costs and risks are reduced to a minimum.
|Systems||The Fund might have access|
to market information through terminals such as INET, Bloomberg or Reuters but generally do not have access to specialist transac- tion costs analysis and risk manage- ment software.
|Access to market information through terminals such as INET, Bloomberg or Reuters and transaction costs analysis and risk management software. How- ever, analyses are generally done|
on investment manager mandate level and not overall fund level.
|Access to market information and transaction risk management software. However, analyses are generally done on instrument or stock level and not overall fund level.||Access to market information through terminals such as INET, Bloomberg or Reuters and transaction costs analysis and|
risk manage- ment software. However, analyses are generally
done on trade level and not overall fund level.
|Access to market information through terminals such as INET, Bloomberg or Reuters and transaction costs analysis and risk management software.|
or stockbrokers or
but not with
the fund or its
|Have good work-|
with the fund
or custodian or
with the fund,
Each of these parties in the table above are key during a transition with definite strengths. However, there are times where it is difficult to know where the responsibilities of one party ends and the responsibilities of the next party begins which creates gray areas and potential bottlenecks or even stops in the process.
Transition Managers are expert project manager who step into the gray areas and makes sure the right parties are called upon at the right moments and the process runs smoothly without stoppages. The Transition Manager sees the full picture while the other parties may only see a portion which makes it easier for the Transition Manager to manage risk and report on the entire transition.
Motivation for using a Transition Manager:
- Good relationships: A major influence on the effectiveness of any transition is excellent communication skills and relationships with all stakeholders.
- Cost Management: The Transition Manager will have all necessary risk procedures and internal processes in place to minimise the risk of direct or indirect costs or loss to the investor.
- Risk Management: The Transition Manager will conduct a pre-trade analysis to determine the best strategy to follow to minimise risk during the transition.
- Administration: The Transition Manager will be able to in conjunction with the administrator collect FICA documentation, open bank accounts, ensure contracts and mandates are in place, instruct the movement and trading of assets and in a fully transparent manner account for all asset movements and reporting.
- Expertise in Managing Transition Projects: A Transition Manager has developed specialist project management skills and experience in managing transitions from a total fund perspective.
- Systems: Most Transition Managers make use of a combination of off-the-shelf and proprietary risk and performance measurement and cost attribution systems all tailored to a specific transition process.
- Reporting: The Transition Manager produces a Pre-Trade Report detailing the risk management strategy for the transition and listing direct and indirect cost estimates. During the transition the Transition Manager conducts daily recon and risk reports. A Port-Trade Report is produces after the completion of the transition detailing the success of the risk strategy and comparing the actual costs experienced with the pre-trade estimates. The Transition Manager also produces Audit Reports to the investor’s Auditors where every asset is accounted for and tracked throughout the transition process.
Transition Managers and independence
As previously discussed, the Transition Manager is a project manager and central point of contact for several different parties. The most efficient Transition Managers would therefore be independent and without prejudice towards any of these parties.
Some of the other parties identified previously could also offer transition services, however that will open the door for conflicts of interest.
If the Transition Manager is part of a group of companies that include a stockbroker, he might be tempted to trade through his own internal stockbroker at higher brokerage even though that stockbroker might not be the best equipped to execute the transition.
If the Transition Manager is not independent from the investment manager he might be tempted to pay higher brokerage in order to gain access to research from the stockbroker that is not necessary during a transition.
If the Transition Manager is also the investment consultant making the recommendation to change the investment portfolio which then necessitates a transition, he might be tempted in recommending changes to investment portfolios that is not necessarily beneficial to the investor.
Non-independence opens the Transition Manager up to a host of potential conflicts of interest. In another article in our series on Transition Management we discuss guidelines for choosing a Transition Manager. In that article we further explore all the factors and risks to keep in mind when comparing Transition Managers.