Complexities in Transition Management

Transcription

1 Complexities in Transition Management Abstract Transition management involves the purchase, sale and transfer of assets, along with the appropriate operations to effect a change in portfolio allocation. While the concept of selling and buying portfolios may s ound like a simple trading exercise, it is important to recognize the wide range of intricacies accompanying many transition events. This paper highlights a series of complexities that can arise in transition management. The topics discussed are not meant to exhaust all challenges, but rather highlight frequently occurring circumstances. The following subjects are explored herein: 1. Hedging in transitions 2. Trading at the close and challenges in benchmarking 3. Funding/defunding pooled funds 4. Defined contribution ( DC ) transitions 5. ETFs: Create or Trade? For each subject, we also offer an overview of some of the techniques a transition manager may use to manage risk. Figures and examples provided are theoretical and not based on any actual transition results. In addition, they do not purport to reflect any expectation of specific future outcomes. STATE STREET CORPORATION 1

2 HEDGING IN TRANSITIONS The Observation Assume that a plan modifies its strategic asset allocation, creating a material variance in one or more broad allocation categories. Examples of categories include asset class, country, style (value/growth), or market cap, as well as duration and sector for fixed income transitions. For instance, the table below shows a target portfolio invested entirely in US small cap equities and a legacy portfolio invested in US large cap equities. This scenario is used for the remainder of this section to illustrate the transition risk and the impact of potential risk - management techniques. Legacy Portfolio Target Portfolio Market Value $125 mln $125 mln Names 500 1,983 Portfolio Beta Benchmark Index S&P 500 Index Russell 2000 Index The Risk/Challenge The difference between target and legacy portfolio returns from the benchmark pricing point, typically the market close on the day prior to the start of trading ( T-1 ), to the open on trade date ( T ), is termed overnight gap. This may result in implementation shortfall which can be attributed to the divergence in returns between respective broad market categories. If the overnight gap is positive (i.e., the target portfolio outperforms the legacy portfolio), then the actual portfolio would have accumulated a relative unrealized loss before trading has commenced. Asset class risk, in this example, may not be limited to the overnight gap. Any security trades that require time to complete on or after the open on T have the potential to contribute to implementation shortfall. In some cases, illiquid positions may take days or weeks to execute, resulting in an overweight in large cap US equities and/or an underweight in small cap US equities for an extended period of time. The issue of appropriate market exposure can be further complicated when liquidity profiles are drastically different between legacy and target portfolios. These variances force a transition manager (and trader) to consider both cash exposure and participation rates in the context of market liquidity. STATE STREET CORPORATION 2

3 The Strategy Exposure risk could be reduced via a hedging program that employs futures, options or ETFs (considering plan guidelines). For example, the transition manager could sell futures which track the legacy holdings ( legacy futures ) and buy futures which track the target holdings ( target futures ). Assuming minimal basis risk between the portfolios and index futures, executing these futures trades at the benchmark time and price will better align the current portfolio exposures with those of the target portfolio. With the hedge, the transition account expects to earn the target portfolio return as proxied by the target futures contract while offsetting the legacy portfolio return via a short position in the legacy futures contract. Below, we extend this strategy to the illustrative example (Legacy: S&P 500 Target: Russell 2000) based on a hypothetical starting portfolio value of $125 mln. We also assume that each fund s holdings mirror the underlying indices (i.e., both funds are passively managed, fully replicated portfolios). The pricing data for equity indices and futures contracts is provided at the bottom of the page for reference. The first step is to calculate the number of futures contracts that will provide the correct exposure. This is done by rounding down the quotient of the legacy portfolio value and the product of the index level and the futures contract multiplier. For example, $125 mln / ( * 50) = 1485 contracts. At the market close on T-1 the hedge is implemented based on the strategy described above, selling legacy futures and purchasing target futures. On T, the hedge positions are closed via offsetting transactions as securities are purchased and sold. Pricing Data Index / Futures Contract Equities S&P 500 Index Russell 2000 Index Close Futures S&P 500 E-mini Futures (ESU3 Index) Russell 2000 Mini Futures (RTAU3 Index) Benchmark Date (T-1) Short Sell ESU3, = $124,925,625 Buy RTAU3, = $124,952,040 Futures Trades Trade Date (T) Buy to Close ESU3, = $125,278,313 Sell RTAU3, = $125,396,410 STATE STREET CORPORATION 3

4 Millions PORTFOLIO SOLUTIONS STRATEGY: COMPLEXITIES IN TRANSITION MANAGEMENT Portfolio Market Value and Return Calculations Target Portfolio = $125,000,000 * ( / ) = $125,511,695 (0.41%) Unhedged Portfolio = $125,000,000 * ( / ) = $125,381,231 (0.30%) Hedged Portfolio = Unhedged Portfolio + Hedge (below) = $125,381,231 + $91,682 = $125,472,913 (0.38%) Hedge Return Calculation ($) Cash P/L Calculation ESU3 = $124,925,625 $125,278,313 = ($352,688) Cash P/L Calculation RTAU3 = $125,396,410 $124,952,040 = $444,370 Total Hedge Contribution = $444,370 $352,688 = $91, Target Portfolio Unhedged Portfolio Hedged Transition Account /29 Close (T-1) 7/30 Open (T) STATE STREET CORPORATION 4

5 Trading at the Close and Challenges in Benchmarking The Observation Current transition management market standards dictate that a transition exercise is benchmarked to the market closing price on T-1 prior to the start of trading on the following business day (T). We refer to this as current market standards henceforth. The benefit of this pre-trade benchmark, in addition to facilitating comparability across providers, is that trading from the open on T cannot influence the benchmark. However, in some circumstances, transitions may benefit from trading at the market close on the benchmark date (a contemporaneous benchmark ). With heightened fragmentation in equity markets and decreased average block sizes, the industry has witnessed an uptick in bids involving Market on Close (MOC) strategies and hybrid strategies as a means to capture liquidity at the benchmark point. These strategies often fuel the philosophical debate as to the most appropriate performance attribution methodology when trading and benchmarking occur concurrently. Taking this debate further, one should question whether the closing price is a suitable benchmark at all. Please see our paper dedicated to MOC trading, Trading Equities at the Close: Considerations for Transition Management. The Risk/Challenge Current market standards, when followed, offer a high degree of performance transparency. However, these standards also limit a transition manager s ability to capture liquidity that may be important in managing the risk of a transition (given that the time-period prior to and including the market close has historically experienced a significant portion of the day s total trading volume). This dilemma is not limited to equity markets; it is also a headline topic in the OTC foreign exchange markets with the WM/Reuters 4pm London Fix. A case can be made for both trading at the benchmark and for waiting to trade to preserve the benchmark s integrity. We would argue that the optimal strategy is often somewhere in between and that it is more important to recognize the benefits and drawbacks of each while demanding greater transparency in pre-trade cost estimation. From a transition bidding perspective, MOC and hybrid strategies can be difficult to compare with strategies that assume trading begins at the open on T following the benchmark. Take the example on the following page. Assume transition manager A submits a bid where trading begins at the open. Transition Manager B submits a bid where 20% of volume is traded at the benchmark with the remainder beginning at the following day s open. If the decision to use one manager over another is purely quantitative, Manager B might be selected on the basis STATE STREET CORPORATION 5

6 of lower mean and opportunity costs. Manager B quoted 25% lower bid/ask spreads and 40% lower market impact as a result of trading at the benchmark. Cost Component Estimated Cost (bps) Transition Manager A Transition Manager B Commissions Bid/ask spread Market Impact 5 3 FX Spread 0 0 Taxes/Fees 1 1 Mean Estimated Cost Opportunity Costs The Strategy Clearly, the 2 bids presented above are not directly comparable, as Manager B plans to complete 20% of the transition at the benchmark. One solution to clarify this ambiguity is for asset owners and/or consultants to explicitly state whether MOC or hybrid strategies are permissible at the onset, allowing transition managers to put forth their preferred strategy. Manager A may have been withholding a more optimal strategy, assuming that benchmark preservation was paramount. A base case strategy, perhaps one that adheres to current standards, could also be requested if a transition manager chooses to submit a MOC or hybrid strategy. In any case, a TM should clearly outline the assumptions used in deriving a bid. Manager B could have submitted the following: Estimated Cost (bps) Assumptions Cost Component Transition Manager B Bid assumes that equity securities trading in volumes less than 2% Commissions 4.2 of trailing 60-day average daily volume and w ith positive marginal Bid/ask spread 1.5 contribution to risk are executed at the benchmark close w ith no Market Impact 3 market impact or spread. The remaining securities are traded FX Spread 0 beginning at the open on T. As a result of these factors, 20% of Taxes/Fees 1 security trading (or $120 mln) is assumed to trade at the benchmark Mean Estimated Cost 9.7 Opportunity Costs 15 close. Assuming the asset owner and/or consultant permitted MOC or hybrid strategies, this description provides more information with which to compare bids. If the detailed assumptions are deemed appropriate, Manager B s strategy may be viewed as more optimal. Alternatively, the asset owner could determine that Manager B s assumptions are overly aggressive (e.g., high levels of MOC trading with minimal market impact) and request a bid with more conservative assumptions. Finally, the asset owner could request a bas e case to facilitate direct comparison with provider A. STATE STREET CORPORATION 6

7 Funding/Defunding Pooled Funds The Observation Transitions often involve funding or defunding pooled funds with potentially different settlement requirements. For the purpose of this section, assume an asset owner is liquidating an actively managed separate account and moving into a passively managed commingled fund that requires a cash contribution. The Risk/Challenge The risk is that the asset owner is not exposed to the market during the period between the sale of the legacy securities and the contribution date into the pooled fund. The greatest challenge is presented when the pooled fund requires cash on trade date (typically executed at the closing fund price). If the legacy account were to liquidate with normal settlement (T+3) the asset owners would be out of the market for three days. Even if all sells were short settled (T+1) the owners would still need to be out of the market for a full day: liquidation on T-1 at the close through contribution on T at the close. The Strategy One solution is to sell legacy securities in advance of the contribution date and purchase synthetic market exposure. In the absence of liquidity concerns, the TM could liquidate all securities at the close on T-1, with 1- day short settlement, while simultaneously purchasing futures contracts to maintain market exposure. On T, a small portion of the short-settled cash could be used to fund the futures margin while the remaining cash could be used to fund the pooled fund contribution. At the close on T, the point at which the pooled fund shares are priced, the futures contracts could be sold and the pooled fund shares could be purchased. On T+1 the futures margin could be redeemed, at which point a residual contribution could be made to the pooled fund. If there is greater flexibility in settlement requirements (i.e., the target pooled fund allows for T+1 to T+3 settlement), the transition will have a greater chance to maintain market exposure without the use of derivatives, which typically introduce basis risk. For example, if the target manager permits T+1 settlement, the transition manager could sell legacy securities for short settlement (T+1) at or around the close on the effective date of the pooled fund contribution. Trades could settle in time to meet the pooled fund cash requirement. When there are liquidity concerns, the transition manager or legacy manager may begin selling positions in the most illiquid names several days in advance in order to complete all sales in line with the effective contribution date. In the case where futures contracts are used to maintain market exposure, futures could be purchased in line with these early sales. STATE STREET CORPORATION 7

8 Other Considerations If there are several legacy and/or target managers with differing settlement timing, various strategies to gain market exposure should be mapped out. As with most strategies, there are pros and cons to consider. The list below highlights some major considerations when mapping a transition strategy. 1. Settlement timing TM must ensure that cash obligations are met while maintaining market exposure as best as possible. 2. Liquidity Legacy assets may take several days to sell based on the liquidity profile which may necessitate early trading to ensure that the liquidation is complete by contribution date. 3. Basis risk Using derivatives to maintain market exposure introduces basis risk, the difference in return between the derivative instrument and the underlying security or index. STATE STREET CORPORATION 8

9 Defined Contribution ( DC ) Transitions The Observation From time to time, defined contribution ( DC ) plans restructure their offerings. The restructurings often comprise several tiers of investment options and various underlying managers and strategies. The structure may entail some or all of the following: individual participants direct ownership of manager-level funds, individuals own white label or core funds which in turn own manager-level funds, individuals own shares of target date or target risk funds which in turn own shares of core-level funds and/or manager-level funds. The Risk/Challenge For DC transitions, operational risks are often more significant than portfolio risks. For example, the transition account structure dictates the distribution of implementation shortfall among participants. Typically, one of the most important issues for a plan sponsor is to avoid contaminating each individual participant s performance with the shortfall which is directly attributable to other participants. Additionally, there is the requirement to maintain daily pricing in order to generate a NAV and provide participants access to transact on their investment options during the transition period. Aside from the operational risks are the typical transition portfolio risks. Portfolio risk is primarily a function of opportunity cost risk, a result of the tracking error that exists between the starting transition portfolio and the target portfolio (for any account structure). Other examples of contributors to portfolio risk may include, but are not limited to, currency risk and market impact risk. The Strategy A defined contribution transition can be viewed from two distinct angles. 1. Structural perspective Analysis of the hierarchical organization of the various plans and their underlying core fund- and manager-level holdings. 2. Portfolio Risk perspective Review of the anticipated investment and trading risks once we have broken down the restructure into simplified buy and sell trade lists. As the portfolio risks are not unique to DC transitions, w e focus on the structural perspective below. STATE STREET CORPORATION 9

10 In evaluating a DC transition from a structural perspective a TM can add value in the account level organization of the transition. Typically there are two options, though complicated circumstances often necessitate customization: Core Fund/Target Structure As of the effective date, the legacy funds are mapped to the target funds and transition accounts are set up for each target fund. Participants in the legacy funds are assigned units of the new target investment options which hold the new transition accounts. Trading is then completed in transition accounts and on funding/contribution date the assets are distributed to the respective managers. The actual custodial/administration accounts used can be either target manager accounts or newly opened transition accounts. The implementation shortfall accumulates at the target fund level and is shared by all participants in each target fund. This structure is typically used when the legacy to target asset class shifts are similar among participant groups or for the consolidation of various legacy plans into a similarly allocated target plan. Participant Account/Legacy Structure Prior to the effective date, assets in the legacy funds are segregated and placed into separate transition accounts or legacy separate accounts are reassigned as transition accounts. Restructure trading will occur in each transition account as needed. As of the effective date the fully constructed portfolios and/or cash from each transition account are mapped to the new target fund structure. The implementation shortfall accumulates in the transition accounts for each participant. This approach is often used when the legacy to target asset class shifts are substantial thus necessitating net cash outflows from legacy investment options. Implementation Examples In the following pages we describe a simplified defined contribution transition plan. Assume the plan sponsor is combining two legacy plans into a single target plan. Plan A participant assets are spread across six core funds and Plan B participant assets are spread across five core funds. The target structure contained six core funds with new managers. STATE STREET CORPORATION 10

11 Target Structure Transition: Core Fund Plan A Manager $mln Fixed Income Manager A 2.5 Large Cap Growth Manager B 4.1 Large Cap Value Manager C 8.2 Target Small Cap Manager D 3.7 Core Fund Manager $mln International Manager E 1.1 Fixed Income New Manager U 11.3 Global Manager F 2.4 Large Cap Growth New Manager V 11.8 Large Cap Value New Manager W 15.4 Plan B Small Cap New Manager X 9.5 Core Fund Manager $mln International New Manager Y 12.2 Fixed Income Manager G 8.8 Global New Manager Z 2.4 Large Cap Growth Manager H 7.7 Large Cap Value Manager I 7.2 Small Cap Manager J 5.8 International Manager K 11.1 In this situation, the target core fund offerings are similar to the legacy core fund offerings with respect to asset class. Additionally, the plan-level asset allocations appear to be consistent between target and legacy. For example, the allocation to the target Large Cap Value ( LCV ) fund ($9.3 mln) is equal to the sum of the two legacy LCV funds ($8.2 mln & $1.1 mln). Therefore, the target account structure could be used rather than the legacy which would entail two transition accounts. On the effective date, the Plan A LCV and Plan B LCV could be mapped to the target account and each participant would receive a pro-rata share of the new account with Plan A participants owning approximately 53% and Plan B participants owning approximately 47%. This structure is fair to participants because similar legacy holdings from Plan A and Plan B participants ( Fixed Income assets) are being transitioned to the same target portfolio. We can reasonably expect that costs would be similar for each group if each Legacy plan was transitioned separately. STATE STREET CORPORATION 11

12 Legacy Structure Transition: Below we show a transition plan where a large number of legacy fund offerings are being consolidated into six target date funds ( TDFs ). Some managers will remain, others will be liquidated, and there are several new managers. In this situation some of the legacy funds may not require any trading and will simply become holdings of various TDFs. However, we note that the fixed income allocation will grow from $35.6 mln to $55 mln, thus shifting some of the equity funds to fixed income funds. In this case a TM could look at the TDF s manager-level allocations and structure the transition accounts by legacy fund. The transition will be traded within the legacy account structure and the target manager values would be mapped under the corresponding TDFs after the completion of the transition. Notably, net sell activity would occur in certain legacy equity transition accounts in order to ensure adequate cash as of the effective date for redistribution to target fixed income mandates. Legacy Plan Target Fund Offering Asset Class Manager(s) $mln Core Fund Asset Class Manager(s) $mln Select US Short Duration US FI A 15.1 Equity H, K, L 13.3 TDF 2020 Intermediate US Corporate US FI B 4.1 Fixed Income A, C, E, New FI1 3.3 Total Return Bond US FI C 8.2 Equity F, G, J, New EQ TDF 2025 Global Strategic Bond INTL FI D 4.7 Fixed Income A, B, D, New FI1 5.0 Foreign Bond Fund INTl FI E 3.5 Equity H, J, K, New EQ2 8.3 TDF 2030 US Strategic Income US EQ F 6.3 Fixed Income A, B, C, D, E 8.3 US Passive Equity US EQ G 16.8 Equity F, G, H, J, K, L 6.7 TDF 2035 World x US Passive Equity INTL EQ H 7.5 Fixed Income C, D 10.0 Global Growth INTL EQ I 7.2 Equity G, H, K 3.3 TDF 2040 Emerging Markets IMI INTL EQ J 5.8 Fixed Income A, B, C 13.3 Global REIT INTL EQ K 9.7 Equity F, G, H 1.7 TDF 2045 Total Return Equity INTL EQ L 11.1 Fixed Income New FI STATE STREET CORPORATION 12

13 ETFs: Create or Trade? The Observation ETFs are often part of an asset owner s target allocation (directly or indirectly via sub-advisor portfolio holdings) or part of an interim exposure strategy. When seeking ETF exposure, an asset owner may have several options, summarized as follows: 1. Purchase ETF shares in the open market 2. Purchase the underlying basket of securities and create ETF shares via an authorized participant ( AP ) 3. Execute with a 3rd party, often a market maker in the referenced ETFs, to deal the ETFs at an agreed upon benchmark (e.g., 3 cents away from the inside bid/offer) The Risk/Challenge The risk is that purchasing ETF shares in the open market may cause greater shortfall than one of the other methods outlined above. Additionally, purchasing ETF shares also requires cash raised by selling legacy portfolio securities. To the extent that legacy holdings are held in the ETF, those securities can result in cost - savings in building a creation unit. Lastly, the relative size of the ETF purchase as compared with the daily trading volume is often too large to complete within a single trading day, resulting in potential opportunity costs. The Strategy When evaluating an ETF purchase (or sale) a transition manager should estimate the total cost, both explicit and implicit, of each of the available strategies. Below we show an example where a $100 mln legacy portfolio containing the S&P 500 Growth Index securities is being transitioned into the SPY ETF. As shown in the table on the following page, where there is a large amount of overlap between the legacy holdings and the ETF creation unit, it is often less expensive to create ETF units. Portfolio Characteristics Legacy Target S&P 500 Grow th SPY Market Value $100,000,000 $100,000,000 Underlying Securities Shares 1,470,600 1,828,640 STATE STREET CORPORATION 13

14 Only 1.3 million shares would be traded under the creation strategy (#2) as compared to 2.1 million shares in strategies 1 and 3, resulting in significant savings. As this example demonstrates, the preferred strategy will depend on various inputs, but most importantly on the composition of the legacy portfolio relative to the target. Estimated Implementation Shortfall Comparison 1. Purchase ETF Shares 2. Creation 3. Third Party Negotiated Deal LIQUIDATION LIQUIDATION LIQUIDATION Traded Shares 1,512,594 Traded Shares 510,761 Traded Shares 1,512,594 Traded Market Value $99,984,406 Traded Market Value $33,674,968 Traded Market Value $99,984,406 Cash $15,594 Cash $15,594 Cash $15,594 Commission $15,126 Commission $5,108 Commission $15,126 Spread (est.) $24,996 Spread (est.) $8,419 Spread (est.) $24,996 Market Impact (est.) $12,998 Market Impact (est.) $4,378 Market Impact (est.) $12,998 ETF SHARE PURCHASE PURCHASE ETF SHARE PURCHASE Traded Shares 552,486 Traded Shares 805,380 Traded Shares 552,486 Traded Market Value $99,999,966 Traded Market Value $33,660,237 Traded Market Value $99,999,966 Cash $34 Commission $8,054 Cash $34 Commission $5,525 Spread (est.) $8,415 Commission $5,525 Spread (est.) $18,000 Market Impact (est.) $4,376 Spread (est./quoted) $34,575 Market Impact (est.) $14,000 CREATION Observed Market Impact (est.) $0 TOTAL COST $90,645 Shares (unit size = 50,000) 550,000 TOTAL COST $93,219 Flat Fee (SPY) $3,000 AP Fee 0 RESIDUAL ETF SHARE PURCHASE Residual Shares 2,486 Assumptions 1. SPY is fully replicated S&P500 Residual Shares Market Value $449, Commissions: 1 cps for US equity trades Cash $34 3. bid/ask: 2.5 bps for legacy, 1.8 bps target Commission $25 4. Avg MI: 1.3 bps for legacy, 1.4 bps target Spread (est.) $81 5. All prices as of November 30, 2013 Market Impact (est.) $63 TOTAL COST $41,918 STATE STREET CORPORATION 14

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