What is transition management?
Transition management is a short-term asset management service which aims to preserve portfolio value and provide accountability during periods of sizeable investment change. This could be triggered by changes to the manager structure, strategic or tactical asset allocation changes, rebalancing portfolios or super fund mergers/de-mergers and so on.
The rationale for choosing a Transition Manager (TM) shares many of the same criteria used to select brokers within the conceptual framework of best execution. An examination of the priority placed on each of these factors can help asset owners identify the type of TM they should appoint to achieve best execution of the entire transition mandate.
What is best execution?
When brokers take customer orders, they assume a responsibility to obtain ‘best execution’. Unfortunately, best execution is not well defined and can mean different things to different people. No single criterion covers every investor and different factors will take priority based on the particular circumstances of the trade. Determining whether a trading strategy has achieved best execution requires a high level of transparency and scrutiny which has led to a growing number of transaction cost analysis (TCA) platforms. Underlying these solutions is the basic premise that ‘you cannot manage what you do not measure’. This philosophy is also at the heart of the transition management industry in terms of how costs and risks are identified and managed during portfolio change events.
Asset managers are required to consider a range of qualitative and quantitative factors and must establish criteria to assess the relative importance of these factors.
Criteria to consider when choosing a TM:
1. Best price / lowest cost
Any period of portfolio change exposes a portfolio to potentially major costs and risks, whatever the motivation may be for the transition exercise. If left unmanaged, these costs can serve as a significant drag on long-term performance that may compromise or diminish the original investment rationale behind the change.
Costs can arise every time assets are transacted or moved between portfolios. Sources of transition cost will include both those that are explicit and those that are implicit.
TMs can employ a multitude of strategies to reduce these costs during a transition that will include in-specie transfers; maximizing in-kinds (identifying and retaining any fixed income securities with similar characteristics to the target rather than an exact match); crossing; and hedging using a wide array of instruments.
The TMs own fee (commonly incorporated in the broker commission or as a separate management fee) is also an obvious component of the overall cost, but it is often the tip of the iceberg. Transparency, as always, is key. Hidden revenue sources and costs will result in underperformance even if the implicit costs such as market movement and impact are materially larger (which is frequently the case). Careful consideration and understanding of a TMs model and expertise in controlling these costs and providing this transparency is required to achieve the best outcome.
2. Speed of trade completion
If speed is of the essence, an investor may opt to incur higher execution costs in order to complete required transactions swiftly. If execution cost minimisation is the primary objective, the investor may elect to reduce disturbance on the market by phasing the acquisition over an extended period, perhaps over several hours, days, weeks or months even. However, the longer it takes to complete the trade, the more an investor is exposed to potential adverse market moves unrelated to their own trading behaviour.
When an asset is acquired over a period of time, this performance impact may be far greater than the cost of fixed fees and taxes. The ideal outcome that represents best execution involves a strategy which strikes an optimal balance between cost and risk (as represented by the “optimal frontier”), subject to an assessment of the investor’s preference and sensitivity with respect to timing. Poor implementation or communication risks trading occurring at a different point along the theoretical curve, or even above it – meaning an unnecessary cost or risk has been incurred by the investor without any corresponding benefit.
3. Minimal information leakage
The speed with which trading takes place is one factor in determining the market impact but it is not the only one and different TMs will leave different footprints in the markets. Activity and volatility in a stock may be expected to increase after a large trade as the information is revealed and digested by the market, however if this volatility appears before trades are executed, it suggests that other market participants were aware of sensitive pre-trade information. Brokers that send out Indications of Interest (IOIs) to asset managers and other market participants hope to generate crossing opportunities, but in doing so risk revealing sensitive information. This potential leakage of information could harm returns. TMs generally operate on the private side of information barriers to other parts of the firm in order to further restrict leakage.
There are ways of mitigating and removing this information leakage and the larger and more illiquid the required trades are, the greater the importance of doing so. IOIs for instance can be formulated to limit sensitive information on the position and TMs that are part of much larger entities are often able to mask their trading by incorporating it into the trading activity of the wider business. The anonymity gained from this means the market is often unaware that a transition is underway. Judicious selection of trading venues, utilisation of block desks and trading algorithms are also effective tools in a TMs arsenal.
Splitting a trade out across multiple counterparties has the potential to either help or harm the execution and TMs must use their judgement and expertise to understand which is likely to be the case for a particular trade. In many instances, trading smaller amounts with a number of counterparties will result in better prices and less market impact, but this will not always be the case and TMs need to be able to justify their decisions to demonstrate they have achieved best execution throughout.
4. Access to liquidity
Liquidity can be likened to oxygen – you only notice it when it’s gone. Post GFC, markets have adapted to changes due at least in part to regulatory reforms intended to enhance the safety and soundness of the global financial system. Monetary policy, record new issuance, and financial regulatory reform have contributed to reduced dealer inventories and lower bond turnover for fixed income. As a result, bond trading has migrated to more of a hybrid principal/agency model. Agency trading, in which buyers and sellers are located and matched by banks and broker-dealers, has played a more prominent role as opposed to facilitating trades more through principal risk taking. In equities, the rapid growth of dark pools such as ASX’s Centre Point, has seen liquidity move away from existing ‘lit’ exchanges.
With liquidity becoming fragmented in recent years, a good TM must use a variety of trading venues and counterparties to ensure that they can aggregate the available liquidity to increase the likelihood of filling an order and trading at the best possible price. Having a multi broker model, using electronic and advanced algorithmic trading and substantial ongoing investment in technology all contribute to ensuring sufficient access is available in a range of market conditions. The use of ‘all to all’ trading technology also provides for better liquidity and creates a greater variety of opportunities to trade a portfolio, including allowing buy-side firms to act as price makers rather than price-takers from a dealer.
The changing market structure also means that building portfolios solely with individual securities is increasingly costly and less efficient than in the past, leading investors to employ a range of instruments both as part of their long term strategy and transition arrangements. ETFs and futures in particular are valuable assets in meeting the market’s needs. Historically, futures contracts have typically been used to gain exposure, but due to the maturation of the ETF market over the last five years, liquidity has deepened considerably and spreads have tightened to the extent that total cost of ownership evaluations can show they offer an optimal solution (even for fully funded investors), via superior tracking error, lower costs and / or improved liquidity.
Exposure can be obtained through ETFs, futures, total return swaps and options. Each of these vehicles have differing liquidity levels, costs and associated risks, meaning TM’s must carefully consider on a case by case basis which is more appropriate to establish the desired level of benchmark exposure.
5. Trustworthiness and integrity
The reliability of counterparties has always been a key factor when considering who to trade with and these concerns are amplified when managing transitions due to the scale and sensitivities involved. An execution provider could offer the lowest fees and fastest execution but if there are concerns around their business model and cost structure transparency, they’re unlikely to be selected.
Well publicised revelations from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry have revealed multiple cases of poor conduct and client interests taking a back seat. In most cases, this has been the result of an unmanaged conflict of interest, something that a well-structured TM model should take care to avoid.
A core divide for TMs is whether they act as principal, transacting largely with their affiliates and acting as counterparty on the trade, or as an agent, with a panel of brokers used to access the most favourable combination of liquidity and price. TMs acting as principal trade securities on their own account which creates opportunities to subsidise transition fees through the additional revenue generated elsewhere in the chain (such as. from generating flow). The industry code of practice, the T-Charter, states that TMs should ‘disclose all sources of remuneration’ but it’s prudent to understand whenever the provider or an affiliate acts as principal and may be generating additional revenues.
Detailed and transparent reporting at all stages of the transition will also help asset owners to confirm for themselves that their interests are being put first. This is particularly important when trading asset classes such as FX and fixed interest where a centralised exchange does not exist to provide transparency. With the right checks and balances in place, either model is capable of producing good results for asset owners, but conflicts of interest must be identified and managed in order to ensure divergent incentives do not arise. A transparent charging structure and fiduciary mind-set are key to ensuring the TM acts with honesty and that their interests are aligned with their clients.
6. Enhanced operational and technological support
A robust TM process requires both experienced professionals and technology. Integrated investment technology enhances the quality of large volumes of data, supports consistent investment workflows and enables timely communications with both internal functions and external parties.
As transition activity becomes more complex and covers an ever-wider range of asset classes, geographical markets and fund structures, it’s imperative that TM systems keep pace. A TM running a transition on a rudimentary platform or using different systems across asset classes increases operational risk and is unlikely to provide the same level of service to asset owners as one with a more integrated and sophisticated approach.
Performance in terms of execution will always be important, but TMs are also required to co-ordinate stakeholders and act as project managers. The ability to provide these services in a robust manner and to act as a partner to the asset owner is often a primary consideration in appointing a TM.
There’s never a guarantee that a transition will run smoothly. However, by acting in a prudent and systematic fashion in the selection of their TMs, the asset owner can maximise the chance of success. This requires a full understanding by the asset owner of each TMs strengths and weaknesses and which is best suited for a particular type of transition.
As the concept of best execution evolves across the wider market, it will be informative to note the extent to which these developments are applied to the transition management business and the selection of these managers by asset owners. Transition trading decisions can be driven by circumstantial and complex factors, rendering it difficult to objectively demonstrate best execution. TMs must therefore establish trading processes and disclosures that together form a meaningful approach to seeking best execution for clients. Only by doing so can they consistently demonstrate that the execution of a transition mandate has been carried out in the best interest of the asset owners.
Important notes
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