Institutional investors spend a great deal of time assessing their strategic choices and investment managers in order to maximize portfolio returns relative to risk taken. This review process leads to periodic changes in investment manager lineups and transitions to new managers from legacy mandates. Too often, though, investors don't spend enough time understanding and managing the transition costs and risks.
These costs are not easy to identify (especially in advance) and, as is said in so many business contexts, what is difficult to measure tends not to get managed. However, there's no question that firing one manager and hiring another will incur expenses — with some expenses being a lot less visible than others. Specifically, there are some transition cost issues you should consider, for both equities and fixed income, before making a manager change.
As institutional investors know, no two actively managed portfolios are exactly alike. Even two passively managed portfolios can have differences. Inevitably, security purchases and sales will form part of a transition, and central to that process is market liquidity, or the ability of assets to be bought or sold without causing a significant movement in price and with minimum value loss.
The basic challenge in a transition is how to move from the current allocation to a new investment structure while minimizing costs incurred and managing the risks involved. So it's worth reviewing how trading costs could be divided into direct, indirect and other components:
- Direct costs are the visible components of a transfer, and include brokers' agency fees (commissions) paid to those who perform the trade; taxes and stamp duties; and any fee paid to a specialist transition manager, normally charged on a project basis.
- Indirect costs are less obvious but typically exceed direct costs, often by a substantial margin. The main examples are bid/offer spreads, or the difference between the price at which market participants will buy and sell a security, and market impact, or the degradation of the prevailing prices caused by one's own actions. Impact occurs because the very act of trading large quantities (relative to the security's normal trading volume) of a particular asset in a short period — or even declaring a desire to do so — can have a detrimental effect on market prices.
- Opportunity costs are the degradation of the prevailing prices caused by the actions of other market participants. If exposure risks are not managed adeptly, unpredictable losses or gains can occur, especially if trading takes place in volatile markets. An extreme case of opportunity costs is out-of-market costs, or return lost due to not being fully invested in the desired asset class.
- Administrative expenses complete the cost picture. These include the time spent by fiduciary committees working through the merits of a manager switch, any adviser fees paid to assist in the due diligence of replacement candidates, negotiation of new contracts including legal fees, rewriting of fund documents and marketing materials, communicating with stakeholders about the change, and custodial fees associated with securities movements.
The volatility of today's markets, together with the availability of dedicated transition management services, means that, even for small plans, the engagement of a specialist manager will frequently be worth considering. The transition manager's role is to take responsibility for the coordination and execution of the entire process and the results. In part, this is achieved by adopting a project management approach that includes procedural safeguards and employs specialized risk-monitoring tools during the trading process.
Because no two transitions are identical, whether it is advisable to employ a transition manager will depend on the mandate's characteristics: the complexity of the restructuring; the difficulty of the trades involved; the absolute size of the portfolio concerned; and the value at risk from market volatility. As a broad rule of thumb, we believe that if two or three of the following factors apply, it might be worthwhile to engage a specialist provider:
- The total transaction volume (purchases plus sales) is in excess of $50 million;
- The transition is complex, involves asset class shifts or has operational demands such as daily valuation;
- The investor lacks experienced and qualified internal resources to effect the restructuring;
- Allocation decisions or settlement cycle differences mean out-of-market risks will be elevated; or
- Investor tolerance for out-of-market risk is low.
For a transition manager, a key to achieving optimal implementation is the ability to assess and use a broad range of trading strategies, which might include internal or external crossing (matching order flows in opposing directions), agency trades (regular trades through a broker) and/or principal trades (where the dealer guarantees execution on a pre-determined basis). Using exchange-traded funds or derivative overlays is a common best-practice to manage market risk. The particular trading strategies adopted will differ by transition and will be affected by market structure, the availability of liquid-hedging instruments, and current market conditions.
In today's investment world, the demand for transition management services is likely to increase, as institutional portfolios become more diverse in asset types and more global in exposure, while market trading environments become increasingly complex. It is worth noting that, although specialist transition management had its origins in equity trading, it has a rapidly growing presence within fixed interest markets, such as certificates of deposit.
Importantly, there are analytical approaches for measuring a transition manager's performance. The most widely accepted is “implementation shortfall” analysis, which compares the target portfolio's performance against the actual transition holdings' performance during the transition period. This method captures both direct and indirect costs because it shows the aggregate portfolio gain or loss during the transition period compared to the theoretical value of the portfolio had an instantaneous, cost-free switch into the target portfolio occurred at the outset. Unfortunately, implementation shortfall does not provide insight into the root causes of the shortfall (e.g., market conditions or transition manager ineffectiveness).
Regardless of the transition process under consideration, the ultimate decision to make a change in investment manager is never easy, so it's important to keep the following considerations in mind:
- Transition costs should not preclude consideration of a manager switch, since high-quality manager selection will often result in net payoffs. However, all relevant effects on the net return to investors should be factored into decision-making.
- The new manager's appointment period should be long enough to offset the switching costs. An appropriate investment horizon needs to exist in order to make the action worthwhile.
- Investors should understand how their existing investment vehicle will influence any restructurings. During transitions, segregated mandates provide latitude for crossing positions among managers when making changes to the underlying manager mix. When pooled vehicles are involved, out-of-market risk can be greater due to the need to manage cash-flows around a unit redemption/application process.
- Investors should appreciate their fund's tolerance for out-of-market risks. Do not underestimate the possibility for significant change in portfolio value (positive or negative) as a consequence of not having measures in place to manage market exposure. Asset prices rarely stay static.
Indeed, making the right decision about changing investment managers is bound to be affected by more than direct and indirect cost projections. Investment goals and market timing should strive for the best possible balance. As with most important decisions, success relies on vision, good governance and expertise guided by a clear view of transition complexities and strategies.
Freeman Wood is a principal and director of the Americas team within the Mercer Sentinel Group in Mercer's investment consulting business.
Paul Sachs is a senior member of the Mercer Sentinel Group, a global team that specializes in the implementation and governance of investment operations, including transition management, transaction cost analysis, foreign currency exchange, securities lending, custodial evaluations and operational assessments.