Cherry Reynard looks at the approaches transition managers take to navigate unexpected market volatility.
In 2018 and to date in 2019, markets have had an ‘end of cycle’ feel. That has meant more volatility, variable liquidity and a certain skittishness when responding to market announcements. This unpredictability presents some challenges for transition managers.
It is not volatility of itself that constitutes complexity. Most transition managers will be prepared for volatility created by known events, such as central bank meetings, key economic announcements or company earnings announcements. This would even apply to events such as Brexit, where the risks are well-understood.
Rosanna Menta-Willis, director, investments at Willis Towers Watson, says: “Larger and more established transition providers have their finger on the pulse. Every transition plan will build in a market calendar noting any significant events that can impact the transition, which are factored in when deciding when to trade. Where volatility is expected or heightened, the transition managers will need to be even more thoughtful about the transition strategy they employ and will rely on a variety of risk tools and resources to do so.”
In a normal environment, the complexity comes from multi-layered transitions, rather than the make-up of the assets themselves. Chris Adolph, director, Implementation Services, EMEA at Russell Investments, says: “For example, with a defined contribution transition there may be many funds, blackout periods and multiple stakeholders. It can be just as much about the type and complexity of the event rather than the type of asset per se.”
That said, some assets are inherently more difficult to trade, he says. Standard developed equities and government bonds are generally straightforward and liquid, while emerging markets, frontier markets or credit and high yield can be less liquid and more complex. While the ideal trading environment is low volatility and high volumes, Tim Gula, a member of the portfolio transition solutions team at Goldman Sachs, says this is rare. Most transition managers will be “looking at relevant market holidays, economic announcements, earnings releases and index rebalancing dates. The estimated impact from unexpected activity should be hedged early on either with use of ETDs (exchange traded derivatives) or optimised basket trading.”
The problem comes when there is significant market volatility that is unexpected - from a news event for example or merger and acquisition activity. That is much more challenging to navigate. Unfortunately, today’s febrile environment is creating a lot of this type of volatility.
Not only will this throw out bid offer spreads and create difficulty moving from portfolio A to portfolio B, it can throw out carefully calculated cost estimates. Adolph says that although volatility can sometimes have a positive impact in terms of increased liquidity: “It can also lead to spikes in the tracking error between the legacy and target portfolios and historic annualised tracking errors (on which the transition range is often based), can count for little when a transition may be completed in just a few days.”
He adds: “Costs may end up being materially higher than estimated. We can model normal liquidity and volatility by looking historically, but when liquidity dries up or volatility spikes, it can be a real challenge.” Transition managers’ objective is to minimise realised execution cost and a large component of this can be opportunity cost. The opportunity cost can rise significantly at points of unexpected volatility.
The traditional way to manage this is to use index derivatives to hedge the market. Gula says: “Transition providers can minimise opportunity cost by neutralising the exposure between legacy (sells) and target (buys), achieved either through the use of exchange traded derivatives or optimised trading schedules that consider correlation between individual orders and positions.”
In doing this, the skill of the traders and the technology they have available to them becomes paramount. “Data driven portfolio execution algorithms are complementing traders’ skills for an efficient management of risks in the transition. Having the right technology is key to adjusting the execution to changing market conditions, for example intraday volume profile,” says Cyril Vidal, head of the portfolio transition solutions team at Goldman Sachs.
Adolph says they work hard to ensure that they are not ‘visible’ in the market - important at times of market dislocation. This means spreading trading across multiple venues. On the fixed income side, he says, they may get quotes from over 60 dealers and trade with as many as 40 or 50 different dealers and venues.
However, trading skill may not be enough in some circumstances. Equally, hedging can be expensive and may not always work. Some argue that using index hedging to try to address some idiosyncratic risk can be ineffective. Futures or options may address part of the problem, but may also introduce other imbalances into a portfolio. As such, the benefits may be minimal. Some are willing to simply tell their clients it does not make sense. Individual names will perform differently from the index. As such, a hedge could be a hindrance rather than a benefit.
Keeping communication lines open
Occasionally doing nothing will be a better option. Artour Samsonov, head of transition management EMEA at Citi, says: “The key word is patience. Sometimes the best approach is not to react immediately to what’s going on in the market, which can be down one day and up another. Holding off - and being much more analytical and opportunistic - could be a better approach. If it’s a really bad day in the market and we believe it results in a better outcome for the client, we may halt trading. However, it is important to communicate with the client and explain your approach. Understandably, the clients get nervous when the markets are volatile.”
Menta-Willis agrees that good transition managers will ask themselves whether they should keep trading. “It’s not very common, but we have had specific situations where transition managers will re-evaluate what they’re trading and change gears a bit. That can mean coordinating with the target managers, client and/or advisor to ensure alignment of goals and objectives.”
Client communication is likely to be very important. How much will depend on the client, says Samsonov: “We won’t just carry on trading regardless of market conditions. Most clients want us to call if something comes up and to take an active role in the transition strategy dialogue. It is important to take the time to understand your client as part of the planning process.”
Menta-Willis adds: “We have some clients that are very detail oriented, while others want to delegate all decision-making and project planning to the transition provider. It is always best practice for the transition manager to consult on changes to the transition strategy and to keep the lines of communication open. While it varies by provider, most of the transition managers have daily updates, showing how much of the transition event has been completed, details on performance of the trade and costs, market commentary and anything outstanding or noteworthy.”
While transition managers can prepare for volatility around trading announcements or political events, they cannot circumvent the risks associated with unexpected market volatility entirely. Sometimes, the best action will be no action, but keeping client communication channels open is vital.
This article features in the Transition Management Guide 2019. Download the full guide here.