Transition Management using Stock Index Futures

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With the exception of the very largest pension plan sponsors, endowments and foundations, the vast majority of buy side investors hire external or outside third party money managers to manage their assets.  These external managers may be equity managers, fixed income managers or alternative investment managers.

For a multitude of reasons, a pension fund, for example, may wish to make a change in one of their investment managers.  The process by which an institutional investor switches manager is known as transition management.

Why a pension fund might transition from one manager to another

    • Change in asset allocation policy.  Several years back a major automaker decided to take their allocation to commodity investing down to zero and increase their equity exposure.  As a result, they had to notify the managers involved and move the assets from one manager (the commodity managers) to an equity manager that would managed the funds within the new mandate.
    • Underperformance:  If a manager fails to perform as expected a pension fund has every right to terminate their agreement with the manager and seek out a new manager.
    • Major changes in organizational structure that causes a significant shift in their investments.  For example, a large U.S. based college endowment shifted their focus from passive investing toward active managers.   Such a shift might require a significant transition period from indexed based managers to active managers.
    • Recently, the industry has encountered more complex transitions that involve derivatives such as swaps, options and futures necessitating the need for transition managers that have experience with derivatives trading desks.  With the extraordinary growth of futures and options over recent years, many portfolios contain these products and thus require specialized attention during transition.

FACTOID:  Transition managers are adding new capabilities to transfer assets in complex derivatives, futures and options, along with traditional transfers of securities. These managers increasingly are using derivatives desks to handle the complex transitions, particularly in fixed income. Ross McLellan, founder and president of transition management data analysis firm Harbor Analytics, calls it “an evolution in the industry that allows transition managers to stay relevant.” – Ross McClellan quoted in Pensions and Investments

The process by which assets or funds are moved from one asset manager to another is referred to as Transition Management.   And firms that offer expertise in this area are known as transition managers.

What are the considerations and risks in transitioning a portfolio from one manager to another? Anytime you sell a portfolio and reinvest in another, you incur costs.   Transactions costs, commissions and other fees can be performance killers.  Moreover, there is market impact.  If the portfolio contains small and/or illiquid securities, the market impact in selling/buying can be much greater than transaction costs.

However, the biggest risks during the transition period is having no exposure to the market during the process.  One of the ways to combat this risk of “missing out”, is to utilize the futures markets.  Say for example, an endowment was going to move their small cap exposure from an active small cap manager to a passive indexer benchmarked to the Russell 2000 index.  From the time securities are sold from the legacy manager, to the purchase of the new issues by the passive small cap manager, there is the risk that the Russell 2000 might rise resulting in tracking error and underperformance.   Hence, the transition manager would consider using E-mini Russell 2000 futures.   See illustration in figure one below.

Whether an investor benchmarks to large cap indexes, midcap indexes, small caps, sectors or international indexes, there are literally dozens of liquid stock index futures available that replicate many key global benchmarks. The S&P 500, the S&P MidCap 400 and the Russell 2000 are primary U.S based benchmarks that have extremely liquid futures contracts and are useful in transition management.  Thus, it’s no surprise that transition managers have come to rely on these instruments to transition portfolios smoothly and quickly.   Other futures such as Treasury futures and commodity futures could conceivably be used in transitions that involve fixed income and commodity managers respectively.

And finally, while derivatives themselves are being transitioned as part of complex portfolios, they are primarily being used to facilitate orderly and efficient transitions from one manager to another.

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Peter Knight Advisor


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