Timing is everything in transition management but, as Emma Cusworth finds, the industry is at odds over the optimal point to transact in order to obtain the best result for clients.
“From the clients’ perspective, if you know what you want to do, it is better to take risk off the table as soon as possible. It has become established practice to put hedges in place on T-1 or before.”
Graham Dixon
Measuring the performance of a transition manager (TM) has become an increasingly important aspect of how investors gauge the value they have derived from using an external TM to help them move assets from A to B. There have been calls for greater standardisation in how TMs report on performance, but very few transitions are created equal. Moreover, very few investors are created equal and, particularly in the world of transitioning assets, the relevance of performance measures varies widely.
IMPLEMENTATION SHORTFALL
One of the most commonly used measures for gauging how successful a transition was is by measuring the implementation shortfall (IS). The IS defines the difference in performance between the legacy and target portfolios. In order to create an objective and measurable starting point, the benchmark for IS is usually set as the closing prices of securities on the day before trading commences.
IS effectively assumes the transition is carried out instantaneously and at zero cost. As a result, it includes two important factors: the first is the impact of transaction costs, spreads, taxes and commissions; the second is the impact of changes in the prices of securities in the market, which is inherent in any deal that cannot be transacted in a single go and has to be carried out over a longer period of time. It follows that in volatile periods or markets, managing implementation shortfall is a more tricky task.
This second point is particularly important because transitions can in themselves influence the prices of securities by affecting the total supply or demand for assets around a trading point. It can also alter the bid/offer spread on those assets.
A CLEAR BENCHMARK?
There has been a growing trend among transition managers to propose strategies in which trading begins ahead of where the benchmark point for IS is set. As such, they suggest trading a proportion of assets in the closing auction the day before the transition officially starts.
By trading some assets early, TMs argue they can achieve cost savings for clients, effectively eliminating the IS on the portion of the portfolio that is being traded. This happens because they can be executed at the closing price, which will then set the benchmark point for IS and are therefore traded at ‘zero cost’ – i.e. there is no shortfall in asset price versus the benchmark.
It is also argued by some TM providers that trading on T-1 (the day before the transaction officially starts, or T) can work to reduce the impact of trading a portfolio of assets on the price movements of those assets, therefore decreasing IS across the whole transition. In other words, trading is more spread out and the trades associated with a particular transition will be a smaller proportion of total market average daily volumes. This, in turn, minimises the market impact of a transition on those assets.
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