An institutional investor dumps one money manager and hires another. It happens all the time. But moving billions of dollars in invested assets from one firm to another is no simple matter. As a result, institutions are increasingly turning to specialists called transition managers, whose business is growing by leaps and bounds.
Last year Deutsche Bank helped clients transition more than $500 billion in assets. “That’s two times the volume of business we did in 1999,” says Matthew Carrara, co-head of North American equity derivatives at Deutsche Bank Securities. “It has been a remarkable growth business.” Consulting firm Frank Russell Co. shifted $110 billion in 2001 -- more than double the $53 billion it moved in 2000. “Five or six years ago, more than three quarters of the clients we spoke to had never heard of the concept (of transition management),” says Robert Werner, director of implementation services at Frank Russell Securities. “That number is probably inverted now.”
Plan sponsors, though, have been overhauling their management rosters for years, so why is hiring a transition manager suddenly de rigueur? Credit the general trend among plan sponsors to hire outside vendors to handle noncore services. “Plans have realized that the entire process can be outsourced very efficiently,” says Charles Shaffer, global head of transition management at Deutsche Bank Securities.
Hiring the right intermediary can have a significant impact on an investor’s return. A poorly managed shift can result in a missed investment opportunity if, for example, the plan is out of the stock market during a big rally. (A transition can take anywhere from a day to nine months.) “The stakes here are very high,” says Deutsche Bank’s Carrara. “Plans that don’t manage transition risk efficiently face the possibility of waking up several percentage points behind their benchmark before their new managers take control of the assets.”
The historic approach has been simple: Fire a manager, sell the holdings, and turn the cash over to the new manager. Obviously, that appeals to the incoming firm because it can start with a clean slate. But such a rapid sale can cost funds as much as 5 percent of assets, according to Plexus Group, a Los Angelesbased consulting firm.
Done properly, transitions -- which can involve a massive trade or a series of smaller transactions to keep a fund’s assets invested as the new manager assumes control -- lower costs. Just as important, they get funds out of the business of market-timing.
But even when they’re handled well, transitions are hardly cheap. A recent Frank Russell study concluded that costs can reach 3 percent of a portfolio’s value.
The fight for a dominant piece of the transition market is largely being waged by three groups: Wall Street firms, namely Deutsche Bank, Morgan Stanley and UBS Warburg; index managers and firms affiliated with custodian banks, such as Bank of New York Co., Barclays Global Investors, Mellon Financial Corp., Northern Trust Corp. and State Street Corp.; and consulting firms like Frank Russell.
Wall Street firms contend that because of their huge program trading operations, they best serve funds that need to move thousands of securities from one firm to another. “You’re either a provider of liquidity or a reseller of someone else’s liquidity,” says Deutsche’s Shaffer.
The big index managers with custodial operations, on the other hand, argue that their nuts-and-bolts expertise and the obvious convenience of using an established recordkeeper make them the natural choice. Says Nicholas Bonn, executive vice president of State Street, which has been in the transition business for 15 years, “While at the core there is a trade to do, this is really a short-term investment program.” The index funds also offer liquidity. “We’ve got access to $100 billion in index funds,” says Mark Keleher, president of Mellon Transition Services. “That’s a lot of money.”
Then there’s the powerful Frank Russell Co., which has exploited its base of clients to build up a significant transition management business.
Regardless of who handles them, transitions can be enormously complex. In the summer of 2000, the then$22 billion Texas Permanent School Fund shook up its roster of money managers, firing a few and hiring several more. In October of that year, the fund hired Plexus to help it move $17.5 billion -- perhaps the largest such transition ever executed in a concentrated time frame. The transfer involved a staggering 500 million shares in more than 20 countries.
The fund hired Morgan Stanley Dean Witter to handle the first, $2.5 billion tranche; the firm executed the trades in November 2000 on an agency basis, selling them as a broker with no capital commitment of its own. In January 2001 the fund hired Deutsche Bank, which used a hybrid approach: 90 percent of the portfolio was traded on a principal basis (in which it did commit capital) and the remaining 10 percent -- U.S. small- and midcap stocks -- on an agency basis.
All told, the Texas Permanent School Fund lost just 66 basis points of value during the transition. And in this market, where even small setbacks are hard to overcome, every basis point counts.
Mellon’s new approach to hedge funds
Most institutional money managers deploy funds-of-funds to introduce pension clients to the complicated world of hedge fund investing. Last month, for example, Credit Suisse Asset Management announced the formation of a $6 billion multimanager hedge fund pool. Managers-of-managers supply the expertise and experience to make informed choices among the 6,000-odd hedge funds plying their trade worldwide -- or so conventional wisdom suggests.
Not everyone buys the conventional wisdom. In July Mellon Financial Corp., with assets of $610 billion, announced its acquisition of HBV Capital Management. HBV runs five discrete hedge funds with combined assets of $530 million; it is not a manager-of-managers. The move follows Mellon’s decision last year to buy a 15 percent stake in Optima Fund Management, an investment adviser to a series of hedge funds-of-funds.
As hedge funds become more popular with the pension crowd, Mellon executives believe that their institutional clients will eventually want to create and control their own portfolios of hedge funds rather than pay a manager-of-managers a typical fee of 1 percent -- on top of the hedge funds’ fees of 1 percent, plus 20 percent of profits -- to make the choices for them.
Mellon and others believe that pension clients will increasingly hire consulting firms to work with them in selecting appropriate individual hedge funds rather than shifting that entire responsibility to the fund-of-funds manager. In this way the pension fund gains a measure of control and evaluates its roster one by one. Consultants offer many of the same advantages as managers, including access to elite hedge funds and risk management.
“While no one would deny the popularity of funds-of-funds, we think that they may be an intermediate step for many of the largest institutional clients,” says Paul Dimmick, director of alternative investments and product development at Mellon. “They will ultimately find themselves mixing their own, so to speak.”
HBV, a three-year-old firm based in New York, manages event-driven hedge funds: a U.S. risk arbitrage fund, a distressed debt fund, a European risk arbitrage fund, a multistrategy vehicle and a recently launched global risk arbitrage fund. Following its acquisition, HBV was renamed Mellon HBV Alternative Strategies.
“The whole panoply of institutions -- public pension funds, corporate pension plans, hospitals, university endowments and foundations -- are looking into hedge funds,” says Harold Kaplan, director of asset management for consulting firm Galway Securities Corp. “Many of these large institutions are maintaining their own consultants.”
Mellon will be placing its own clients into the funds run by HBV Capital, but it won’t eschew other hedge fund opportunities. And the HBV vehicles will continue to reel in new accounts wherever they may find them.
Charles Gradante, managing principal of New Yorkbased Hennessee Group, applauds Mellon’s recognition of the growing role of consultants -- perhaps not surprisingly, since his firm consults pension funds on their selections of hedge funds in lieu of a manager. “A customized fund-of-funds makes it easier to verify compliance with the pension plan,” he says.
But a 2001 study by UBS Warburg concludes that if an investor allocates less than $100 million to hedge funds -- far beyond what most pension funds are currently putting into the category -- then the cost of doing the legwork would be higher than the costs associated with a fund-of-funds. That cost differential is one reason John Van, chief financial officer of investment consulting firm Van Hedge Fund Advisors International, finds the Mellon move interesting -- but doesn’t think hordes of asset managers will follow suit. Says Van, “One acquisition does not a trend make.” -- Jennifer Friedlin
