In recent years, some very large institutional investors have begun to move away from holding segregated mandates with asset managers towards managing those assets in-house. Likewise, others have sought to bring specific functions under their control, such as transition management, while continuing to outsource day-to-day portfolio management.

On the face of it, such moves are simply about controlling costs; nobody likes to pay fees. Public pension funds may also be motivated by a desire to report lower external fees, made possible by taking greater control. However, cost isn’t the only consideration. While there has been a major effort by transition managers to improve transparency, some asset owners may believe they can do even better.

If asset owners believe they may be able to reduce costs and improve transparency by internalising transition management then it could prove to be in their best interests. But much will depend on the size of the entity, the assets it is seeking to exit and invest in as well as its internal skills base.

Simple transitions

There has been a considerable shift towards the use of passive investment strategies in recent years. This has undoubtedly encouraged some owners to package up their passive holdings and use or develop their own internal asset management capabilities. Though a couple of basis points might seem little to pay for management, across many billions of AuM it quickly adds up.

This is changing the relationship between large owners and their external managers. But just because asset management is being brought in-house, it doesn’t necessarily mean the same logic applies to transitions.

“While we certainly have seen and heard of clients taking passive or simple transitions in-house, that does not mean they have ceased to use transition managers all together. To the contrary, the larger sovereign wealth funds (SWFs), which many would consider very sophisticated investors, still use external transition managers extensively,” says Chris Adolph, head of transition management, EMEA, Russell Investments. “They do this mainly for the more complex events.”

Engaging an external transition manager can offer greater transparency over costs, says Adolph, and they can also often offer a broader insight into the cost and risks involved in more complex transitions.

Though some of those that have taken the function in-house may be prepared to do some types of transition. While the risk is relatively low in a passive event, for more complex events transferring that risk to a third party is often preferable – and is likely to be the main driver for seeking an external provider.

Complexity can be introduced as a result of the asset class – for example less liquid fixed income, emerging markets, multi-asset and multi-manager. It can also be introduced by a prolonged time horizon, where in-house resources might be stretched to manage the project while handling other on-going internal activity.

Measuring cost

Engaging an external transition manager means clients also gain access to different points of view and trading strategies. Transitions are typically measured using ‘implementation shortfall’ and while this is an accurate reflection of the cost of managing the event in performance terms, it can also lead to a very short trading horizon.

The speed of execution may not be the only consideration for a client; the assets may have been part of their strategy for many years. They might also want to consider ‘timing risk’, the risk that on the day of trading adverse market conditions lead to locking in a one-off greater than estimated cost. Trading strategies can be implemented to minimise market impact, or be spread over multiple stages.

“High yield and emerging market debt may dictate the use of different strategies, and with banks unwilling to provide the capital they used to, having access to a large variety of dealers is advantageous and cost effective. It is less likely that in-house teams will have a list of counterparties as extensive as some transition managers,” says Adolph.

“For a liquid asset, taking the capability in house can make sense. But portfolios are getting ever more complex, with much more going into complex fixed income portfolios. This remains an area where transition managers’ experience will show though.”

Transition management is also an area where what counts is not always what you know, but also who you know. Larger asset management firms or asset owners may run large dealer panels, but many would struggle to compete with agency-only dealers, says Adolph. For example, his firm Russell Investments, on the fixed income side, sourced liquidity from 219 unique dealing books spanning 132 firms globally in 2015.

Economies of scale

Many entities will find that they cannot maintain the capabilities to manage transitions internally. There’s a fundamental reason and it comes down to scale, says Cyril Vidal, executive director and co-head of transition management at Goldman Sachs. “Unless you have huge flows, it would be difficult to have the relevant expertise in-house and be as efficient as a business that manages transitions in or out each day.”

Though every fund will turn over a portion of its portfolio each year, even a $30bn or $40bn fund wouldn’t have sufficient deal flows to support an internal function and will choose to leverage the best practice and products of external managers.

“It’s simple mathematics. You are far better off putting the panel into competition and picking the best-suited provider and then insource where there is expertise,” says Vidal, adding many would run at least a three-strong panel.

Many moving in-house will come from the sell side and without on-going exposure to regular trades may find their expertise become a little stale, he says. They almost certainly won’t have access to the strategists to allow them to optimise hedging strategies, for instance.

The fact that some large asset owners are looking to do their own transitions is of little concern to Michael Gardner, global head of portfolio solutions, Cantor Fitzgerald.

The trend is only among the largest and has been going on for years. Of greater importance is that while they continue to insource certain elements, these clients choose to utilise their providers for a broader set of implementation and risk management services, beyond transition management.

The rise of fiduciary management, or the outsourced chief investment officer (OCIO), has created many more businesses gathering large amounts of institutional assets that have no interest in internalising certain specialist functions, says Gardner. As a result, these as well as others running assets in-house have become his “best clients”.

“I understand why clients are interested in internalising transition activity,” says Gardner, “but what they really get, along with project management and execution, is an insurance policy. If they do the work and there’s a mistake, someone gets fired. If we make a mistake, we have to write a cheque to make them whole again.”

Keeping a transition management machine running in-house is an expensive luxury, even if no expensive mistakes happen. Gardner adds that the experience may make them appreciate the value of transition managers and lead them to come back.

Broader remits

It is also true that maturing pension funds are increasingly looking to run assets in-house and this is reducing the scale of these clients. They may require more than a basic transition, and whether it is access to liquidity, more robust reporting pre and post-trade, they realise that providers offer a lot more than just transition management.

“Eight or ten years ago, we were very global trading focused,” says Gardner, “but successful businesses now must be much more multifaceted in their offerings.”

This includes offering services such as interim management, so if the client hasn’t completed due diligence or a manager has experienced a team lift out, the provider can stand in with an interim solution. This would have been very uncommon for most providers a decade ago.

Another function clients may seek from a certain providers is as an overlay manager, says Adolph.

“While the structure may be right, they may want some downside protection and decide how much without broadcasting that to the whole market. They may choose us as a broker on an agency-only basis because we can’t use the information elsewhere.”

It is clear that some groups of clients – large pension funds, public funds, sovereign wealth funds and endowments – will continue to insource asset management. While this may appear to reduce the pool of assets on offer for the transition managers, there is general consensus that increasing complexity, regulatory oversight and restricted liquidity will mean that it is one aspect of the market that will not dry up.

Unless these asset owners have sufficient scale – and this will likely be in excess of $50bn AuM – or are prepared to build the infrastructure and teams required, they will struggle to do everything they need to operate effectively. While the larger public schemes may seem ideal for such a development, they are heavily focused on costs and don’t wish to be seen spending money on services that might be offered at better value elsewhere.

Technology cannot help beyond a certain point, either. While equity has trading platforms and is dominated by algorithms, that isn’t possible in the fixed income space, which remains highly resource-intensive. While those with their own transition teams will continue to process the less complex and critical assets, such as passive funds, the rest will be left to the experts.

If external quotes remain competitive and providers demonstrate that they add value through managing risk and saving the client money, why would the client build the capability in-house? “Even if it only cost one or two basis points, why would you do it?” asks Adolph. “Instead, you could focus that resource on improving your alpha capabilities, be it at the portfolio or asset allocation level.”