TACOMA, Wash. - Portfolio transition management services apparently have cost pension funds at least $21 billion more than expected since 1998, according to a new study from Frank Russell Co.
The study, which looks at the difference between cost estimates given to pension funds by transition managers and the actual costs incurred during the transition, found that on average pension funds wound up paying 99 basis points more for transition management services than the estimate predicted.
Those extra costs largely were due to performance slippage during the transaction, according to the study.
"This suggests that typical cost estimates have little relationship to the results that plan sponsors and money managers are likely to achieve," said Robert Werner, director of implementation services at Frank Russell and author of the study. Frank Russell is among the firms that offer portfolio transition services.
Transition managers help pension funds move assets from one manager to another, usually when a plan sponsor terminates a manager.
Frank Russell estimates that between 1998 and the beginning of the third quarter of 2001, pension funds moved roughly $2.2 trillion with the help of transition managers. Plan sponsors are moving more assets every year, according to Russell's numbers. In 1998, pension funds moved roughly $25 billion in assets. That number nearly doubled in 1999 to $43 billion. Through the second quarter of 2001, plan sponsors have moved $96 billion in assets.
The Russell study looked at portfolio transitions by more than 100 pension funds from the United States, Canada, Australia, the United Kingdom and Europe between the third quarter of 1999 and the first quarter of 2001.
Substantial gap exists
"The goal of this exercise was to see if low-cost estimates result in low-cost transitions for clients," Mr. Werner said. "Clearly they do not, and clients were generally unaware that such a substantial gap exists."
The biggest factor affecting transition management costs was performance slippage, or returns lost because assets were not moved as effectively as they could have been, Mr. Werner said.
A number of factors play into this lagging performance.
Transition managers often offer transaction-based benchmarks that compare the price at which the transition manager sells the plan sponsor's securities with the opening or closing price of the security that day or with the volume-weighted average price of the security during the day.
In the report, Mr. Werner said these benchmarks at best don't tell the whole story and at worst can be manipulated to make the manager look better - and sometimes earn the manager extra fees for beating the benchmark.
An example
Take a transition manager that uses the daily closing price as its benchmark, collecting an extra fee when it closes trades at "better-than-closing prices." First, it's easy to manipulate trades of large blocks of equities to beat the closing price. Say the transition involves selling 100,000 shares. The manager can sell most of them throughout the day at one price, then sell the remaining shares in bulk over a short time at the end of the day, driving the closing price down. The average price per share will beat the closing price, but only because the manager manipulated the stock using the plan sponsor's own assets.
The manager has beaten the benchmark, but the plan sponsor has incurred costs associated with performance slippage because the stock unloaded at the end of the day didn't fetch the price it could have had it been sold over the course of the entire trading day at a higher price.
Ross McLellan, vice president of transition management at State Street Global Advisors, Boston, said his firm does not use such transaction-based performance benchmarks.
"When we do it, we get a target benchmark for the client for the period and we measure how the performance of the portfolio was during the transition period," Mr. McLellan said. "If the client could snap their fingers and have all the assets transitioned instantaneously without incurring any costs, that's our benchmark. Any deviation is a cost."
Problem with crossing
Another big problem is what's known as "crossing." Some transition managers tout their ability to sell stocks that are part of a transition within their own index funds, often getting better prices and reducing trading costs. But the downside to crossing, Mr. Werner wrote in the report, is that after the stocks are sold, the plan sponsor gets an unwanted exposure to cash for a period of time during the transition, instead of earning returns from the stocks it eventually wants to own. Transitions can take anywhere from two days to two weeks to complete, depending on the complexity and the amount of stock to be sold and bought, Mr. Werner said. Because of the volume of stock to be bought and sold, it can't all happen at once, and some of the assets from the sold securities are held in cash during this time until they can be used to purchase new securities. So the apparently good sale prices aren't much help in the long run when the lost returns are factored in.
Many plan sponsors have been told by their consultants that the lowest-cost transition managers are the ones who have good crossing networks. That's not always the case.
In fact, the Russell report found that high levels of crossing almost always are associated with higher costs, not lower costs.
"While crossing would have provided benefits measured in basis points, the foregone returns due to unwanted cash exposure could easily be many times higher," Mr. Werner wrote. "Crossing should be utilized only in the context of minimizing the strategic mismatch between the starting and target portfolios."
Cheapest may not be best
When it comes to cost estimates, lowest isn't always best, Mr. Werner wrote in the report. To win business, transition management providers sometimes provide "very low estimates," it said. These estimates almost never correlate with the final cost, when performance slippage is included in the formula. A perfect correlation between the cost estimate and the final cost would be a 1.0, according to the report. Russell found a correlation of 0.13.
"The 0.13 correlation suggests that cost estimates typically have little relationship to the results transition clients are likely to achieve," Mr. Werner wrote in the report.
So what should pension funds do? Mr. Werner offers a list of considerations in selecting a transition manager:
* Have a transition management policy in place.
* Choose a performance benchmark that reflects the plan's overall objectives. Portfolio-based performance benchmarks include time-weighted performance vs. an index, which measures portfolio performance against the benchmark used to evaluate performance before the move; implementation shortfall, which compares portfolio performance during the transition to what it would have been had the transition been instant and at no cost; and time-weighted performance vs. the "legacy portfolio," or the portfolio as it was before the transition.
* Choose a transition manager well before the transition.
* Review candidate track records and business models.
* Ask for estimates of likely results of the transition and a range of possible outcomes.
* Carefully compare the results of the transition with estimates and ranges provided beforehand.
* Demand confidentiality and learn whether the candidate can provide it.
* Base the selection on a combination of the candidate's people, philosophy, capabilities, track record and referrals.
Above all, Mr. Werner said, don't suspend the overall portfolio's goals during a transition. Keep the same portfolio goals in mind during the transition that govern portfolio management during other times.
