Transitioning investments is difficult and can be far more intricate and complex than it initially may appear. If not managed correctly, investors can incur significant expenses and delays which erode long-term performance.
For pension funds, each pound inadvertently lost in a transition is a pound not used to fund their liabilities. With funding ratios continuing to be challenged as schemes age, it is more important than ever that a pension fund not only has the correct investment strategy but also implements change correctly and as efficiently as possible.
In this article, Steve Webster, MJ Hudson Allenbridge's Head of Transitions, shares his top ten tips to consider when changing between asset managers:
1. Start the clock when agreeing investment change
Pension funds often encounter protracted delays in implementing investment change, as a result of infrequent trustee meetings, lengthy manager searches, complex legal negotiations and operational headaches1. A delay in investment implementation is an unmeasured and arguably unmanaged investment risk, which can be managed but often isn't. Event Shortfall is a method of measuring this risk, which effectively starts the performance clock from the time the decision is made to change managers. This is a great way to motivate those decision makers and suppliers (i.e. the transition managers and the investment managers) alike, to either find an interim solution or shorten the investment timetable.
2. Measure using implementation shortfall (when not using event shortfall)
Transitions result in expense, which can be explicit (commissions, taxes, etc.) or implicit (impact, spread or market movement). The industry standard method for counting these is Implementation Shortfall, which is favoured given its simplicity and completeness in measuring actual versus paper (benchmark) returns from a fixed point in time and is inclusive of all costs and performance. From this aggregated measure, clients can begin to distinguish luck from judgement. Without this, it would be virtually impossible to determine the costs incurred and the responsibility and accountability for any expense.
3. Cheap isn't always pretty
Transition managers are often selected based on competitive estimates of explicit and implicit costs and too often we see selections decided on the cheapest overall quote. Unless an estimate of low cost is aligned with a credible and relevant solution which differentiates it from others, then it is simply just that... a low-cost estimate. The selection of a transition manager should start big and finish small. This means starting with relevant core capabilities and skills, then specific solutions aligned with cost estimates, then accuracy of quote and, if all else fails, the cheapest price...
4. Target fund managers are not always best placed to manage your transition
It would seem intuitive to use the new target fund manager to manage the required transition of legacy assets, as one would expect the manager to be incentivised to get the best result to ensure they maximise the proceeds they are managing. However, a fund manager is not a transition manager and this is an important distinction:
- Whilst they are expert in buying the new assets that they want to hold, this might not be the case for transitioning from the unwanted assets they don't want to hold.
- Target managers, also won't typically start counting the cost or measuring their performance until they have their new model portfolio in place.
- Importantly, target managers may also be constrained from trading in certain securities, as a result of the size of their aggregate holdings (investments which they have made across their business) or where they are made an "insider" to a corporate event, potentially restricting them from dealing at a crucial time, unlike an unconstrained transition manager.
Investors should be aware of the risks of using the target manager and to possibility that such a choice could quite easily result in false economies in hindsight.
5. Conflicts, damn conflicts and conflicts
All transition managers will have conflicts of interest with those for whom they are transitioning assets. Some transition managers have greater conflicts than others, but it is important to be aware that these conflicts come in very different shapes and sizes and it shouldn't be assumed that a broker is necessarily more conflicted than an asset manager. The key conflicts relate to undisclosed earnings or benefits (reduced costs) associated with the transition, which the transition manager gains directly or through an executing affiliate. Ask how these conflicts are managed and if not convinced... walk away.
6. Don't assume it's all about the equities
Whilst transition management originated out of the management of passive equities, transition managers have multi-asset skills, which set them apart from others. While some might believe that a transition manager cannot add much value to a change in asset allocation, nothing could be further from the truth. Managing risks and execution across asset classes arguably delivers even greater savings than transitioning within a single asset class, given the added risks and propensity of investors to accept an, unmanaged disinvestment where a transition manager isn't used. That said, as in all asset management, not everyone is good at everything, Investors need to do their homework and decide who to appoint based on what it is that needs to be done.
7. Take care of FX and it will take care of you
Asset owners may believe that FX is a by-product of the transition process. A change of regional exposure will result in major changes of FX exposure and therefore risk. Hedging this exposure risk is as important as managing the other investment risks and is comparatively simple and inexpensive. Therefore there should be no reason for FX exposure to remain unhedged in transition, through alignment of currency forwards with the Implementation Shortfall benchmark.
8. Don't be afraid to ask for your money back
Transition managers are generally great value for money given the complexity of the task, but occasionally they do get it wrong. Errors or process failures may be disguised (possibly inadvertently) as a simple loss of performance. A sign of potential errors or failures might be protracted/unexplained delays, reversals of purchases or sales, or a deviation from a previously defined strategy. Where negligence results in losses, clients typically have a strong case for remediation, but often seem reluctant to ask as it may imply a failure of their judgement in selecting the provider. Where investors are advised, (i.e. by a third party that has helped them with strategy, choice of transition manager and possibly monitoring and oversight of the transition), then the question will always be asked, but if not, then simply don't be afraid to put your hand up.
9. Don't assume all that glitters is gold
Implementation Shortfall is "a big number", but as stated above there are a lot of moving parts (some outside of anyone's control). Just because the result of a transition is in line with the estimate, doesn't necessarily imply it's a good result.. Or put another way, it's the starting figure, not closing figure. Looking into the background of the cost result is fundamentally important to understanding how things played out. For example, if a transition was inadvertently delayed by three days and cost 20bps, but without the delay would have resulted in a significant outperformance, then the transition result, which appears to be an acceptable outcome, is actually concealing a loss.
10. Lastly, get some advice
Of course, we are talking our own book here, as this is what we do, but... In our experience many asset owners, particularly those who have not gone through major transitions, appear to have little understanding of the transition process and are even less familiar with the reporting provided by transition managers. Given that transition managers are generally not providing advice, asset owners are left to agree/instruct on a process they may not fully understand and judge performance based on the say so of those that are being judged, never a good position to be in.
It's also important not to underestimate the value of stepping back and taking a strategic view, i.e. considering the transition in the context of the asset owner's broader investment strategy, not to mention market environment. For larger transitions, having that strategic perspective along with a deep knowledge of how transitions work in practice, can have a significant impact on the how a transition should be structured. There is often a "better way" to minimise risk, better maintain the desired investment exposures (i.e. the strategic asset allocation) and/or optimise timings, to avoid periods of being out of the market.
1. 70% of US transitions in 2015 experienced and average delay/implementation period of between 1 to 12 months. State Street Event Shortfall Research