Issue: July/Sept 2010
Back to basics 3
Ups and downs of transition management
What it means and why its so important to pension funds, especially for reasons of cost. Jaco Maritz and Deon van der Merwe of Cadiz Securities explain, and sell hard the case for specialised professionalism.
Maritz...less stress, less cost
Although transition management has been around for years, many trustees are often unfamiliar with the ins and outs. They should know what a transition is, what a transition manager can do for them, and how to judge the managers performance.
What is a transition?
Whenever a pension fund requires a change in its portfolios, it implies a movement of assets. This is a transition. It has many forms, for example when:
Moving house can be stressful, but a professional removal company can spare unnecessary costs and ensure a smooth relocation experience. The same applies to transition management.
Tale of two transitions
Once, there were two identical pension funds (one called X, the other Z) each at the same time wanting to perform identical transitions because of a change in equities manager. X decides to contract (on recommendation of its investment consultant) the services of a professional transition manager, while Z wants to save on fees and requests its consultant to arrange the move.
The transition manager for X immediately contacts the terminated and new fund managers to obtain current holdings (initial portfolio) and a wish list (target portfolio). She then compiles a pre-transition report for X to consider, including a risk analysis, liquidity analysis, and a transition plan with a time-line. Her analysis reveals a 50% in-kind component; hence 50% of the initial portfolio can be retained as is for the target portfolio. She also quotes a discounted brokerage rate, and all fees and other costs are explicitly estimated.
The consultant of Z reluctantly agrees to perform the transition, knowing that he is venturing into rather unknown territory. He also requests the current holdings. Instead of
obtaining a wish list from the new fund manager, he sends the current holdings to the new fund manager.
In the e-mail he asks the fund manager to keep the portfolio contents confidential, but to pick out what he wants for his portfolio. The consultant duly sends a list of unwanted assets back to the terminated manager, with the request to sell them and transfer the cash proceeds and remaining assets to the new manager.
Meantime, the transition manager opens special accounts at Xs custodian bank and arranges for transfer of the terminated portfolio into these accounts. She then coordinates the transition trading so that the risk of underperforming the new portfolio is minimised.
This is done by ensuring that the portfolio remains fully exposed to the equities market. She gives special attention to various risk-management considerations, such as matching asset allocation to the target portfolio, the liquidity of assets and the timing of trades.
Xs trustees get regular updates on the progress of the tran sition, and the portfolio is valued daily. To their delight, the trustees learn that the portfolio was entirely exposed to the equities market which had risen by 6% during the period when the transition trading took place.
At the same time, the terminated manager of Z managed to sell the last unwanted share, a pesky holding of an illiquid small cap for which buyers werent readily found.
Unfortunately, because Zs portfolio was only50% exposed to the equities market during the liquidation effort, it now lags Xs by atleast 3%. Finally, the terminated manager transfers the portfolio to the new manager, who then starts the process of purchasing the required equities to complete the portfolio.
The transition manager for X delivers the complete target portfolio to the new manager, with precisely the assets in the correct proportions as required in the wish list. In the post-transition report, the brokerage costs, taxes, and bank charges are explicitly accounted for. The performance of the portfolio during the transition period is calculated, and the implementation shortfall (a measure of transition performance) is reported.
The consultant reports to the trustees of Z that no costs were incurred during the transition. Zs board notes that all the assets and cash were transferred to the new portfolio, including the last bit of interest and dividends earned. When some trustees ask whether the fund benefited from the rally in the equities market the previous month, the consultant shakes his head: It was the opportunity cost of moving the portfolio. The new manager will quickly make up the costs.
An astute trustee of Z asks whether the information leakage of the portfolio shown to the new manager prejudiced the fund. The astounded consultant had never considered such a possibility. Another trustee wants to know how much this transition had cost.
The board of Z instructs the consultant to compile a full report, showing all charges including opportunity costs. His analysis reveals that the fund paid 37,5 basis points (0.375%) of the portfolios value on brokerage fees and taxes. Added to the loss of performance, the total cost was 337 basis points.
When the principal officers of X and Z meet, they compare like for like. The principal officer of X points out that the cost for his fund came to 27 basis points in direct fees and 15 basis points in opportunity cost, making for a total implementation shortfall of 42 basis points.
Not only this, but X also got full disclosure of all trades and regular feedback as well as a complete post-transition report. One party had controlled the entire process.
Oh dear, says principal officer Z. Wed thought the do-it-ourselves method would spare us headaches and save us costs.