Pension funds rebalancing during the stock market's spectacular rise, or reviewing allocations during the recent turmoil, often find themselves in the position of changing their investment managers.
Deciding to change managers leads to an important consideration: how to minimize transition costs. While the reasons for a shift might be compelling -- such as a need to raise cash, a decision to shift investment strategies or style, or a determination to rebalance assets to meet an asset allocation target -- the process should be managed carefully. The cost of switching managers can be lofty, typically ranging as high as 1% to 2% of the portfolio's asset value, and can therefore make a dramatic impact on the plan's current or future gains.
If the fund is relatively small, less than $100 million or so, or if the timeframe for shifting funds is short, the sponsor can consider using a discount broker to sell the assets. This approach offers the advantage of low transaction costs combined with time efficiency. A discount broker can bid on the cost of selling the shares and should provide a method of measuring the quality of execution.
One method of substantiating that trade executions took place at fair prices is the volume-weighted average, which represents the price at which most shares of a particular stock traded on any given day. If the trade price meets or exceeds that benchmark, the broker achieved a good, quality execution for stocks.
But often a fund's substantial size and time flexibility indicate other methods for handling the transition to a new manager. The outgoing manager can sell holdings, or it can provide the new manager with a list of securities under management. Neither of these options is likely to be optimal, as there is little incentive for a fired manager to put much effort into disposing of stocks effectively; and because the main focus of an investment manager's business is making good buy and sell decisions, not trading.
There also is the principal purchase approach, whereby a pension plan sponsor gives the characteristics of the portfolio to a group of brokerage firms, which bid for the opportunity to buy the stocks at the market close. This method allows the sponsor to choose a broker that will purchase the entire portfolio for its own inventory. It results in quick executions but typically is expensive, because brokers bid on the business without knowing the stocks held in the portfolio.
Another method of handling an investment manager shift that is attracting increased popularity is to hire a transition manager. This approach allows the pension plan to give the new manager a combination of cash plus securities, if the new manager wants to retain any of the issues held by the previous manager. More importantly, this approach also allows a pension plan to move assets into a transition or holding fund to be passively managed until the plan hires a new investment manager -- a process that can take several months. There also is an added benefit of exposure to a desired asset class during the decision-making process.
Transition managers are typically large managers of passively managed funds that assess a fee to handle the disposition of a portfolio. Thus, a pension plan will be able to closely determine, before hiring the transition manager, the costs and savings involved with liquidating a portfolio vs. going into the open market and selling all of the desired holdings.
The transition manager strives to "cross," or absorb, with its own portfolio many of the issues held in the fund being liquidated. Because index managers have big appetites for securities, they find themselves in the market on an ongoing basis, buying and selling securities. Transition managers, like pension plans, are looking for ways to minimize their transaction costs, and being able to cross is a win-win situation for both the plan and the transition manager. Typically, there are no market impact or commission costs associated with these trades.
After determining which holdings can be crossed, a transition manager next will look to cross other stocks held in the plans with a variety of external services. These trades typically take place at a relatively low cost, between 1 cent and 2 cents a share, and also usually have no market impact. Once trades have taken place, whether internally or externally crossed, the transition manager can invest the cash in the futures markets or in an index fund, providing market exposure to an asset class determined by the pension plan. This minimizes the opportunity cost of switching investment managers by allowing the pension plan to participate in the market while making an investment change.
Another benefit of using a transition manager with the crossing capability is the opportunity to eliminate or reduce transaction costs, including market impact, or the undesired downward pressure on a security's price as it is being sold in the open market. Using a crossing system, where investors anonymously display a desire to buy or sell stock at a certain price, the transition manager may be able to sell all or part of a fund's position in several days without causing undue gyrations in a security's price.
After working through the internal and external crossing networks, the transition manager will provide an analysis of what was sold in the portfolio.
Typically, the analysis will estimate savings vs. having gone to the open market to sell holdings, as well as the market impact costs the trades would have been exposed to in the open market. Depending on the quantity and type of securities being sold and market conditions, a transition manager can shave 20% to 70% off a portfolio's potential commission and market impact costs in the open markets. The less liquid or thinly traded a security, the greater the benefits of using the transition manager tend to be.
Very often, the transition manager is not able to dispose of all securities held in the pension fund through its crossing activities. At that point, the pension plan should consider taking the remaining securities to a low-cost brokerage firm for execution.
Shifting an investment manager's portfolio requires careful examination of all transition costs -- commission fees resulting from selling of a portfolio, market impact costs from selling securities and opportunity costs of being out of the market -- that can have a negative impact on the fund. Plan sponsors can choose various ways to handle the disposition of a portfolio and should thoroughly research the options and their costs before embarking on a change.