Dan Bryant was looking to give his portfolio a lift. So last October the CIO of the $13.8 billion Teachers’ Retirement System of Louisiana decided to replace his six small- and midcap value and growth managers with five so-called smid managers, who would be free to buy small- or midcap stocks, value or growth, as they chose. The amount involved was substantial: $2.1 billion, or nearly one sixth of the pension plan’s total assets.
To move the money quickly, smoothly and cheaply, Bryant set out to hire a specialty firm known as a transition manager. After an eight-week search, he chose Credit Suisse Group, a relative newcomer to the business. The investment firm persuaded him that it could trade out of the old positions with efficiency and transparency -- and at a very attractive price.
“The process was transparent, and we basically got the transition done in one day at a total cost of $20 million, including commissions and market impact,” says Bryant, who had expected to pay closer to $55 million.
Every year institutional investors like the Louisiana fund shuffle between $2 trillion and $2.5 trillion from one portfolio to another. They do so for a variety of reasons: to change or rebalance asset allocations, to revise investment styles or to select new stock pickers.
The business of helping them has long been dominated by big custodians, indexers and consulting firms, including Barclays Global Investors, Russell Investment Advisors and State Street Global Advisors. Now Wall Street firms, such as Bear, Stearns & Co., Credit Suisse and Merrill Lynch & Co., are pushing into the area, looking to boost their paltry market shares by marketing their trading infrastructures, trumpeting the transparency of their practices and fees -- and cutting prices. In their effort, they’re building staff, using the traditional means of any good market-share fight -- poaching talent. In May 2005, Bear Stearns recruited Michael Gardner, Russell’s manager of trading implementations, to run its transition business. Last year Merrill Lynch hired Deutsche Bank’s global head of transition management, Charles Shaffer, as well as its North American transitions chief, William Stush. Shaffer now co-heads Merrill’s global transitions business with London-based Michael Marks, and Stush runs Merrill’s North American business.
Although transition managers typically earn only a penny or two on every share traded, the huge volume of assets in play can yield substantial commissions. But access to liquidity is as big a lure to firms specializing in transitions -- the liquidity that flows to a trading desk, deepening the firm’s knowledge of what’s going on in the market.
“Transition managers are seeking this business because liquidity has strategic value,” says Paul Sachs, a Mercer Investment Consulting principal who focuses on investment operations. “Liquidity begets liquidity.”
Not without complications, though. Major transitions can involve thousands of securities moving through multiple markets, time zones and currencies. Custody and clearing arrangements need to be coordinated. Transition managers must be sensitive to changing market liquidity and volatility conditions. Risk management is of the essence.
Securities firms have a way to go in pursuing this business. According to a 2005 Greenwich Associates survey, no investment bank placed among the top five U.S. transition managers. The leaders, ranked by number of transitions performed, were State Street, Barclays, Russell, Northern Trust Global Investments and Mellon Transition Management Services. All told, about 40 firms offer transition services, though for some the business is not a strategic priority.
Among investment banks, three -- Bear Stearns, Credit Suisse and Merrill Lynch -- are the most aggressively pursuing transition deals. Bear Stearns transition chief Gardner boldly predicts that the firm will claim 15 percent of the market in seven years, up from roughly 2 percent now. Last year Bear Stearns snared a four-person fixed-income trading group from brokerage Northeast Securities; it’s separate from Gardner’s six-person group but will help the team do fixed-income transitions. Gardner plans to hire more transition staffers as well.
Credit Suisse has doubled the size of its transition team to six full-time staffers over the past 18 months. Recently, it introduced a new trading program, SponsorCross, designed specifically for transitions. “Qualitatively, our product is already better than that of any of our competitors,” boasts Hari Achuthan, head of sales and strategy for transition management at Credit Suisse.
Merrill Lynch is competing fiercely on price. When it makes a pitch for a transition assignment, the firm estimates the likely opportunity cost, which occurs when the market moves against a plan sponsor before a transition is complete, and the market impact of trading large positions. Merrill’s offer to plan sponsors: If its estimate of these costs is off by more than a single standard deviation, it will refund half its fee, generally about 3 basis points, to the client; if it’s off by more than two standard deviations, Merrill will refund the entire cost.
“We’ve created a structure that is as efficient as can be,” says Shaffer, Merrill’s co-chief of transitions. He argues that the practice adds integrity to the bidding process by removing an incentive to underestimate costs.
In making their pitch for business, Wall Street firms argue that they handle the lion’s share of trading and boast the greatest expertise in complex trades involving derivatives and thinly traded securities -- critical skills for transitions. They point out, too, that custodians, consultants and indexers execute a portion of their transitions through the Street, adding a layer of expense. Beyond the added cost, Gardner notes, “there’s increased information leakage, worsening risk control.”
“Traditionally, plan sponsors have had the choice of using custodians and consultants who lacked their own trading infrastructure but were transparent or global broker-dealers who had execution power but might have been trading against you with the house book,” says Bear Stearns’ Gardner. “Now firms with global trading systems are trying to aggressively add transparency and the ability to take on a fiduciary role to have the best of both worlds.”
Custodians and indexers counter that they are every bit as expert and efficient in their trading as their Wall Street rivals. “Many years ago technology was all on the broker-dealer side of things,” says Kevin Hardy, global head of transition management at Northern Trust. “But the tools the buy side has now are more or less identical to those on the sell side.”
With a few exceptions, players in both camps will act as fiduciaries when they manage a transition. Increasingly, plan sponsors demand it. As defined by ERISA, the 1974 statute that governs corporate pensions, a fiduciary must always act in a client’s best interest. In the aftermath of the mutual fund market-timing scandals and amid the demands of the Sarbanes-Oxley Act, many plan sponsors insist that their transition managers share the obligation to act in the best interests of plan recipients. Nearly half of all plan sponsors always engage transition managers as fiduciaries, according to Greenwich Associates; a further 20 percent sometimes do so.
Major indexers, custodians and consulting firms are all registered investment advisers, but many of Wall Street’s broker-dealers are not. To serve as a fiduciary, they must enlist their internal investment management arms or partner with a third party that will act as a fiduciary.
“The fiduciary issue is a challenge, but for the most part, everybody’s come up with a solution,” says Paul Meyer, who runs Lehman Brothers’ transition business. Lehman partners with third-party investment consulting firms and money managers that assume fiduciary obligations.
“Due to a potential conflict of interest, we do not act as a fiduciary,” says Meyer. For example, a conflict could exist if Lehman were moving assets from a money manager for which it was simultaneously executing trades.
On the other hand, Merrill Lynch chose to integrate Merrill Lynch Investment Management into its transition management business last year, allowing the firm to act as a fiduciary. Says Shaffer, “We deliver the best of the fiduciary model and what broker-dealers are good at -- low-cost direct execution.” Merrill declines to comment, but plan sponsors and competitors expect that its transition structure will remain unchanged after the October 1 merger of MLIM and BlackRock.
Wall Street firms, led by Deutsche Bank, Goldman, Sachs & Co. and Morgan Stanley, made their first big push to compete in transition management in the late 1990s. They had been executing transition trades for Barclays, State Street and other established transition managers, but they saw an opportunity to sell their services directly to plan sponsors.
No Wall Street player was more aggressive than Deutsche Bank in pursuing this business. Often acting as a principal, it offered guaranteed low prices to clients. Deutsche’s 1999 acquisition of Bankers Trust was a major boost because the bank custodian provided index fund liquidity. The sale of Bankers Trust in 2003 had less of an impact; Deutsche had already penetrated most of the accounts it had gathered through the custodian. At its peak, between 2001 and 2003, Deutsche was one of the top five transition managers in the U.S.
But in April 2005, U.K. financial authorities levied a $350,000 fine on Deutsche Bank for “failing to act in its customer’s best interests.” The Financial Services Authority said that in April 2002, Morgan Grenfell, the investment bank owned by Deutsche, had traded shares in its own account in stocks that it knew a customer planned to trade. Investment banks argue that the practice, known as prehedging, can allow them to quote a lower price, but whether the house or the client ultimately benefits is not transparent. Prehedging is legal in the U.S. but not in the U.K., unless it is disclosed to the client ahead of time.
“The episode in question was a risk portfolio trade in competition with three or four other investment houses where no list of stocks was given,” says Garth Ritchie, who runs Deutsche Bank’s equity trading operations in Europe. “It was common practice at the time.” Deutsche still runs a transition division, but the business is no longer a priority.
Once a leading investment bank in transition management, Morgan Stanley has been less aggressive in the market over the past year or so. It lost its transition chief, Fred Fogg, who was part of the exodus of executives who left in the months after John Mack returned as CEO. Fogg, who joined Citigroup as head of U.S. transition management in February, has not been replaced.
Goldman Sachs’ transition business is much smaller than its rivals’ on the Street, but the business is growing, says transition chief Peter Herbert. The firm specializes in complex projects involving multiple assets and managers.
Whether their transitions are complex or straightforward, plan sponsors are concerned most with their bottom lines. “Ultimately, it comes down to who can implement transitions at a low cost,” says Credit Suisse’s Achuthan.
Determining who will perform a transition most efficiently is anything but straighforward: There are myriad methods of estimating and calculating a transition’s cost. That may help explain why Mercer finds that almost 40 percent of the bids transition managers make in response to requests for proposals have errors or serious ambiguities in their assumptions.
Still, metrics are improving. In 2003, Russell introduced T-Standard, a methodology that aims to capture all costs -- including brokerage commissions, taxes, fees, bid-ask spreads and opportunity costs. It has been adopted by many transition providers and plan sponsors. A group of industry players, including Goldman Sachs, Merrill, J.P. Morgan Securities and Mercer, are developing a set of principles known as the T-Charter. Focused on European markets, it would, among other provisions, prescribe a standard approach to cost estimation.
As Bear Stearns’ Gardner sees it, standardization of cost measurement will commoditize the transition business. “When this happens,” he says, “firms that own the infrastructure -- major brokers like Bear -- will have a competitive advantage.”
Maybe, maybe not. Certainly, investor demand for proven transparency is already intensifying the competitive pressure on all transition players -- custodians, indexers, consulting firms and investment banks, as Gardner acknowledges. “The marketplace is evolving, and in two years everyone will have to adopt a transparent business model,” he says.
