The financial crisis and subsequent volatile markets, quantitative easing and ever-tightening regulations are still influencing how asset owners manage their affairs. It is has been having a knock-on effect on transition managers, which are likewise having to adapt and find new ways to meeting the changing demands of their clients.

One of the biggest changes has been the increase in the number of clients approaching transition managers with illiquid equity portfolios. These cannot always be transitioned in a few days and may take weeks or even months to complete. These require a different skillset as it depends less on execution capability, instead relying on access to a very broad range of liquidity providers.

In order to get very illiquid positions traded, achieving sufficient liquidity entails dealing with a wide range of market participants, accessing a broad crossing pool and gathering indications of future interest. The situation is getting more acute as the amount of stock involved is often in multiples of average daily volume. This leads to a different balance of risk, as the transition manager won’t know how or when they will be able to trade and must determine whether to hold back portions or set up interim exposure through futures baskets or exchange traded funds (ETFs).

The market has also changed in terms of the breadth of client types requesting their services. Asset managers, sovereign wealth funds, large pension funds and increasingly insurance companies are all seeking transitions but they may have very different priorities; not all are driven by managing operational complexity.

Clients have also become more sophisticated and, with governance a key concern for many, have higher expectations. “Transition managers need good operational know-how and a view of the big picture,” says Artour Samsonov, head of transition management, EMEA, Citi. “More is demanded of us in terms of mandates, covering transparency, and with the regulations coming into effect we need to offer proof of best execution.”

Market structure

There have also been shifts in market-structure that have impacted transition managers. One of these is the shift from actively-managed to indexed assets, which has accelerated over the last decade. At the same time, some investors have balanced this beta exposure with alpha exposure, highly concentrated equity mandates (or high active share) that is purposefully uncorrelated with the index.

“Asset owners are investing in high conviction mandates, which, by definition, can’t be hedged by liquid index instruments,” says William Cobbett, head of transition management, Americas, Citi. “These mandates require discrete implementation as the market impact could erode the alpha generation.”

An increase in the assets managed by outsourced CIO (OCIO) managers has provided a new market for transition managers. Following the introduction of several new types of fund – particularly diversified growth, target date and smart beta – OCIOs have become heavy users of transition services to restructure their funds. “They are fantastic clients to work with,” says Cobbett. “And not just because they are successful. We have a number of clients that use us regularly, get used to our processes and have interests are aligned with our own.”

OCIOs also gain from the economies of scale, due to their buying power, to achieve lower rates than less frequent clients. OCIOs will be keen to minimise charges but Cobbett is happy to oblige saying “the more clients they have, the more swings of the bat we get”.

Synthetic instruments

Citi uses futures and ETFs to hedge the transition where appropriate but Cobbett believes there is often too much faith placed in the use of synthetics, as they can carry a lot more base risk than many people realise. “We’ve been doing complicated trades for a long time,” says Cobbett, “but we are constantly upgrading our analytical tool-kit. Clients are switching to viewing it in terms of risk factors and we have to move in parallel with them so we can see the transition it in the same way.”

When it comes to swaps, a transition manager’s role can be limited to just helping a client with novating or moving them, says John Minderides, head of portfolio solutions, EMEA, at State Street. “We use futures to hedge and contain risk when it makes sense, or by using ETFs or forward FX transactions.”

The complexity being introduced through margin rules in 2017 will force the industry to think carefully about how it will provide margin and collateral management for transition events, which by their nature are short term. “A client may only be around for a few days, yet the best way to manage risk may be to use forwards, which will introduce variation or initial margin depending on the jurisdiction,” says Minderides. “The problem with transitions is they are in and out, not a long-term mandate.”

Although margin requirements won’t bite next year the industry needs to communicate these changes to its client base and be prepared for the new rules. Minderides says that the tools at his disposal are much more sophisticated than in the past and he has recently been focusing on delivering best execution monitoring, along with transaction costs and post-trade analysis. State Street has gone down the route of introducing a third-party tool that will introduce independence into the process and provide better execution and provide greater transparency, according to Minderides.

But not all complexities are as easily addressed. Pooled funds are “interesting” to Minderides as their increased of use presents two difficulties. The first is restrictions imposed by some funds on whether they will take in or ex specie assets (legacy assets or cash). This can be countered through conducting a detailed cost analysis of bid and offer prices to confirm whether the client is better off trading units with cash or securities. However, pooled funds are not always as transparent as transition managers might like. The second is non-standard deal days, says Minderides, when “you get into a settlement mismatch between buying and selling and have to fund the trades, which adds friction costs and complexity to the whole event”.

“There’s nothing wrong with these restrictions, but they can influence costs and may impact the most efficient way of moving from one manager to another. It doesn’t mean that the transition manager is less valuable for pooled fund exposures, it’s equally valuable, but a different analytic.”

Managing perceptions

Minderides has started to work with clients to make them understand their portfolio is exposed to risk not just from the chosen trading day, but the very moment they make a decision about a restructure. “It’s something of a hobbyhorse of mine, but clients need to understand their target versus legacy portfolios are already at risk from the moment they decide what they wish to do,” says Minderides. “While there may be many reasons you can’t transition until a certain date, one of the things we do is create a framework for the measurement of that performance impact.”

Minderides is convinced measurement is the best way to reduce costs. By measuring performance drags, they have been able to help clients by providing them with interim management. “They may want to swap one manager for another, but may not have investment management agreements (IMAs) lined up, investment guidelines or their fees agreed,” he says. “We can put a futures overlay on for them or take the assets from the legacy portfolio and manage on an index basis until they are ready, all to deal with the result of inaction while they are dealing with all the other things they need to do.” Minderides calls this “event shortfall” as it goes beyond just implementation shortfall and encompasses a total measure of the cost the client incurs for an event.

Cobbett also has a subject he feels needs to be addressed by transition managers: the widespread focus on crossing. “At the end of the day – literally the end of the trading day – when the trade is booked all that matters is the price,” says Cobbett. “Internal crossing, external crossing, these ideas are frankly anachronistic. Our clients understand that we invest on algorithms and smart order routing technology to get our clients the best possible price regardless of venue type.”

Though clients are more demanding of transition managers for trade execution, capacity analysis and reporting, they also expect a partnership with the transition manager throughout the project. The role of the transition manager has become one of a trusted adviser rather than an occasional provider, serving new clients in new ways as customers find ever more uses for their services.