Setting the agenda

PARTICIPANTS:

Amelie Labbe, Global Investor (chair)

Andy Gilbert, EMEA head of transition client strategy, BlackRock

Paul McGee, head of portfolio solutions

EMEA, Macquarie Capital

Ashish Patel, EMEA head of transition management & portfolio solutions, Citi

James Woodward, global head of State Street’s transition management business

David Edgar, director of transitions at Inalytics

Chris Adolph, director, customised portfolio solutions EMEA, Russell Investments

Cyril Vidal, head of portfolio transition solutions, Goldman Sachs

In early December 2022, Global Investor brought together the industry’s leading transition managers and consultants to discuss some of the key issues affecting clients including costs, the impact of interim solutions, the evolution of data analysis, and how business models are adapting to market conditions.

Setting The Scene

Amelie Labbe: How has geopolitical and economic uncertainty impacted clients over the last 12 months?

Andy Gilbert: Volatility remained elevated throughout the year across the majority of asset classes. It is during these periods of excessive volatility that there is a greater need for transition management to assist clients when they are undertaking change. If you don’t identify these costs and risks, how can you ever expect to manage them?

It is incumbent on the transition management industry to highlight risks and costs and identify how they can be managed, whether that is via hedging strategies or improved access to liquidity to trade more efficiently.

Ashish Patel: Clients who use transition management are typically very long-term investors who can afford to be patient during times of volatility. So what we do as transition managers is to assist these clients to continually assess or validate how they think about these impacts of volatility on portfolio allocation, asset manager selection. What we have found this year more so than ever is that we are being engaged earlier in the investment lifecycle.

Clients come to us and ask ‘what does this portfolio structure look like’, ‘how can we reduce tracking error’, and ‘how can you guide us in the investment decision process’.

As Andy alluded to, we have to think about the opportunity cost, the access to liquidity amongst these restructures. What that further means is that when clients have a potential go live date, can we think about moving the goalposts?

David Edgar: A lot of clients are making changes for strategic reasons and in many ways, the political backdrop and global economic situation doesn’t necessarily change that. Much of the skill comes in taking the client through the transition experience without any surprises.

What is completely different is what happened in September and October this year in the DB pension world, and I am not sure we know exactly where that is leading, but I think there will surely be changes in 2023. I expect that pension funds are taking stock and thinking about what the future holds for them. There could well be new regulation around that, which would mean further changes.

Paul McGee: I would agree that what we have observed with heightened volatility is more of a requirement to handhold our clients, such as assisting them with ongoing assessments of current market conditions, and cost estimates. They are looking to us to advise them, for example, on whether they should phase their transition as opposed to going big-bang on one particular trading day. We have also seen a need for more regular communication, not only in the lead-up to transition but during the trading, perhaps talking to the client three or four times a day to assess conditions and whether we proceed on the planned participation rate.

Cyril Vidal: The sort of things I would really encourage the client to look at include ‘what flexibility can my provider give me’ and ‘can they show me some evidence of that’.

Chris Adolph: In periods of high volatility there can be a wider range around the mean cost estimate we give our clients, and that can be challenging if it moves dramatically away from that estimate. This is where communication becomes really important and also for clients to understand how we propose to manage such periods.

James Woodward: The point about manager communication is important because we are seeing some of the stocks within model portfolios changing substantially, moving up to 10% in a single day. Communication in terms of whether clients want to maintain their weight in a particular stock, especially if it is a position that has been built over a number of days, is important to make sure the validity of the model is still there with the manager under the circumstances.

Client Needs

Amelie Labbe: Are clients becoming more cost conscious and have managers become better at explaining the value of the service and what they provide?

Cyril Vidal: It is about managing costs and reporting them. But more important is listening to what the client wants us to report and how they see cost internally and making sure we don’t deviate too much from that.

James Woodward: What we have seen with market volatility is greater variability in terms of pre-trade versus actual result. Typically, if the clients use an implementation shortfalltype benchmark it is not uncommon to see an overnight gap of 20 or even 30 basis points. There are some ways in which we can mitigate that overnight risk, but it really comes down to those markets - if you are trading the next day using a previous close benchmark, they are not available to trade because those markets are closed.

At the pre-trade stage we have done a much better job over the past five years as an industry in terms of outlining volatility. Many of us have used calendar heat maps to help guide customers in terms of particular days where there may be an earnings release or an announcement from the Fed. However, sentiment is unpredictable.

David Edgar: James is making a key pointthere are only certain costs that a transition manager can control – and the definition of ‘cost’ in this context is also important. We call it costs because transition managers have this implementation shortfall benchmark, but the reality is a lot of it is actually portfolio performance and it is a measure of what is happening to the performance of portfolios relative to each other as you switch from A to B. Most of that, generally, is due to external market factors over which an individual transition manager has little control.

Ashish Patel: We’ve talked about transaction costs and market costs, but another element to consider is the most cost effective fund structure, how clients think about pooling funds to mitigate operational costs and have more streamlined structures.

It is up to us to explain the qualitative and quantitative drivers of cost and link them in a very easily digestible format to the client.

Paul McGee: We should remember that the value of a transition manager goes far beyond just cost reduction. So as long as the actions you have taken whilst managing the transition have been appropriate and suitable, the costs will be what the costs will be. There is much more to the value-add of employing a transition manager, such as taking away the operational burden from clients, and coordinating all the project stakeholders.

Andy Gilbert: I agree. What we are really talking about here is trying to preserve portfolio performance as we go through a transition, and what we are actually doing is estimating what that performance is likely to be.

That ability to estimate is influenced by many factors but I totally agree with Paul’s point. The value add of a transition manager isn’t just limited to preserving portfolio performancemanaging operational risk is just as important.

Interim Solutions

Amelie Labbe: How much of a role are interim solutions playing in the transition management space?

Paul McGee: We continue to see the need for interim solutions for a number of reasons. It may be that a client has had a manager on watch for underperformance for a period of time and has now decided to pull the trigger and terminate the mandate. However, they may not be there yet in terms of deciding who they are going to appoint or with the legal documentation, potentially even when they have identified who they would like to appoint.

Equally, we might see a so-called emergency exit situation where there may have been a team lift-out from an investment management house, the departure of key staff or a star fund manager, or even a corporate scandal where the client has lost faith in the management of the firm they have appointed.

The ability to offer a temporary home for the mandate and buy the client some time to make an informed decision is very valuable. We can put that client into a safe, stable, low risk mandate of their choosing.

Chris Adolph: We had an example of team lift-out this year where a client had literally just gone through the process of hiring a new manager and allocating a large amount of money into emerging market debt. The manager was only in place for a month and a half when the whole team was lifted by another asset manager.

Within a week or so we were having a conversation about transition because we had pitched for the original event and the client came back and said they now needed something else.

This process can be relatively quick, but if you have to do other things like go through an onboarding due diligence process, you are having to squeeze due diligence that might normally take months into a very short period. I think we went from having a conversation to looking at transferring assets within a month, including a due diligence visit.

What you tend to do is a number of different scenario analyses to find what suits - some clients might want to go almost completely passive, others will take the view that there is no point since they taking all that risk off and then going to have to transition again into a new portfolio. What works for the client is key and transaction costs often sit right in the middle of that.

David Edgar: This is one of the reasons why we suggest that clients set up a panel of transition managers. If they do find themselves in this situation, they can move quickly - if they have the panel in place, they can just pick up the phone and get it done.

Andy Gilbert: We have occasionally seen clients that have looked at the tracking error tolerances of their mandates and have wanted to reduce them. The key factor here is that the interim management proposition is suitable for the client’s needs.

Prior to undertaking the assignment, it is just as important to explain to clients what interim management is and what it is designed to do as what it isn’t. Essentially, it is just a bridge to manage exposure until they’ve found the most appropriate home for those assets going forward long term. You are putting guardrails around the portfolio that meet an investment objective that that client has, and that objective can change.

The landscape is changing and complexity is increasing in the context of interim management. For example, in some European jurisdictions sustainability requirements have appeared, adherence to SFDR regulation is mandatory and the reporting that goes with it comes into play.

There is no plug-and-play approach here, you really have to work with your client in advance to fully understand their exposure objectives and have the in-house capabilities to support that, whether it be through reporting, monitoring, adherence to regulation, etc.

Chris Adolph: That regulation point is important. It is sometimes why not everyone offers interim because if you think of your typical transition and how you manage it (and with some of that reporting in the guidelines) we have a very limited discretion on what we can do. In interim we are selecting the portfolio and how we construct it, acting much more like an asset manager, so the onus on us becomes much more like that of an asset manager than a transactional exercise.

It can add up to a lot of monitoring and if you are only going to be managing for a couple of months you might ask whether you want to go through all that reporting.

James Woodward: I think one of the applications of interim that we have seen this year is in the context of asset allocation. Significant negative returns in some asset classes have caused asset owners to think they need to rebalance.

When rebalancing, there might be a particular asset class where the asset owner needs to implement a temporary tilt or beta exposure until they can find a more permanent home for an exposure. We have often undertaken research to examine the types of benchmarks clients are looking at and the tracking error that was mentioned before to find the best solution until they can suitably apply those monies down to a long term manager.

Cyril Vidal: I view the transition manager like a toolbox. We have the ability to provide execution, the operational capability with having the authority on an account that has custody, and we also have a structuring mindset where we can come up with some bespoke reporting.

There are many occasions where this skillset is probably not necessarily well known to our clients and sometimes we find situations where they didn’t intend to appoint a transition manager for a specific situation but we have been able to take something off their hands to solve for complexity because we used part of that toolbox to find a solution to their problem.

David Edgar: That is a great point - the breadth of knowledge that sits within a transition team is quite exceptional because they have to cover every asset class, the back office, middle office and the front office.

James Woodward: I often think of an asset owner having a transition management agreement in place as a bit of an insurance policy. In all these situations we have described the interim service can be that stop gap if they need an emergency set of exposures implemented. It really is a value add, a necessary piece in the armory of an asset owner.

Esg Transition

Amelie Labbe: In what way is the industry evolving to meet the demands and requirements of the ESG transition?

Andy Gilbert: Before we look at how the industry is evolving, I think we should spend some time thinking about how ESG is evolving. The first evolution focuses on sustainability considerations. We have seen clients thinking about how this philosophy can extend to their whole portfolio and asking how they can think about sustainability and ESG, not just across their equity portfolio but across their fixed income assets - credit, high yield and emerging market debt portfolios.

ESG as a concept is still evolving in the minds of clients. In the past, adopting ESG may have simply meant excluding certain sectors or securities and certain indices were constructed to address that. At a point in time, clients may have been thinking low carbon. More recently, the focus has been around net neutral/ Paris Aligned with benchmarks, portfolios and strategies designed to reflect that. This demonstrates how ESG has been evolving in the minds of clients. But what does that mean from a transition management perspective?

It has become increasingly important for the transition management industry to provide the right level of support to ESG transitions, whether that is providing insights on factors, the impact of different benchmarks, or scoring.

We also need to be on top of regulatory requirements. The ability to implement governance structures will continue to be critical: for example, coding restricted lists, and the correct interpretation and implementation of client guidelines. We need to be able to put a framework around the portfolio.

ESG isn’t a one-size-fits-all and the transition management industry needs to be flexible in tailoring and customising its approach.

David Edgar: I don’t see ESG suddenly resulting in a massive transition. I think a lot of asset managers will move their portfolios to their new benchmark, whatever it may be. I am sure we will see lots of new funds launching and assets moving from old funds to new funds, but I don’t see any massive uptick in transition work over the next two years due to ESG although it will be another thing for transition managers to have to think about and deal with.

Chris Adolph: I was going to ask around the table in terms of whether people had seen clients asking for specific ESG reporting, because as Cyril points out we are producing the portfolio of their target manager, so the end result is a manager who has constructed something in line with what the client might get.

During that journey we are moving closer to that portfolio all the time so it is a question of what is our role here, other than to deliver what the client has already agreed with the manager. I think it is a review of the exclusions and (especially if you are dealing in funds in Luxembourg) various regulations. The evolution of the systems that we use really helps here in terms of coding and making sure we can manage all of those exclusions on a real time basis.

David Edgar: There has been some discussion about whether if everyone is moving in the same direction and having to sell the same stocks and buy the same stocks we see trading anomalies within the market, but I’m not aware that there is anything obvious happening there.

Chris Adolph: Consider how many years we have been talking about ESG. When those conversations were happening from an asset management perspective it was all a question about clients, what potential alpha are you giving up by doing this because potentially you are forcing your pension fund to make changes based on certain criteria. It was then a question of are we giving something up? Now the conversation isn’t about what you are giving up, it is about constructing portfolios that people believe are going to outperform going forward.

Ashish Patel: We are almost entering this period of ESG 2.0 in terms of redefining and reclassifying funds. Just this week we have seen Article 9 designation being removed from about $125 billion of assets under management.

For us as transition managers it is about identifying what are ESG transitions, as

David said, and it can quite quickly become a momentum trade, so we have to be very conscious of the sector biases, those signature names within certain ESG portfolios that can cause liquidity constraints.

When you get down to that level of idiosyncratic risk it becomes very difficult to hedge and transition from legacy to target, so that is where the value add is as transition managers, using our skillset and knowledge base as we apply it holistically to portfolio and risk management, but through a more specific lens with ESG.

Paul McGee: I agree with that point entirely. We have helped a number of clients with ESG fund launches in the past year and the common theme is highly concentrated portfolios and putting big positions into single stocks that can be very volatile. So you need to have a carefully designed trading strategy and look at your biggest risk contributors. Some well-known stocks that feature regularly in ESG portfolios can move 5%, 10% or even 15% on any given day and 30-stock global, highly concentrated portfolios are common theme.

The Value Of Data

Amelie Labbe: Is the transition management industry fully realising the value of data?

James Woodward: Transaction cost analysis and the use and application of data has advanced significantly over the last three to five years. Historically, TCA has been strong in the equity space with a good set of vendors and that has extended to fixed income, foreign exchange, and exchange traded derivatives.

It is important to understand the quantum of data that we are talking about for each transition event. In the equity space, hundreds of individual orders can actually result in thousands of orders and tens of thousands of fills. It is those fills that are a result of people using algorithms and smart order routers to acquire and distribute orders to where liquidity is strongest and analysing that data is key.

For the client it is used to provide transparency, a third party lens into the transition data that enables the client to see items such as performance and attribution. It can also be very useful to drill down into a very granular level of detail where there might be a single stock in a particular transition that drove the overall outcome of events.

The client may be able to get a detailed understanding of participation, stock performance before and after trading, reversion, particular algorithmic strategies that were used by the transition manager and the counterparty used, even down to gauging the level of signaling risk and whether the algorithm was deemed to be having too much market impact. Moving away from a specific client event, transaction level data becomes more meaningful when it is examined over a longer period of time and spans a number of events. That particular data set can be used by a transition provider to analyse whether an algorithm or a particular counterparty is more or less effective than alternatives. It can be useful in assessing participation levels across different markets and to help improve future outcomes or future strategies that have been generated.

Transaction cost analysis can also help assess trading team performance, and individual trader performance.

Ashish Patel: Data has very quickly become the most valuable commodity in our industry aside from human capital. In a transition we get data from various sources - whether it be the investment manager or the custodian – and also generate much of it ourselves, whether it be for the purpose of transaction cost analysis or defining trading strategies at the outset. It is our job to know the client and how much data we present that makes sense whilst being transparent. It is about converting potentially hundreds of thousands of lines of data into an easily digestible format.

It is hard to talk about data and analytics without thinking about the new wave of machine learning and evolution of algorithms. This can be divided into four pillars, the first of which is client intelligence - how we can better understand or use data to understand what our clients want from us and deliver that service in an ever-evolving complex world.

The next pillar is market intelligence, how we can use that data to create more efficient trading algorithms. The third pillar is automation and we have talked about how we can create operational efficiencies and mitigate operational and project management risk, which is within our control, as opposed to execution risk or market risk. The fourth pillar is supervisory intelligence - how can we use that data to protect ourselves and our clients to ensure that we uphold the highest level of fiduciary obligations during the transition?

David Edgar: Transaction cost analysis in itself has limited value for each individual transition because as James pointed out, the value lies is looking at lots of trades where you are doing the same thing over and over again. But for all the people working at trading desks, who are monitoring their daily trades and using it to constantly improve their systems, processes and algos it is invaluable.

Can you look at the minutiae of the orders in a particular transition and draw too many conclusions from that as it relates to that transition? Possibly not, because you are often required to trade in a particular way due to external factors. You have to start with the macro strategy and work down and providing you have got your strategy right at the top level, everything else should follow. However, transaction cost analysis is key for trading desks to improve their processes.

James Woodward : About 80% of a good transition post-trade report is attribution at the parent level - high level attributions, starting at sectors and countries and then moving down to the stock level. It is only probably a subset of that post-trade report that warrants diving down into the individual transaction cost analysis for a particular stock, although if there are those outliers it is obviously important to be able to provide that level of detail should the customer be interested.

It also very much depends on the sophistication of the customer. You can’t go and dump 20,000 securities on a customer and expect them to know what to do with it - they need the right views and lenses that some of the transaction cost analysis vendors can provide.

Chris Adolph : One of the key evolutions of data is that we are able to drill down much more into the component parts of risk in a portfolio. An example would be looking at very stock specific risks - so instead of just looking at whether you are overweight Russia vs Germany, for example, you can drill down to whether 5% of the total risk in the whole transaction is this particular name.

Andy Gilbert: Data for the sake of data does not deliver much to a client – what they really want are insights into how the markets and execution came together to give us the outcome we got. Data can help, but are they going to be able to derive conclusions from it? Maybe not. That is where we help them understand what the data means and what insights they can draw from it.

Cyril Vidal: I think I was the first to mention around this table a few years ago the electronification of fixed income. We see far more diversified, granular portfolios which brings another challenge around data - how do you synthesise all the information about liquidity of particular bonds into a single number that you can present to the client and evaluate the transaction cost accordingly?

Outlook For 2023

Amelie Labbe: How are business models likely to adapt to market conditions over the next year or so?

Ashish Patel: We have talked about business models, not necessarily discussing brokerdealer versus asset manager in the transition management space. For all of us here, it should be centered around the business model that focuses on our fiduciary level obligation, our level of care, which essentially ensures that the oversights that have been placed upon us during the transition are constantly aligned to the ever-evolving needs of the client, ensuring that our service delivery as a transition manager is always aligned.

Andy Gilbert: Complexity is on the rise, whether that is the increase in assets on platform-based strategies or whether pooling is going to exist beyond local government pension schemes and into defined benefit schemes.

We are looking potentially at whole portfolio changes, not just changing some equity managers or an allocation to fixed income. I think whole portfolio change is going to be an increasingly dominant theme not just for 2023 but beyond.

Other themes that we have already discussed, such as ESG, are going to continue. I foresee increased scrutiny on transparency and governance around the discretionary decisions that transition managers are making, which is a positive development.

When I consider business models I think similar to Ashish. How does this industry need to evolve, pivot and adapt to take on the challenge of clients moving towards? How can we build the expertise of our teams to meet those increasing complexities and changes?

Transitions can no longer be thought of as just a trade. We have all talked about the other benefits that transition management can provide to a client, as well as execution. It is around managing that complexity, anticipating clients’ future needs.

David Edgar: We have seen years, and will continue to see years, of consolidation within the asset management and pension worlds. Pooling within pensions will become a bigger theme, possibly as a knock on from what has happened this year, particularly among the smaller schemes. We are not quite sure what is happening with superfunds yet.

What is required is flexibility. Coming back to what Cyril said before about the toolkit and what I said about the fact that if you want a one-stop shop to solve a problem, it is a transition manager because they have the expertise and they continue to evolve. for major strategic asset allocation changes, especially in the pension fund industry. That could lead to a lot of activity, not just as a transition, but overlay activity as well.

As an example, it’s the knowledge of pooled funds, the way they work, what can be done in them and what each regulatory environment involves. Transition managers are quick to evolve and they just need to continue to do that because the environment continues to change. It’s changed every year I’ve been doing this and it’s going to continue to change. Transition management teams have done a very good job over the years of keeping up to date with change.

The fiduciary point is about putting clients first, which we have always done whether we are acting in a trading capacity or an asset management capacity.

We recently conducted a survey with JPES Partners, who reached out to institutional investors to ask them what they think their biggest challenge is going to be in 2023. The number one challenge highlighted in the survey was volatility, so it is up to us to ask them how we are managing that volatility and come up with solutions.