The long-awaited T Charter sets the first standards for transition managers but falls short of requiring managers to disclose how much money they make from lucrative “pre-hedging” practices.
“It’s the easiest way to make money on Wall Street,” warned Nicholas Bonn, executive vice president for State Street Global Markets, the trading and research arm of State Street Corp., Boston.
To reduce transition costs, pension funds and other institutions often hire transition managers when they are terminating one manager and hiring another, or when they are changing target asset allocations. Some transition managers trade off their own inventory of securities. Those transition managers that do so can pre-hedge the trades by buying or selling securities ahead of the transition.
Sometimes pre-hedging can help a client. If the client needs a large supply of illiquid stocks, the transition manager can buy those securities at a good price in advance of the transition when there is a good opportunity.
Other times, pre-hedging can hurt the client. For instance, if a client wants to get rid of a certain stock, the transition manager may sell that stock off its own books ahead of the transition. That selloff drives down the value of the particular stock. Then the transition manager buys the stock from the pension fund at a lower market value, making a profit on the difference.
Some experts would like the standards to require transition managers to say how much they make from pre-hedging. T Charter requires a transition manager to “fully disclose all the sources of client remuneration received by the manager and/or its affiliated companies, whether paid explicitly in fees or other charges or earned implicitly through income sharing, rebates or trading revenue.”
However, the standard does not require the transition manager to disclose how much it makes from each source, including how much it earns from pre-hedging.
“There could be a tremendous amount of money they could have saved the client by not pre-hedging,” said Mark Keleher, global head and chief executive officer of Mellon Transition Management, San Francisco.
Another section of the T Charter does require managers to disclose when pre-hedging is contemplated. The charter states that managers must disclose the rate at which they are sharing revenue generated from pre-hedging with the client, but not the total amount the manager makes from pre-hedging.
This charter should require the manager to explain exactly how much they are pulling in from the pre-hedging, not just the rate at which profit is shared. Mr. Bonn explained. He said many pension funds might see the rate at which pre-hedging revenues are shared, but have no idea just how big those revenues are, both Mr. Bonn and Mr. Keleher said.
‘Out in the open’
Stacy Scapino, global director of Mercer’s Sentinel Group, a London-based specialist unit within Mercer’s investment consulting group, said that by forcing transition managers to at least disclose they are pre-hedging, it should minimize some of the pre-hedging that is bad for clients and should make clients aware they should put their own controls around pre-hedging when they hire the transition manager. “The T Charter brings it out in the open,” she said.
Still, experts said the standard — unveiled in October after three years in the works — represents a good first step in setting best practices for the burgeoning transition management business.
“All in all this is a great first start. It does not solve the basic problem of how people make money in this business. It’s up to clients to understand the issues and act in the best interest of their beneficiaries,” Mr. Kelleher said.
However, adherence to the T Charter is not a “Good Housekeeping Seal of Approval.”
“We’re supportive of the T Charter because it moves a bunch of people in the industry closer to the middle,” said State Street’s Mr. Bonn. “But just because someone signed the T Charter does not mean the client can avoid doing further due diligence.”
Those familiar with transition management and are not affiliated with a specific manager claim the charter did some important things.
The charter requires transition managers who abide by it to disclose potential conflicts of interest in their business.
It also sets guidelines for how a transition manager presents cost estimates and how that manager measures performance. “When a pension fund goes to shop around for a transition manager, they will be comparing apples to apples,” said Kal Bassily, managing director and global head of Bank of New York global transition management. “No longer can a transition manager low-ball the estimate.”
Guidelines on reporting the performance of the transition manager will also help the industry. Pension funds “can compare the actual cost with a pre-trade estimate to see if the manager performed how they said that they would,” said Rick Di Mascio, the CEO of transition measurement firm Inalytics Ltd., London, and the chair of the T Charter group. “We hope that by having a more informed client base it will continue to drive the costs of transition management down.”
