Transition transmission

Transition managers have moved outside of their traditional role as intermediaries helping funds to reallocate their assets in an efficient manner by offering risk analysis, currency overlay, short-term investment management and other services. But these new mandates, combined with more complex asset allocation, present challenges. By Rachel Alembakis

Australia has the fourth-largest managed savings pool in the world - despite having a population of only 21.2 million people - with its asset managers overseeing A$1.18 trillion at the end of last year, according to the Australian Prudential Regulation Authority's (Apra's) latest quarterly superannuation performance bulletin of March 2008. And, as the volume and sophistication of investments by pension funds has increased, transition managers have moved to assist in the efficient shifting of assets from one individual fund manager or asset class to another.

Transition managers say they have seen an upswing in the number and complexity of transactions they manage in both the equity and the fixed income areas. And, increasingly, transition managers are also offering a range of other services, ranging from currency overlay and risk analysis services to the short-term investment management of monies that are left in limbo between the termination of a legacy funds manager and the selection of a destination manager.

The pool of assets under management has led many institutions, ranging from asset managers to investment banks, to proffer themselves as transition managers. "The role of a transition manager has evolved to become a bit of a fix-it man for superannuation funds and other institutions," says Nicholas Carrigan, managing director and head of the institutional funds group at UBS in Sydney. "It used to be about moving mandates from one funds manager to another. Now there are overlay services, interim fund management services, risk analysis and other value-added things. We do them all and what you find is that, as client problems become more complex, the things we're asked to do have expanded. We think that's a good thing."

Others parties stress the importance of new asset coverage. Michael Jackett-Simpson, director of investment and pension services at Citi Australia in Sydney, for example, says there has been a push for multi-asset class transitions over the past three years. These transitions primarily involve dealing with fixed income assets, as equities and currencies were already well covered by transition managers. "What you're also seeing in terms of developments is that transition managers are offering implementation solutions, and are using derivatives, exchange traded funds (ETFs) and swaps," says Jackett-Simpson. "As a general catch-all phrase it's becoming more complex and the pace is probably increasing over the last few years."

Challenging new developments

The new developments in the market are raising a number of challenges. For example, some market participants warn that the rise in volatility in credit and equity markets during the past six months has demonstrated that risks attached to transitioning a portfolio can be underestimated. They say superannuation fund trustees should be aware of the liquidity risks attached particularly to small market capitalisation equities, which can be difficult to source at a given point in the transition. The use of derivatives and futures deployed by managers when they conduct a transition event and the skill of the managers themselves before selecting a transition manager and going ahead with a transition event are also important considerations.

As superannuation funds are turning to transition managers to run things like overlay services, risk management, interim funds management, there are also concerns the models of some transition managers may not be able to keep up with the times. "Transition managers with a (execution-only trading) broking model will be the ones under pressure as super funds' investment structures are becoming more complex and demand for end-to-end services increases," says Lounarda David, a Sydney-based Asia-Pacific director of Mercer Sentinel, a specialised transition and operational consulting group.

"Due to the sophistication of superannuation funds in the market and constant increase in complexities of implemented consulting models, the type and level of services required in the market is becoming quite different," says David. "Transition managers that can provide the whole scheme of services, not just execution, will have a better chance of surviving."

Russell Investment Group offers 'interim portfolio management' - short-term investment management of a portfolio - in addition to its transition management services, says John Moore, director of implementation services, Australasia, for Russell Investment Group Management in Sydney. Moore says "a handful" of transition management clients take advantage of the service each year. These have generally terminated an underperforming fund manager but have yet to select a new manager for a portfolio.

In these circumstances, Russell constructs an interim portfolio based on quantitative portfolio management techniques, using tracking error and trading costs determined with the client as the benchmark. The mandates usually last between two to four months, says Moore, and the portfolios can be based on indexed funds, futures and ETFs, according to the company's marketing material.

While transition managers report greater use of their services by superannuation funds, they also say that volatility in equity and particularly credit markets has caused clients to turn to overlay management services to put off transitions. "Fixed income transitions are much more difficult. There are fewer market-makers making prices and spreads have widened," says Carrigan at UBS. "They're much more difficult than they were 18 months ago. What we're seeing is more overlays so that people don't have to undergo a transition in fixed income. People are coming to us who want to do transitions but are realising that now is not the time and are asking for our help to put them off."

In some cases, it's a matter of recommending to clients that they should not transition a portfolio at a certain time, says Russell's Moore. "A lot of portfolios have seen losses or underperformance because of the widening of credit spreads and executing the transition crystallises those losses. It's a matter of getting them to look at those factors as well, and consider whether it'd make sense to hold certain positions until maturity - assuming they're not in a potential default situation," Moore says. "We've had clients who have delayed, but most have said 'let's just get out' and invested with the new manager."

Fixed income transitions are not the only events that are less likely to take place due to the current bout of volatility in the financial markets. QIC, the fund manager for the A$50 billion Q Super for Queensland state employees and families, manages its own transitions in house but has not performed an equity transition in the last six months, says Greg Liddell, director of implemented equities at QIC in Brisbane. The Queensland superannuation fund has not performed a transition in that time, partly because it has funded new mandates from cash rather than terminating old mandates.

Market ructions

As a result of market ructions, clients are also re-examining their transition managers' techniques, risk control measures, pre-trade estimates and post-trade analysis. "The last six months have forced clients to review some of their existing arrangements to get a better understanding of the risks and rewards of these arrangements," says David of Mercer Sentinel. "They're not necessarily all moving away from securities lending or restructuring their programmes, rather being forced to get a better understanding of how these arrangements and relationships work, risks and exposures of these arrangements for the funds, and, more importantly, how these risks are being managed. That's not a bad thing as it does put the responsibility back where it belongs - with the trustee."

Managers emphasise that, in times of market volatility, risk management, understanding liquidity constraints, knowing where to find liquidity and having proper benchmarks to measure transitions' performance are essential. "Market volatility makes portfolio risk management as important as finding liquidity," says Carrigan of UBS. "Finding liquidity is an essential part of managing the risk, but somebody who understands volatility in markets is very important, someone who understands how overnight moves can impact stocks is very important. That comes back to the quality of the transition manager."

Understanding liquidity risk is particularly relevant in the Australian context, where company stocks of certain industries are highly illiquid, such as the mining and resource industry. "You have to be aware of sector bets, currency bets and country bets in the portfolio, and making sure you're moving systematically from one portfolio to the other," says Moore of Russell.

For example, if a client was transitioning a portfolio that was increasing its percentage of holdings in mining industry companies, selling a liquid stock such as BHP Billiton on one day to obtain a less liquid stock in another mining company that could not be sourced on that particular day, it could result in seeing a portfolio's percentage in the mining industry drop rather than progressing to the increased percentage, Moore says.

To reduce the liquidity factors as well as minimise trading costs and taxing implications, managers point to developments like algorithmic trading systems and internal crossing networks. "It's at the very early stages," says Jackett-Simpson of Citi. "All the investment banks to some degree will tell you that they execute client orders by algorithmic systems and crossing engines. Transition managers use it somewhat but it's in its infancy. It is a function of transition managers looking for smarter ways to implement the transitions and clients also wanting to get lowest cost outcome."

In addition to liquidity risks, there are other concerns to manage as well, including counterparty risk. QIC's implemented equities team deals with six to 10 counterparties from a pre-established, vetted list of about 25, and seek out both agency and principal bids for trades including guaranteed close, says Kevin Wan Lum, a portfolio manager on QIC's implemented equities team.

"We used to do the majority of trading with a (volume weighted average price) benchmark, but along with agency bids we now look to seek principal bids for a guaranteed closed or guaranteed volume weighted average price as the benchmark," Wan Lum says. "We have also started to use over-the-counter derivatives to reduce the tracking error risk to get the exposures more precise to the clients' underlying benchmark. There are other risks that we manage - we look to ensure that we are fully invested. We will seek brokers to guarantee completion for trades. We'll look to ensure that any of the trades are within the limits of our guidelines. We minimise cash and take derivative exposure to reduce cash drag."

This increased focus on precise measures of transaction costs is in line with a greater push within Australia to examine trading outcomes, says Glen Gee, regional head of trade cost research in Hong Kong for ITG, a brokerage and research firm.

wWhat institutions are looking for is best execution. For example, with the proliferation of liquidity pools, they have a choice between quantity discovery and price discovery, whether that's through ITG's Posit, Chi X from Instinet, Liquidnet or alternate pools. It's an important tool within the transition process."