Transition management has become an industry buzzword as the high outlay of switching managers draws increased attention. Experience reveals that costs lounge not merely in such factors as bid/offer spreads and commissions, but also with the market impact associated in trading institutional-sized positions, opportunity costs caused by stochastic market fluctuations and the more routine operational setbacks and settlement penalties. Typical estimates of the total costs of transitioning between managers range from 100 to 200 basis points, undoubtedly an astounding amount in a milieu where expected returns are roughly 8 % per annum. Beyond the hefty fee of transitioning portfolios, the process remains problematic. Communication between the client, investment managers, and custodians is indispensable to guarantee all assets that can be transferred in specie or in kind actually are.

The initial step is to spot each player’s operational task: the transition manager coordinates, the client authorizes and instructs; the custodian opens accounts, certifies assets, and helps settle the trades; and the investment manager identifies the shape and risk characteristics of the new portfolio. The issue of accountability is a real one, a missed wire deadline, incorrect settlement instructions, or incorrect portfolio lists can all spell disaster. Once a transition manager identifies the operational concerns, he must undertake a rigorous liquidity study of the legacy and target portfolios. The transition manager must also consider the specific factors causing the residual risk between the legacy and target portfolios (residual risk, in this instance, is a measure of the potential opportunity cost of holding the old portfolio rather than the target portfolio).

A trading strategy is developed after considering the trade-off between liquidity and the risk of holding (or not holding) a security in terms of potential opportunity cost. Often the strategy will use futures or forwards to hedge a macro-asset allocation decision, then focus on the optimal trade sequence in which to trade securities or sectors. This trade sequencing is critical, as it enables the transition manager to mitigate the residual risk between the legacy and target portfolios using liquid securities, thereby reducing the urgency that illiquid securities with potential market impact problems must be traded, minimizing transaction costs.

A fine transition manager completes all simultaneously, whilst searching for liquidity, accepting and rejecting trades based on an appraisal of market impact against risk contribution on a total portfolio basis to keep the operational issues and processes under tight control. Transitioning assets will always have overheads. It is also critical to understand the potential risks of a transition, risks that, if uncontrolled, could wipe out a diligent investment manager’s alpha. Once these points are understood, and a plan is developed to monitor transition risks and minimize trading costs, it will be straightforward to observe how risk control can escort cost control.

<B>Nitish BENIMADHU

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