Unless you are a twenty something millennial living in New York or San Francisco, you most likely own a car. If you are old enough like me you may even remember your first car probably with a manual gear shift. Mine was a Burgundy 1988 Honda Accord with a manual gear shift and flip up headlights. I thought they were so cool back then. When you are driving you may need to slow down, accelerate, turn, or you may need to brake, and change gears. Every one of those actions introduces some element of friction in the process of transitioning from one speed to another or one direction to another. In the world of investment implementation the process of changing investments or transitioning assets introduces friction in the form of unnecessary costs and unintended risks. Transition management is an investment exercise that is intended to minimize frictional costs and risks, while aiming to realize the investment returns expected of such assets while they are in motion. These assets could be equities, bonds, currencies, derivatives or any other publicly traded securities.
There are many reasons why assets need to be transitioned such as changing investment managers, changing strategic asset allocation, rebalancing a portfolio, or redeeming assets for operating needs. A clearly articulated investment strategy is necessary during such times to identify and mitigate unnecessary costs and unwanted risks i.e. friction in your portfolio returns. Many clients may choose to use a transition manager – hopefully a reputable one with a fully transparent cost structure / business model and a fiduciary practice of acting in the best interests of the client.
Sometimes clients may choose to implement a transition in-house. If you choose to do so, does your team have the right capability, infrastructure and tools necessary to accomplish the investment outcomes and cost savings that you would expect from a transition manager. Who will be accountable for the performance outcomes that your portfolio is still expected to achieve during this transition period. Many clients would be better off hiring the right transition manager rather than the “Home Depot Do-It-Yourself” approach to transitions.
What about my investment managers, you ask? Can they not do this on my behalf if the old manager sells the legacy assets and the new manager buys the target assets. Sure they can trade the assets but legacy investment managers are likely to use this outflow of assets as an opportunity to restructure their portfolio for the benefit of remaining investors. New investment managers are likely to demand a performance holiday, where no one is held accountable for returns on the investments. This path could save you a few basis points in transition manager costs but could very likely cost a lot more in investment returns and risks.
Transitions involve costs – explicit and implicit, and risks – financial, operational and reputational. Explicit costs such as brokerage commissions and transition manager fees are a good objective measure, but they should not be the only decision making criteria. Implicit costs such as bid/ask spreads, FX transaction costs and the opportunity costs from timing of a transition should also be considered. Financial risks such as exposure gaps, poor trade implementation and more importantly information leakage could be significant depending on the size and complexity of the transition. Operational risks such as regulatory compliance, trade settlement risks, and overdrafts may be minor yet important risks that need to be managed by a competent and professional transition manager.
The decision to work with any transition manager does involve reputational risk for the fiduciary decision makers if the chosen transition manager fails to deliver the expected outcome or worse behaves in a manner that would not comply with fiduciary obligations. Asset owners must be cognizant of this fiduciary responsibility to choose transition managers that act in the best interest of their clients rather than use the lowest explicit costs as a crutch for decision making. You need an implementation strategy that clearly articulates the reasons for choosing or not choosing a transition manager, ways to manage explicit and implicit costs, the potential risks involved and strategies to mitigate those risks. The implementation strategy is a roadmap for helping you accomplish the investment outcome that you want and deserve.