Dec 2007-Jan 2008

TRANSITION MANAGEMENT: Controlling the show

In an increasingly complex marketplace, investors are finding they need specialist help in transferring funds between portfolios –  enter the transition manager. By Nick Fitzpatrick 07_12_transition_management.jpgChoosing a hedge fund is difficult enough for institutional investors, yet once a fund is selected the problems do not end there. In fact the next stage is arguably as crucial: that of transferring assets into the hedge fund’s portfolio. This is because hedge funds are famously secretive about what they own, meaning that investors who opt to make an allocation to a hedge fund may quite literally not know what they are getting themselves into. To keep their portfolios a secret – even from their clients – hedge funds often require investors to give them cash so that they can buy their assets more discreetly. Traditionally when an investor moved between two long-only managers, the target manager would require not cash, but a ready-made portfolio of assets. This makes long-only portfolio transitions much more transparent. The problem with this cash requirement is that it can mean the investor has to tolerate a cash exposure for weeks or even months while the hedge fund builds its often-complicated portfolio. And finding an appropriate hedge for the target portfolio in the meantime may be difficult when nothing but a few characteristics about the portfolio are known.

Confused investors

Transition managers, the specialists who help investors move from one asset manager or portfolio to another, have had a few years to work out a solution thanks to larger pension schemes who gave them early experience in the matter. But transition providers now report a significant uptick in hedge fund allocations by smaller funds. “We are increasingly seeing mainstream funds make allocations into alternative strategies like hedge funds,” says David Edgar, head of transition management at Barclays Global Investors (BGI). His view is reflected by other providers such as Citi and State Street. In the past, when indexation ruled and when one plain long-only portfolio could be transitioned almost in its entirety from one manager to another, the investor hardly needed to employ a third-party transition manager. In comparison to today’s more complex transitions, a pension fund had to do no more than flick a switch. Then the objective was often to simply obtain a better manager for the same portfolio rather than materially change the portfolio composition. But diversification into more complex asset classes and strategies such as hedge funds, emerging markets and liability-driven investment (LDI) mandates, means offering specialist transition services to confused investors is a good business to be in for the banks and asset managers that offer them. Providers say they are finding more business flows from an ever wider base of investors who seek their help, and that the size of the trades is increasing.

Changing role
But as well as bigger business, increasing complexity means that the role of the transition manager is changing. “We are not simply talking about moving assets in and out of portfolios anymore,” says Edgar. “Transition managers are being asked to take more of a strategic view for their clients, such as providing advice on futures overlays, or offering interim portfolio management.” Interim management is important when it comes to sitting on cash for several weeks. In fact an investor’s assets may sit between portfolios from anything between a few days to as much as six months. Ed Pennings, managing director of portfolio solutions at State Street, says: “With some hedge funds, it is possible to build a portfolio, but a lot of them just want cash.” He adds: “I understand why they want to do this and there are good reasons for it.” The reason is, of course, to keep their alpha-generating assets a secret. This is well and good for the investor once in the fund, but sitting with a prolonged cash exposure is not very desirable. But this cash scenario is not unique to hedge fund transitions. It can also be an issue with other assets, like property. Tim Wilkinson, global head of transition management at Citi, says: “If you are selling assets and buying into absolute return, the new manager may demand cash, which introduces out-of-market risk that needs to be carefully managed.” Typically, when a portfolio transition begins, the first stage is to put in place an overlay strategy and a hedge while the initial portfolio is liquidated. It is a common strategy in all kinds of transitions, but in the case of very exotic hedge funds or assets like property and swaps it can sometimes be difficult to find an appropriate overlay, so an interim benchmark will be used, typically one that outperforms cash. Edgar says: “When you deal with alternative managers, investors typically provide them with cash and in the case of property, this becomes a timing issue. The question is: When does the property manager want the cashflows and what do you do with the interim exposure, as it’s not going to be easy to hedge it? Some asset classes can be hedged with ETFs (exchange-traded funds). But some assets can’t always be hedged on a like-for-like basis.” BGI has built a long-short portfolio for clients transitioning into one of its own long-short funds and it is developing a similar strategy for transitioning clients to other managers. Pennings, of State Street, says: “As a fiduciary we can hold certain investments for a longer period of time. If the portfolio is in cash for a long time, we might advise a move to another asset class, implementing an interim overlay strategy.” Providers report that hedge fund transitions are still only a small part of their overall business, despite their growth. Much bigger drivers of their businesses in Europe in recent months have been emerging market portfolios. Providers also say that LDI mandates have been a significant source of business over the last year. Pennings believes the rise in LDI may be because funds have “finally reached a stage where they are happy to sell out of equities since the markets recovered”.

Pursuit of alpha
Also, according to Wilkinson at Citi, there is an increasing shift between high alpha managers after investors were left disappointed when the hoped-for stellar results were not gained. Similarly, Pennings says: “We are seeing the first turnaround after the initial move from balanced to specialist mandates... Some of the specialist managers are now being turned over in favour of others.” Commodities and timberland, too, are driving business, say the providers. Indeed, it is the pursuit of alpha, risk and diversification that is fuelling the transition management industry. But these services have to be paid for, and the more complex the transition, the more expensive the service. The first consideration when deciding whether to use a transition manager is whether it is worth the cost. Transition managers market themselves on the ability to add value in transitions. They say they offer more value than an ordinary execution brokerage or than the target manager could offer. Yet, as hedge fund transitions mean that a transition manager may only execute one half of the transition – ie, liquidating the legacy portfolio – they can only add value for this half of the process. Mark Dwyer, a vice president in Mellon Transition Management Services, says: “By giving cash to hedge funds, the investor may not get the added value that a transition manager can bring by buying the new portfolio.” But managers feel that their services are being recognised. The growth in their business is, after all, down partly to an increasing take-up by investors. Kal Bassily, global head of BNY Global Transition Management, says: “We have seen an increase in transition management activities and it has been driven partly by more and more asset owners who realise that transition management can add value.” Bassily says that BNY Global Transition Management has carried out transitions totalling around $100bn globally in the past year, and that mutual funds and multi-managers are increasingly among clients. State Street reports that it has carried out over 800 European transitions globally in the past twelve months out of London. Pennings, of State Street says: “Five to six years ago when an investor did not use a transition manager, they may have witnessed a 2% drag, but now that figure can be as low as 20bps or better if the transition is managed properly by a specialist. “So the decision to use a transition manager now is much easier to make.” © fe December 2007 / January 2008

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