Increasingly sophisticated clients are demanding ever higher standards from their transition management teams.
Citi’s Tim Wilkinson
Complex portfolio alterations require specialist knowledge across numerous fields, and pension funds, asset managers and insurance firms are increasingly looking for a transition manager to handle the process. It is a cost-effective way to make major changes in assets or structure, and that cost is going down rapidly as the transition management market becomes more competitive.
Struan Malcolm, head of transition management sales at ABN AMRO, says the market is growing exponentially, with new segments of the investment community looking to take advantage of what transition managers can offer. “We are seeing a growth in breadth of interest, and our end client base is expanding,” he says. “Historically, it was typically pension funds that used transition management services, but in the last couple of years we have seen many other segments of the investment community looking to take advantage as well,” he points out. “For example, asset managers and insurance firms are now looking at the product—many for the same reason as pension funds but also for other reasons, such as managing the move to outsourcing.”
One region that is seeing substantial expansion in the use of transition management is Europe. “Certainly in Europe the regulatory environment is driving growth,” says Malcolm. The numerous regulatory changes for pension schemes and asset managers in the United Kingdom, for example, are creating much change in the way that funds are managed. The long-term effects remain to be seen, but one thing is sure: The complete overhaul of the pension system has created much business for transition managers.
Malcolm says that a big driver of growth globally is changing investment trends, including the move to more liability-driven investment and greater use of alternative investment products. For example, Finland recently liberalized regulations to allow greater use of alternative investments by Finnish pension funds. PensionDanmark, with E8.6 billion under management, increased alternative investment exposure by 2 percentage points in the first quarter of 2007 over 2006 to 4.2%. That exposure will grow to 10% by 2012.
In addition, British Energy is considering adding a proportion of active management to its £2.45 billion British Energy Generation Group fund and may shift assets to provide better asset and liability matching for its £55.4 million British Energy Combined Group fund. Mercer Investment Consulting is advising the trustees.
In Search of Efficiency
In addition, many pension funds are changing not just asset allocation but also how they are structured. Tim Wilkinson, managing director and global head of transition management at Citi, adds: “Part of the reason for the ever-increasing growth in transition activity is that in addition to all the traditional themes—there always are some funds underperforming or changing asset allocation—a variety of structural factors are also in play, which are contributing to further demand for transition management services.” For example, some funds are changing the way assets are managed, including moving to a core/satellite investment structure, in order to sustainably reduce fixed costs.
Wilkinson also points to increased consolidation of both asset managers and pension funds to enhance productivity or improve member services. “In an era of sustained low inflation and correspondingly lower nominal returns, allied to a sharp increase in the regulatory regime, fund trustees and other guardians of assets are being held more accountable and taking more responsibility for all aspects of fund activity, and especially for managing ‘gap risk’ to preserve performance,” he says.
As a result of accounting and legislative changes, as well as stock market conditions, pension schemes are under increasing pressure to match assets to liabilities, diversify portfolios and maximize returns on investment. And increasingly they are turning to transition managers to help with that process.
There are a number of important factors to consider in choosing a transition manager, and sometimes it can be difficult to distinguish between the capabilities of different providers. As more players enter the market, it is increasingly important to ensure transition managers can deliver on promises and have the track record to prove it.
“There are quantitative measures for estimating the cost of the transaction,” says Malcolm, “and there are simple things you should do to make sure you can compare apples to apples. You should ensure that you send the same information to each provider, ensure they are sticking to the same assumptions and so on. When the cost comparison comes out, you will then be able to evaluate each bid with some level of confidence.” Most transition managers use implementation shortfall as a full-in figure for total cost, including out-of-market risk, hidden costs of trading, tracking error and so forth.
In addition, conducting proper due diligence is essential. “Understand every aspect of the provider’s set up and service—their track record, systems and people,” advises Wilkinson. “Seek clarity on fees and ensure all potential conflicts of interest have been adequately dealt with. Insist on references.”
While conflict of interest has been much in the spotlight in recent years, according to some transition managers this issue is over-played. “Every provider has potential conflicts to address, regardless of model and whether a fiduciary or not,” explains Wilkinson. “A fiduciary just has less.”
Another big issue in choosing a provider is the risk of low bidding to win. “When it comes to comparing pre-transition cost estimates, clients need to be aware how easy it is for a provider to come up with an unrealistically low estimate aimed purely at winning the mandate,” says Wilkinson. “Clients must therefore demand each provider clearly demonstrate an established track record of delivering upon its estimates and promises.”
Thus, according to Wilkinson, selection of provider must not be overly focused upon the level of pre-transition estimates. “Various qualitative criteria should carry much greater weight in the selection process,” he says. “Transition managers that forecast low but deliver high, while being unable to clearly articulate that the variance was entirely unforeseeable and beyond their control, should be treated with great caution with respect to any future mandates.”
Transition management has become an increasingly competitive field, which has advantages and disadvantages from the perspective of clients. According to UK research firm Inalytics, the cost of a transition is less than half what it was five years ago.
Part of the reason for this competition is the increasing advance of the big investment banks into the transition management business. While some of the biggest banks have been in this space since the late 1990s, as the transition management market has seen big gains over the past two years, firms have placed greater importance on, and resources into, the transition management business.
However, the strong competition has also led to a lot of bickering about what makes the ideal structure for a transition manager. John Minderides, managing director and global head of transition management at JPMorgan, says that this reflects competitive squabbling rather than actual issues. “There is a lot of jockeying for position—there is a mentality of ‘we are a better provider because we are structured this way or that way.’ It is non-productive and is primarily driven by providers, not clients,” he says. “What is important is that you have a well-resourced, diversified and experienced team who can deliver all elements required for the transition.”
As the market is in a huge growth spurt, it looks like competition will just continue to grow. However, some of the internal squabbles are being addressed by market-driven standards such as the T-Charter and T Standard. The T Standard is a methodology for calculating portfolio performance during a transition, to provide a standardized way to measure performance and make it harder for providers to disguise bad results. The T-Charter is a code of best practice for transition managers. It covers disclosure and conflicts of interest, client confidentiality, systems and processes, cost estimates, remuneration, and dealing strategy and practices, among other things.