Moving gang

The Pension Protection Fund is a new U.K. government agency charged with administering the pension assets of bankrupt British companies -- a rough equivalent of the U.S.'s Pension Benefit Guaranty Corp. The PPF made its debut this summer, naming a bank custodian and a roster of approved fund managers. And in a no-less-noteworthy announcement, the agency identified State Street Corp. as its first "transition manager": the firm that will move billions in assets between money managers on the PPF's behalf.

"We expect to be doing a a lot of transitions," says Partha Dasgupta, head of investments and finance at the PPF. "It made sense to bundle up some services with one provider. We may appoint other transition managers in the future."

PPF joins a growing contingent of pension fund overseers that are deploying third-party firms -- Wall Street investment banks, money managers (chiefly indexers) and bank custodians -- to handle portfolio reassignments. The goal is to expedite such transitions in the most efficient, cost-effective manner possible.

The business keeps evolving. During the U.S. mutual fund trading scandals, many plan sponsors were determined to fire their money managers but were not sure how to replace them. So they called on transition managers to warehouse assets for them -- turning portfolios into index funds -- until they could find new portfolio managers. "We've done a lot of warehousing in the past few years," reports Rory Tobin, head of investments and capital markets at Barclays Global Investors in London.

The most common transition management assignment occurs when a plan fires one portfolio manager and hires another, but it can also involve asset allocation shifts and changes in benchmark indexes. Tower Group, a Needham, Massachusetts­based financial services consulting firm, estimates that 1.9 trillion moved through transition managers in the U.S. in 2003. Other consultants say the market grew about 20 percent last year.

Among the dominant names in the field: Bank of New York; BGI; Goldman, Sachs & Co.; Merrill Lynch Investment Managers; Russell Investment Group; and State Street.

Yet with increased activity, transition management has come under closer scrutiny from pension funds. "I don't claim to know every trick," says Christopher Ailman, chief investment officer of the $116 billion California State Teachers' Retirement System, "but I know there are abuses going on, and I know funds are being ripped off." Transition management falls under the aegis of securities regulators -- the Securities and Exchange Commission in the U.S., the Financial Services Authority in the U.K.

Many plan sponsors are anxious to avoid what investment banks term "prehedging," in which a broker-dealer carrying out a transition positions its trading book to benefit from the impending asset shift, potentially driving up the cost of the securities to be purchased. Investment banks argue that the activity actually reduces expenses for the client, especially in a principal trade in which prehedging allows the bank to quote a lower price, knowing what the impact on its own book is likely to be.

The problem for the client, though, is that the process is not transparent. In the U.S. transition managers have no legal obligation to disclose prehedging, although they are obliged to comply with antifraud provisions in securities laws.

In the U.K., however, prehedging is illegal unless it is disclosed to the client in advance. Last April, Britain's FSA slapped a £190,000 ($350,000) fine on Deutsche Bank for allowing its traders to buy the stock of Daily Mail and General Trust -- which is relatively illiquid for a large-cap equity -- in the run-up to a transition management trade involving that stock. Deutsche Bank declines to comment.

Part of the problem is that no industry standard governs transition management in either the U.S. or the U.K. A group of leading transition managers, including BGI and Russell, have been meeting since early this year to draft rules for a so-called T-Charter, which would frame minimum business conduct rules. Their discussions, however, are in the preliminary phase.

To guarantee that they get the best execution, some U.S. plan sponsors demand that firms handling transitions for them act as plan fiduciaries under the terms of ERISA, the 1974 U.S. pension law. That way, the managers are legally bound to act in the best interest of plan participants.

When CalSTRS issues a request-for-proposal for transition managers later this year, it will demand that eligible firms act as fiduciaries. Another plan that has chosen a similar course is the $46.2 billion Washington State Investment Board.

Although the potential for abuse is a real concern, the biggest issue for the plan sponsor is determining the cost of transition management. Measurement is difficult: The explicit costs in commissions are tiny, typically between 1.5 and 5 basis points, but they are dwarfed by bid-offer spreads and market impact, which may together account for two thirds of the real cost of the trade. Says Craig Niven, Morgan Stanley's head of transition management in Europe, "With many funds in deficit, every penny is being counted."

As they compete for business, transition managers emphasize their respective strengths. Wall Street firms say that they are best suited to manage a transition because the process is, as Niven puts it, "a program trade with some settlement issues attached."

Unsurprisingly, bank custodian Mark Keleher, president of Mellon Transition Management Services, in San Francisco, disagrees with that assessment. "The brokers would like to say this is a program trade, but it's not," he says. "It's a project management event and a settlement event with many complex tax and regulatory issues that need to be gotten right. I'd say execution is 30 percent of the problem."

For their part, indexers like BGI and State Street argue that they make natural transition managers: After all, they have a constant need to rebalance portfolios, creating huge volumes of trades and plenty of opportunities to cross trades internally.

For all the participants, transition management is a thin-margin business. But for custodians and money managers that have the requisite infrastructure and technology, it can be an attractive sideline.