The tricky proposition of simultaneously restructuring portfolios while changing investment managers can be daunting for even the most sophisticated pension fund sponsor. If badly handled, a transition can severely impact the health of a pension fund.

Transition managers allow pension funds to allocate assets efficiently – both with reference to a scheme’s liabilities and across fund management providers – by facilitating the change process in a way that gives the pension manager comfort that the portfolio migration will run smoothly and that the scheme’s assets will be preserved throughout any portfolio restructuring.

A comparison can be drawn between the role of a stock market and the role of the transition manager. The world’s stock markets allow for the efficient allocation of capital to the world’s leading companies by providing a transparent, orderly and cost-effective way of trading individual stocks and bonds. Similarly, a transition manager allows for the efficient allocation of pension assets across the world’s pension funds and managers by providing a transparent, orderly and cost-effective way of restructuring entire portfolios.

We all know that stock markets can go up or down – or, put in terms of a fund manager, that past performance is not necessarily a guide to future returns. But transition management services are a win-win scenario. The quick and efficient restructuring of investment portfolios can only help the pension fund industry achieve higher returns and tackle the increasing demands of the current investment climate.

Smooth transitions and maximised performance

Over the past five years the dominant theme to the majority of transitions has been the move from balanced to specialist managers. Initial performance analysis1 has indicated that this move to specialist management has had a beneficial impact on the basis of both raw and risk-adjusted returns.

Any pension fund considering using a transition manager to effect a smooth transition with maximised performance should bear in mind the following standard transition objectives:

  • minimise all the transition costs associated with the restructuring;
  • provide a smooth and efficient migration process;
  • maintain client confidentiality;
  • pro-actively manage both portfolio and operational risk;
  • minimise market turnover by maximising portfolio retentions and internal crossing, and
  • provide full and transparent reporting, including a complete audit trail.

Any transition manager that successfully achieves these objectives will deliver significant benefits to the pension manager. But what does that mean in practice? Let us first consider what is actually involved in the successful completion of a complex transition project. Figure 1 gives a summary of the tasks and interaction between all the parties involved in a transition we recently completed for a UK company pension scheme.

One glance at this complex diagram highlights the need to use a transition manager to assume responsibility for this process and to provide significant comfort to a board of trustees. However from a transition manager’s point of view, the diagram really only shows his day-to-day role, completed swiftly and efficiently for every transition he manages.

Life becomes a little more complicated when the specific challenges of an individual transition are identified. This is where a good transition manager truly adds value. These challenges will be different for each transition; below are some examples from recent transitions completed by our transition team:

  • managing the portfolio risk (7.3% tracking error between the target and legacy portfolios) of a $1bn (e850m) portfolio to be traded over a number of days;
  • managing complex tactical asset allocation and currency overlay mandates across a number of portfolios during the transition process;
  • the concurrent restructuring of 20 daily priced mutual funds ranging from emerging markets to corporate bonds with daily cash inflows and outflows;
  • building an automated interface with a client’s back and middle office systems;
  • liquidating an extensive portfolio of investment trusts, OEICs and UK unit trusts while maintaining the desired target asset allocation, and
  • restructuring an emerging market portfolio involving six different fund managers and investment vehicles.

As transition management services grow, pension funds are imposing ever more urgent and complex demands. It is in providing these client-specific services where a transition manager can provide the extra level of comfort to a pension fund.

Preserving assets and minimising performance drag

Given that the transition manager has delivered a smooth and efficient transition process, how does he preserve the value of a scheme’s assets or alternatively minimise the performance drag during the transition period? It is obviously this function that is most important for the efficient allocation of pension fund assets, which is the ultimate responsibility of all fund trustees.

There are four key factors that are fundamental to minimising performance drag:

  • choosing the right transition benchmark,
  • the ability to access multiple liquidity sources,
  • removal of all conflicts of interest between a pension fund and its transition manager, and
  • risk management.

It is in the area of risk management that key advances have been made and in which the influence of transition management techniques can be seen on other areas. Risk management processes have resulted in the average costs of portfolio restructuring enjoying a continuous fall over recent years. While discussions of risk management can quickly become very technical, there are two key themes that should be borne in mind:

  • managing the performance risk of the portfolio, and
  • ensuring that the risk management strategy runs through the complete execution process.

While the first point may seem obvious, it is often overlooked by transition managers overly focused on peer group trading benchmarks such as the market close or volume weighted average price (VWAP) during a transition. These benchmarks will often not be in the best interests of a fund. And there is a clear analogy here between managing a pension schemes to a peer group rather than to a scheme-specific benchmark. If portfolio restructurings are managed against an inappropriate benchmark, they can lead to sub-optimal results.

To achieve the best results, a transition manager should manage the performance risk to which a pension fund is exposed during the transition process – that is, the tracking error between the target and legacy portfolios. This tracking error should be consistently reduced throughout the implementation process. To achieve this, risk management strategies should be managed throughout the life of a portfolio restructuring. The execution process will often involve transactions with multiple liquidity sources and the risk management process should overlay the combined execution process, as represented in Figure 2.

Driving transition growth

The irreplaceable role of transition managers in preserving the value of pension scheme assets while smoothing the transition process has been the primary driver for the transition sector’s rapid growth over the past 10 years. The success of this process has inspired many clients to make subsequent alterations to parts or all of their portfolios.

At the same time, pension plan managers have seen the benefits of transition management ‘passed’ from fund to fund, resulting in the current ‘virtuous growth circle’. This has allowed pension funds to minimise the performance drag of major portfolio restructurings and efficiently allocate resources with regard to scheme liabilities across asset management providers.

This can have only one effect: to help the pension fund industry achieve higher returns and tackle the increasing demands of the current investment climate. Further developments, such as advances in risk management and the ability to handle ever-more complex transitions, will continue to reduce restructuring costs and risks, making the overall pension fund industry more efficient.

Lachlan French is a vice president at State Street in London

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