Transition managers answer call for sophistication

Transition managers are adding new capabilities to transfer assets in complex derivatives, futures and options, along with traditional transfers of securities.

These managers increasingly are using derivatives desks to handle the complex transitions, particularly in fixed income. Ross McLellan, founder and president of transition management data analysis firm Harbor Analytics, calls it “an evolution in the industry that allows transition managers to stay relevant.”

The need for such enhanced capability was highlighted in the rush among pension funds and other asset owners to consider terminating Pacific Investment Management Co. following the departure of William H. Gross, co-founder and chief investment officer, who moved to Janus Capital Group in September. Much of PIMCO's Total Return Fund invests in derivatives and interest-rate swaps that required additional capabilities for transition managers.

“PIMCO Total Return is a very complex portfolio,” said Mr. McLellan of Hingham, Mass.-based Harbor Analytics. “It has a ton of derivatives in it. The portfolio contains many interest-rate swaps, credit-default swaps and forward currency transactions in addition to futures. The issue with transitioning from it is that most transition managers will counsel their clients to ask PIMCO to close out the derivatives. That creates a big problem. In the interim, the portfolio will look nothing like what PIMCO was intended to do for the client once the derivatives are removed. You think the portfolio's duration is three when it now is six.”

“On the fixed-income side, there are a lot more structural impediments because of the derivatives in their portfolios,” said Kevin Byrne, vice president, head of transition management at Fidelity Capital Markets, New York. “In the past, those complex derivatives would be liquidated by the terminated managers, and the transition manager would be left to transition the bonds. But that's changing.”

Added Steve Kirschner, managing director and global head of transition management at Russell Investments, Seattle: “Gone are the days when transition managers came to the client with the cost of the transition and that was it. The assets used are far more complex.”

And at a time when more asset owners are selecting transition managers from an approved list for specific tasks, those with the capability to handle derivatives “enhance their standing on the bench,” said Robert Holland, senior product manager at investment management software provider Linedata, Boston.

Transition managers with such capability, according to industry sources, are BlackRock Inc., State Street Corp. and Russell Investments. One source who spoke on condition of anonymity said BlackRock is the top provider “and no one's close,” although he said its cost is “real expensive” compared to other providers.

Executives at pension funds said the ability to handle complex derivatives is noted when selecting a manager from a pre-approved list to perform a transition.

“If I had a PIMCO or a Western Asset as a manager, I'd want a transition manager with the capability to handle complex derivatives,” said William Atwood, executive director of the $14 billion Illinois State Board of Investment, Chicago.

Mr. Atwood said the evolution of fixed-income portfolios — from comprising bond funds exclusively 20 years ago to having a mix of Treasuries, corporate securities and “any number of derivatives” today — has meant that shifting managers has changed dramatically. “It's a transition for everybody,” he said. “You used to say a fixed-income fund is a bond fund. That's not the case any more.”

David Cooper, chief investment officer of the $29.9 billion Indiana Public Retirement System, Indianapolis, said managing the transitions of derivatives and swaps is “one of the many factors INPRS considers when hiring a transition manager.” Global Transition Solutions Inc., Russell and State Street are on the retirement system's list of transition managers from which it chooses on an as-needed basis.

Even investment executives at pension funds with less complex derivatives in their portfolios “could understand where people would be concerned about” a transition manager's capability, said a public pension fund executive who asked not to be identified.

Harbor Analytics' Mr. McLellan said that in the past, “index companies and some transition managers set up temporary assignments that removed larger risks in the portfolio while maintaining exposure without the full turnover associated with going completely passive. The benefits were obvious — do it very quickly, pay no transition management fee, it's a win-win.”

“To me,” Mr. McLellan added, “it's evolved to where interim teams in transition management now have access to different products — swaps, futures, ETFs — with access to a variety of markets in the interim. Once they're hired, it's easy to transition through them. Flexibility, speed, lower cost — those are what's behind this. It's more about what asset owners are asking for. If a plan sponsor wants access to a new allocation, this is a quick way to do it. Some are comfortable with it, some are not. It's not so much for better transparency, it's really just a better mousetrap.”

Linedata's Mr. Holland said transition managers with derivatives capability are better able to do “a deeper dive, and put more time and work into the transition” as opposed to leaving the wind-down of derivatives up to the terminated manager. “Transition managers with a specialty desk that will do all the hard and heavy lifting can take those illiquid assets, assess their risks, put a hedge around them to limit volatility and unwind them in a shorter period of time,” Mr. Holland said.

Driving this trend, he said, is transaction cost analysis. Once focused more on equities, it's now made its way to fixed income. “A terminated manager might not be incentivized to get the best execution on those derivatives. Transition managers are more incentivized to do this with as little disruption as possible.”

The trend toward derivatives capability among transition managers has dovetailed with fewer asset owners parking assets in index funds as an interim move between terminations and new hirings. Lance Vegna, Americas co-head of Macquarie Portfolio Solutions, the transition management business of Macquarie Group, New York, said firms use more exchange-traded funds and futures in transitions. “There's more transparency, more risk control, more flexibility in those other transition strategies than with index funds,” Mr. Vegna said. “Someone who wants $100 million in emerging markets equity exposure can get it right away in an ETF, while that's not so with separate accounts that can take weeks to establish.”

Added Fred Fogg, co-head of Macquarie Portfolio Solutions: “I wouldn't label the shift away from index funds as much as a trend as it is a lot more best practice on the part of asset owners.”

The effort to bulk up on derivatives in transition management comes at an opportune time, said Russell's Mr. Kirschner, as more asset owners consider changes in their overall fixed-income investments. “A lot of people were looking at PIMCO last year and were looking for a reason to move. But what (the PIMCO reviews) really did was give asset owners a reason to review their fixed-income investments,” Mr. Kirschner said. “There's been a trend in equities from U.S. to global strategies; there's been a mirror of that on the fixed-income side. There used to be a huge country bias among investors, but now they're looking for more yield, emerging markets debt, foreign currency portfolios. I don't think that's going to reverse anytime soon.” n