Confessions of a transition manager
Executive summary:
- Meeting or beating a trading benchmark doesn't equate to good portfolio performance. In order to measure the success of a transition, utilizing a T-Standard transition performance measurement methodology is critical.
- Transition management is so much more than just trading. We see a transition manager's greatest value as prudent risk management strategies and organized project plans.
- Without performance measurement, there is no accountability and thus no fiduciary. This is why we believe that measurement of performance is the most important due diligence question an investor can ask when determining who should manage their transition.
Our director of transition management shares five key takeaways from a career in managing portfolio transitions.
Confession #1
We love our jargon in transition management! It’s often a challenge for existing transition clients, let alone those unfamiliar with the industry as a whole, to get their heads around all the jargon we use as transition managers. We take it for granted that clients know what the T-Standard is or what Implementation Shortfall means, and that the T-Charter has been read by all users of transition management services, but this might not always be the case! With this in mind, here’s an explanation of a few key terms.
T-Charter - Established in 2007, the T-Charter represents a set of 10 principles drawn up by the transition management industry to provide greater transparency into how transitions should be managed, resourced and measured. The T-Charter also provides pro forma templates for all cost estimates, so clients can more easily compare transition managers’ cost estimates. Prior to this, fees were often quoted in very different ways—sometimes in a very opaque manner—and every manager had their own way of reporting costs, which made comparisons extremely difficult.
T-Standard - Established in 2003 by Russell Investments, the T-Standard has been adopted as the industry-standard methodology for treatment of the critical factors that drive portfolio performance during a transition. The T-Standard Implementation Shortfall is the arithmetic difference between the return on the actual transition portfolio and the return on the new portfolio, performed on a daily basis. The T-Standard measure of implementation shortfall (IS) was adopted by the T-Charter as the recommended default calculation for IS.
Implementation Shortfall (IS) - Generally accepted industry standard for measuring the cost of a transition. IS captures all of the costs associated with a transition, including brokerage, taxes, fees, foreign exchange, bid/ask spread, pooled fund spreads, dilution levies, market impact and opportunity cost/gain. IS compares the actual transition portfolio return with that of the new portfolio return, assuming the new portfolio had been built on the day before the transition commenced and at zero cost.
Confession #2
All trading benchmarks can be gamed, but there is no gaming time-weighted performance.
Trading benchmarks like today's close, today's open, volume weighted average price (VWAP) and other trading benchmarks can be influenced by a trader's contemporaneous executions and directly influence these benchmarks. Savvy traders will execute trades in a way that will influence these benchmarks to create the perception that they have met or beat the benchmark.
In reality, meeting or beating a trading benchmark does not equate to good portfolio performance. A trader can consistently beat their given trading benchmarks while concurrently damaging total portfolio performance. This is why T-Standard transition performance measurement methodology has been so important for asset owners for measuring transition success, because it can't be gamed.
To be T-Standard compliant, the reference date/time/prices must be the most recent closing prices prior to when the transition manager receives all the information needed to execute trades. This is the only measurement that will capture all of the transaction costs and opportunity risk and can't be gamed. If you want to know the true cost of a transition, measure it with T-Standard implementation shortfall with the previous night's closing prices (T-1). If you just want to see trades align with their trading benchmark, benchmark against today's close (T) and instruct market-on-close (MOC) orders. You literally can't miss your benchmark, but don't expect portfolio performance success because it won't be there.
Confession #3
Transition managers like to talk about trading, but trading is not the most important thing in transition management. Trading is important, but other factors are more correlated with successful transition outcomes. Transition managers like to talk about execution and technology (the sexy stuff), but in reality the transition manager's greatest value is prudent risk management strategies and organized project plans, with estimates that set expectations and inform the investor about the transition process.
It's not as interesting as the trading technology and execution tactics, but transition managers satisfy a more basic need: prudent stewardship over the process of implementing portfolio changes. No single venue, technology or transaction is the key to successful transition management. Like everything else with investing, it's about the process. Successful investors will look for providers resourced to provide comprehensive risk and project management, combined with a transparent process that consistently delivers value again and again. Successful investors recognize they need experienced and skilled resources to help them navigate through a transition project, not just execute a trade.
Confession #4
Not all crossing is beneficial. Crossing is often viewed as a serendipitous win-win, where both sides benefit with no drawbacks. For decades, it’s been touted as a panacea of cost reduction for transitions, but we confess that it's not as correlated with good performance as it's been portrayed by many transition management providers. Often such crossing, especially “internal” crossing, took place at the end of the trading day. Therefore, although cost reduction—in terms of spread and market impact—might have been evident, this was at the cost of an extra full day’s risk for names that, quite often, could have been completed early in the day at little cost anyway.
Furthermore, high frequency trading (HFT) exposed that a trade is more than just a trade. Any trade, even a cross, can also be a powerful signal. Case-in-point: We discovered that ECNs, ATSs and Crossing Networks were all being exploited by a few smart, very well-funded trading firms that discovered milliseconds matter and that speed can enable certain market participants to extract profits with almost no risk.
This isn’t to say that HFTs are inherently bad or evil, but rather that they’re innovative. In essence, they took the misguided conclusion that crossing is always fair and equitable and molded a business around the reality that any trade, cross or not, can provide information about an investor’s next move. That is incredibly valuable information.
All HFT strategies involve the use of crossing platforms and, as it turns out, these crosses were only good for side of the trade. Blind faith in crossing is imprudent. More important is the structure of the trading process in which the cross takes place. Knowledge of venues and safeguards in process, combined with trading expertise, are the only protections you have in trading, crossing or otherwise.
Confession #5
Without performance measurement, there is no accountability and thus no fiduciary. Time-weighted performance is the quantitative measure of transition success, but it's also so much more. When the rules of success are so clearly defined as they are with the T-Standard, the motives and intent of the transition provider will align with the client's goal of minimizing the performance impact of the event.
Transition management has similarities to ongoing asset management, but transition services are very different than what your ongoing asset managers provide. We all have our place in the investment ecosystem and although we use much of the same vocabulary and many of the same tools, transition managers and investment managers serve very different functions.
Investment managers build processes and systems to scale long-term investment value to thousands of investors concurrently. Transition managers focus on a small sub-set of time in the investment process when change takes place, efficiently moving assets between investment strategies for a single investor at a time. Yet we frequently see asset owners employing ongoing investment managers to implement transitions, mostly out of indifference for the transition process. Using ongoing asset managers to manage transitions is neither prudent nor effective. Transition managers provide a specialized service with process, systems and skill to efficiently implement portfolio changes. And how do we know this? Because we measure results.
Measurement of performance is the most important due diligence question an investor can ask when determining who should manage their transition: Will the provider measure performance with T-Standard implementation shortfall? I.e., will the provider be accountable for performance?
Categorically, investment managers will not provide T-Standard implementation shortfall performance results. In fact, an investment manager will always choose option B: a performance holiday. They are not wrong for electing to take the holiday if granted to them by the investor. After all, why assume the burden of setting expectations, measuring performance, and taking accountability for something that is not core to the business and does not provide any economic incentive? And this highlights the performance-holiday fiduciary paradox: You can't be a true fiduciary without accountability, and you can't have accountability without measuring performance. Yes, an investment manager can trade, but transition management is so much more than trading. It's short-term intensive project management combined with astute risk management crammed into a very short time horizon. To implement successfully, investors need to set the bar higher. They need a transition specialist.