As transition managers pursue improved performance for their events, the reporting, and measurement of the performance during these mandates has become ever more critical.  This greater focus on measurement has led to changes in how some transition managers trade assets – most notably with the rise of T-1 trading. However, investors should be mindful of the potential consequences of these trading strategies on the resulting performance of the transition.

We discuss below some of the implications of trading at an implementation shortfall benchmark on the performance on a restructuring exercise. What effects crossing at the close can have on performance and the potential conflicts of exercising discretion over both sides for different client types in the same crossing process.

Access to liquidity and reduction of costs has always been the aim of a transition management exercise, but as alternative execution strategies are employed it is important for clients and providers to have a clear understanding of the implementation being proposed, the risks involved and how to objectively measure the costs of that implementation.

Implementation shortfall

The typical way to measure the performance of a transition event is by evaluating the “implementation shortfall.” This is defined as the difference between the actual portfolio return and the target portfolio return, assuming the target portfolio is created instantaneously and at zero cost. It reflects both the fixed costs involved in trading - such as taxes, commissions and fees - and the variable costs caused by that trading.

Variable costs can include the effect of market volatility on prices, as well as the effect that the act of trading can have on the price of the assets being traded. For example, by affecting the supply-and-demand dynamics of a security, this trading activity often changes the bid/offer spread and the price of the assets themselves.

Implementation shortfall works by selecting an objective starting point for the transition, where the benchmark price of the assets cannot be influenced by the transition itself. This is normally set as the closing prices of the securities to be traded on the day before the transition commences, i.e., the closing prices on T-1 - where T is the day on which trading for the transition begins. The transition seeks to minimise the difference between the price at which trading is executed and the benchmark prices at the T-1 close. The more successfully the transition achieves this goal, the lower the implementation shortfall will be.

Trading at T-1

There is a growing trend among transition management providers to propose strategies where trading begins at - or even before - the benchmark is set at the close on T-1. The reasons for this head start can appear compelling at first glance.

By trading a proportion of assets at the close on the day before the transition officially begins, managers may claim they can achieve significant cost savings. In effect, trading on T-1 eliminates the implementation shortfall for that portion of the assets being traded, by executing at “zero” cost. They may argue that this approach brings down the overall cost of a transition by reducing the impact of the transition on bid/offer spreads and trading prices. Cost savings of as much as 20-30% can sometimes be cited, based on carrying out some 30% of trading on T-1 (see Table 1).

Table 1: Example of pre-trade estimates for commencing trading on T vs T-1

This argument also assumes that trading on T-1 should not impact the benchmark price for the transition, because only a ‘small’ proportion of the assets are being transitioned early.

Zero spread execution?

This may seem a compelling approach for clients that want to minimise the implementation cost of a transition - but does T-1 trading really save on cost?

The argument is made that the trading on T-1 has no market impact and won’t affect the benchmark price for the transition. But the submission of a trading order into a closing auction directly affects the “last” price set for that day — a buy order will increase it and a sell order will decrease it. While these trades occur at the “closing price” — which will also be the benchmark price for the transition, therefore implying zero cost — they will nevertheless have directly impacted the benchmark price.

A strategy of trading on T-1 results in an unmeasured impact on the value of clients’ assets, and, in turn, the cost of the transition.

The last price in the closing auction on T-1 also carries over to the actual transition start date, T. A price driven higher at the close on T-1 by a buy order is likely to mean that the opening price of that security is also higher than it would otherwise have been. The same is true of the price of a security sold on T-1, which is likely to open lower.

This real cost to the client will not appear in the pre- or post-trade report as it is hidden in the movement of the benchmark price against which the implementation shortfall - and therefore the transition manager - is measured. It is difficult to argue that this approach is transparent. In addition, where these implied efficiencies are built into a transition manager’s bid during the selection process, unless explicitly explained, it can be very difficult to make “apples-to-apples” comparisons between different transition managers’ bids and performance of the event.

Potential hazards of “T-1 crossing”

Where a transition management provider is also an asset manager, the arguments for the cost-saving benefits of T-1 trading will often be used to justify “crossing” the transition flow against its own asset management flows at the closing prices on T-1.

It is common for asset managers to seek to net out - or “cross” - client flows against each other at the day’s closing price and avoid going to market. Asset managers use closing prices for their benchmarking and NAV calculations. Asset managers who are also transition managers therefore have an incentive to cross as much transition flow with their asset management flow in order to achieve the fund benchmarks at the lowest implied cost possible.

The argument is that crossing trades from one client to another will incur zero spread, zero impact and zero opportunity cost versus the client’s implementation shortfall benchmark (T-1 close). These factors will be used to promote crossing as the most efficient liquidity for the client, and the pre-trade analysis will appear cheaper than a trading strategy beginning on T. However, it could leave the transition management client at a disadvantage and will impact the cost of the overall transition.

For the asset manager to meet its benchmark objectives, its flow will need to be executed on its relevant day, which in this case would be T-1 for the transition client. Consequently, that flow will need to be executed in the closing auction or leading up to the close if more liquidity is required in order to target the asset management client’s performance benchmark. This trading will impact the closing price in that security on the day.

However, if  an asset manager crosses the buy orders from its transition management client with sell orders from asset management clients, this will naturally support the price of the asset by limiting the number of sell orders placed in the market or closing auction. However, the transition management client, whose event does not begin technically until T, is better served by waiting until T, when the additional asset management flow that would have otherwise been traded in the market is likely to have pushed down the closing price of the asset on T-1, leading to a weaker opening on T than would otherwise occur.

This would mean the transition client could buy into a more attractively priced market on T. It also means the benchmark for that security for the transition would be lower, affecting the trading and benchmarking in that security for the whole transition. Conversely, if the transition management client is a seller of an asset, but trades on T once the asset management flows have gone through on T-1, they would sell into a stronger market.

In all cases, the transition management client is disadvantaged relative to the asset management client if its flow is traded and/or crossed on T-1. The asset management client always benefits in being able to not impact their own benchmark and find cheap liquidity.

Focus on transparency

While trading at the T-1 close may remove some opportunity costs by avoiding the overnight risk of trading on T and benchmarking to T-1 close, there may be implications for clients. Whatever strategy is used for execution, it will have an impact on the prices of securities. More importantly, trading on T-1 and at the close will affect the benchmark against which the implementation shortfall is measured. This will have implications for the cost analysis of the transition.

This impact needs to be very carefully considered where an asset management transition provider is offering to cross flows between its transitions and asset management clients at so-called zero cost. The ultimate impact on the transition client could be significant and may be disadvantageous versus the asset management clients’ outcome.

If it is beneficial for the transition client to cross flow on T-1, before the transition officially commences, then the question needs to be asked as to why wait to the end of the day on T-1 and incur a day’s volatility in the market; why wouldn’t you look to access liquidity all day?  One reason is that this would effectively change T-1 to be the transition start day T from the clients perspective.  This is obviously a circular argument that is only solved by choosing an objective benchmark and ensuring that it is treated that way if Implementation Shortfall is the chosen approach for the transition strategy.

At the very least the transition bid should be transparent about a T-1 trading strategy. It should explain and quantify the risks that will be incurred, outline how the cost estimates of a standard implementation shortfall strategy are affected, and provide enough information to allow for “apples-to-apples” comparisons.