By no means does this data conclude that the end of the month is always a more volatile time to move assets. However, looking at the data back to 1998, there is a pattern indicating that volatility for both the S&P 500 and Russell 2000 at the end of the month is higher than midmonth, despite the fact the gap has compressed significantly since 1988.
Establishing the strategy of a transition is very critical to the implementation process, especially when the transition involves actively managed portfolios with tracking errors that are significantly higher than those of passively managed portfolios. While the overall market volatility has compressed over the past few years, this strategy becomes all the more important when market volatility increases.
The timing of transitions affects not only the potential implementation costs of securities traded in the open market, but also the cost of those securities that a provider "crosses" internally. Many transition providers have argued plan sponsors should choose to execute at month end because crossing levels will be higher at that time because of potentially higher liquidity. It is important to remember, however, that higher crossing levels do not necessarily equate to lower implementation shortfall costs. Although crosses do not traditionally have commission or impact costs associated with them, they will absolutely have opportunity cost because most crosses are not performed at the benchmark price of T-1 Close. (T-1 Close is defined as the closing prices of the securities that constitute the transition portfolios the day before the first trade date of the transition. For transitions that trade over multiple days, the T-1 Close benchmark is also the closing price before the first trade date.)
Users of transition management services need to perform a cost benefit analysis in each case to determine the true tradeoff between crossing at trade date close and executing as agent in the market. A second analysis needs to be performed to calculate the tradeoff between liquidity and volatility. The predicted volatility and potential opportunity cost during the transition period becomes key as the transition manager attempts to determine whether the explicit costs accumulated through open-market transitions will outweigh the chance to mitigate opportunity costs incurred through crossing on trade date. The transition manager must clearly articulate all costs, and plan executives need to focus on the total implementation costs rather than on explicit commission costs.
As many of us have heard all too often, no two transitions are the same. It is therefore essential that transition managers provide a customized approach for each assignment with a strong emphasis on managing opportunity costs. It is well known that actively managed portfolios are a lot more complex to move than passive portfolios. It is crucial to schedule a transition during a period where one expects fewer crosscurrents and lower market volatilities. While it remains true that the market is highly efficient and no one can accurately predict market behavior over time, transition managers who draw on their experience and recent historical data to set a strategy in this way will, overall, make the best risk management choices for their clients.
Hari Achuthan is director, pension strategies & transition management, at Credit Suisse Group, New York.