Bank failures mean transition managers need to prove their commitment. At the same time the demand for portfolio changes has increased as a result of the financial crisis, finds Nick Fitzpatrick. Plus, we present three years’ worth of transition data from top managers.As if investors did not have enough to worry about when shifting their assets between investment portfolios, the financial crisis has recently added an extra risk to the exercise known as transition management. The risk is that the service provider collapses during the operation.
There has always been the remote possibility that this might happen, of course, but not until recent months did this particular risk register anywhere near the serious mark. Before the failure of Lehman Brothers the main risks associated with portfolio transitions were of the more run-of-the-mill kind, albeit still complex. These were trading risks and information leakage, among others.
But if a transition manager was to collapse, this could see assets virtually disappear altogether, leaving investors and their custodians with the superhuman task of establishing ownership and exposures.
At least one large institution, and probably more, was halfway through a portfolio transition with Lehman Brothers as its provider when the bank failed. Portfolio transitions have always been nerve-racking. But trustees and other fiduciaries will gnaw deeper into their fingernails now.
The possibility of provider failure is currently the worst-case scenario facing institutions involved in portfolio switches. Transition managers have grown up in recent years exactly because they could control or contain the various risks associated with transitioning between one portfolio of assets to another. But now that they themselves may be a risk in their own right, institutions will seek extra assurances of commitment to the industry.
Peter Walker, head of transition management at BlackRock Solutions, says: “Clients will want to see more depth associated with a provider’s commitment to transition management. To help clients gauge this, they will assess how much is being invested in resources, analytical tools and technology.”
Given that the financial crisis so far has centred mainly on banks, it is the transition management operations run by investment banks that could come under the most pressure to demonstrate their levels of commitment, which is not easy given the high levels of redundancies. Credit Suisse, for example, is axing 650 jobs from its entire UK workforce. Aside from this the head of its European transition team and other members have left, although the bank says these will be replaced.
Hari Achuthan, director in transition management, says: “London is still the headquarters for our European transition business. The team is now more aligned with the global product offering going forward.”
It would be wrong to rule out all investment banks, including Credit Suisse, from the transition management business. JPMorgan’s fortunes have increased lately. It recently expanded its transition management team in Europe, with recruitments from Lehman and UBS. It also saw record flows of transition business in 2008. John Minderides, global head of JPMorgan’s transition management operation, says that earlier in 2008 the bank conducted a transition in excess of $15bn (€11.8bn) and that transitions such as
this helped increase JPMorgan’s transition flows by two-fold in the first three quarters of the year.
Credit Suisse claims a record with the transition of a notional value of $18bn in 2008.
As well as the more routine transitions that result from the rebalancing of portfolios, Credit Suisse and JP Morgan say a lot of activity witnessed in 2008 has been non-typical and related to collateral management, which increased as a result of the crisis.
Pent up demand
Beyond investment banks, custody banks, like State Street and BNY Mellon, and asset management companies, such as BGI, Russell Investments and BlackRock, also provide transition services. All of them are likely to see more business in the months ahead because, say certain providers, many portfolio changes that are a result of the crisis have not yet been made. Uncertainty about the trading environment is creating a pent-up demand for the future.
Achuthan, at Credit Suisse, says: “In terms of asset allocation decisions, pension funds are waiting for the markets to stabilise. There will be more transitions from this towards the end of Q1 and in Q2 next year."
Minderides, at JPMorgan, says: “A lot of transitions by clients in reaction to the crisis are probably still to come. The recent state of the markets will have left asset allocations out of sync, but some people do not want to trade in these conditions.”
Minderides acknowledges that managing risks in equity transitions – such as opportunity risks, trading risks etc – has become much harder in markets where stocks might move up or down by 10% in any single day.
“Markets become much more directional, meaning we have to trade at just the right time,” he says.
But the increased volatility may have actually reduced the market impact of large transitions, which would become practically invisible in heavily swaying markets.
“Quantitatively it could be argued that the market impact of transitions may have reduced, because the volumes are there if you can find them, but the opportunity costs have gone up.”
This refers to the opportunity to trade in and out of stocks at appropriate prices. Minderides says: “Sector performance, for example, has been very important, more so than in the past. If you have a trade linked to the direction of financials, then the risk has to be managed appropriately.”
Similarly, Walker at BlackRock adds: “Market exposure has to be maintained at an optimal level throughout the transition process. If you’re selling Europe and buying Asia it’s hard to do so at the same time, as one market is closed while the other is open. So which do you do first? In one case, if you buy before selling then you potentially gear the portfolio. However, if you sell before buying then you have the opposite effect as you are effectively out of the market for a while.
“But using futures or ETFs [exchange-traded funds] you can trade both simultaneously.”
The crisis added liquidity to equities markets. But this is not the case for fixed-income instruments, such as bonds. This is where the most pent-up demand is situated.
Walker says: “Liquidity has been very challenging. Trading corporates in particular has been difficult because of the reluctance of banks to make prices and volatility in spreads. Bonds are not generic and there is considerable name-specific risk.”
He adds: “Investors have had to really consider whether now is a good time to change bond managers if it is the result of underperformance.
“After all, this is a credit crunch, and the banks have not been providing the liquidity that they were providing a year ago. Unlike equities, bonds are not traded on an exchange and instead you have to buy and sell through a bank. The credit crunch has handicapped banks. What would normally take less than a week to transition is now taking longer.”
Walker says he has seen an increase in bond enquiries recently. “[Bond transition activity] was quiet through the second and third quarters and into October. However, we are now being asked to quote more and I think there is a demand for bond transactions building up in the pipeline. Some investors have been looking to make changes for twelve months.”
Minderides, at JPMorgan, adds: “Many types of bonds have been affected by liquidity, although this is not so much the case
with governments or treasuries.” JPMorgan has added to its fixed-income capability over the past year as part of its broader expansion.
In essence, transition management is an extension of everyday portfolio management and many investors might still depend on their asset managers to do this for them. But a transition specialist adds value particularly when a manager is fired – after all, the outgoing asset manager is much less likely to worry about obtaining a good sell price when relinquishing a portfolio.
According to a TABB Group report in May 2008, transition managers now receive about 45% of all transition mandates. The report (The Optimal Transition: Mitigating Risk and Minimizing Market Impact) says this results from the risks associated with increasingly complex, global, multi-asset portfolios for institutional investors.
Transition managers currently trade over $2 trillion worth of assets annually worldwide, the report says.
The optimal transition, says Adam Sussman, director of research at TABB Group, “is where you move from a legacy to a target portfolio by minimising the opportunity and transaction costs, and where you do this quickly without tipping the market off.” This is more of an art than a science, he adds.
One thing seems certain: there will be fewer transition managers with more business in the year ahead.
Achuthan, at Credit Suisse, says: "From a broad market perspective, we are all seeing a rapid consolidation of providers. Ten years ago there were 30 providers; now there are more like 12 to 15 and it will potentially shrink to something like five or six."
©2008 funds europe