The T-Charter, a code of best practice for transition managers, was unveiled at the end of 2007, but even before the ink was dry it appeared that it did not go far enough. Frances Maguire looks into whether the industry is better or worse off.
The transition management industry has grown from the specialist knowledge needed to build algorithms around the crucial timing of the buying and selling of securities, and the correct assessment of the risk and market impact. Transition management has come of age and is rapidly proving that it can add value and lower market impact.
The complexity of making large portfolio changes creates the risk of market moves during the period between liquidating the assets of the legacy portfolio and buying new securities for the target portfolio. Financial institutions and pension funds are getting better results, reduced tracking errors and lower impact costs by using specialists. As well as the need for greater diversification, the growing number of mergers and acquisitions has fuelled the growth of the transition management industry as pension managers come under greater scrutiny and pressure to cut costs. International trades also need to have the currency risk hedged during the transition, giving more reason for handing over to a transition manager than handling it in-house.
At an industry conference in December 2004, three transition management specialists confronted their peers about a lack of standards and instances of poor practice. That led to a formal debate among the leading transition management firms – the first, tentative steps towards a transition management code of best practice, often referred to as the T-Charter. The proposed code was circulated widely in the industry and at the end of 2007 the long-awaited and somewhat controversial T-Charter, signed by 17 providers of transition management, was launched.
Although none disagree with the 10 guiding principles of the T-Charter, three members of the draft committee – State Street, Barclays Global Investors and Russell Investment Group – immediately objected that the code did not go far enough. They believe that the standards should truly reflect best practice and not merely represent a level or standard that all potential participants can achieve.
Principles of the code
The code’s principles cover all aspects of transition management, such as disclosure, client confidentiality, systems and processes and remuneration, and include guidance on the evaluation of implementation shortfall, errors involving financial loss during transition, and compliance.
Part of the problem is the diverse nature of the transition management industry. It includes providers that are either custodian or investment banks, or investment managers, all with different business operation models in place. The implication – and part of the reason why the 10 principles took two years for players to agree on – is that the T-Charter had to be diluted to include the widest range of providers.
The debate has now begun over whether it should be made tougher and legally binding.
David Edgar, transitions strategist at Barclays Global Investors (BGI), says: “BGI fully supports and endorses the charter but believes that it could provide better protection for clients. The issues of enforceability, transparency, conflict of interest and pre-hedging have not been fully addressed.”
BGI believes that the T-Charter should be legally binding on members to ensure full compliance, as opposed to a non-enforceable code of best practice; the use of pre-hedging for transition clients should be ruled out because it results in a material conflict of interest; and clients should be provided with full and clear disclosure of all fees and other remuneration.
Mr Edgar says that while BGI will continue to apply the highest level of customer service and protection, it will also work proactively to develop industry best practice in these important areas.
The practice of pre-hedging or pre-trading – the execution of trades by a transition manager for its own account, ahead of the transition client’s benchmark point – has drawn the most objection because it results in the transition manager effectively taking the other side of the client’s trade as this position is then sold on or purchased from the client at the benchmark point.
“This means that if the transition manager realises a profit on their transactions this will result in a higher price (purchase) or lower price (sale) for the client. This is a clear conflict of interest,” says Mr Edgar. “It is often argued that it is most cost efficient to execute trades over a period of time rather than a single point of time, with which we would absolutely agree, but if trades are to be executed for a client ahead of their benchmark point then they should be executed in the client’s account [not the transition manager’s] thus removing the conflict of interest and ensuring that all the benefit [cost savings] accrue to the client.”
Given this conflict of interest, combined with the large trading values involved in many transitions, Mr Edgar says that BGI’s stance is that pre-hedging of transition trading should be banned rather than better disclosure being introduced. “We do not think there will ever be sufficient transparency in the execution of principal trading with a direct market counterparty to overcome the conflict of interest,” he says.
Growth industry
The growing use of algorithms in finding fragmented pools dark of liquidity, post-MiFID (Markets in Financial Instruments Directive), will further enhance the case for using a transition manager. But as the industry continues to grow, so does the need for greater client protection.
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Ed Pennings, head of transition management at State Street Global Markets, also believes that the practice of pre-hedging should be banned. “In the context of transition management, it presents an inherent conflict of interest between the provider and the client,” he says. |
While the increased liquidity brought by the growing number of dark pools should benefit clients, the charter’s guiding principles will still be valid, following the implementation of MiFID. “The charter is very helpful in that it provides clients with important points to consider and questions to ask their potential providers when transitioning their portfolios. It does not, however, provide them with the transparency and fiduciary level of service they should expect from their provider,” says Mr Pennings. “The T-Charter is a voluntary code, not legally enforceable and open to wide interpretations.”
Aims and consequences
Although the T-Charter is aimed at making it easier to compare the services offered by the diverse range of providers, it will also make it easier to understand the differences between transition managers and their business models.
However, in a joint open letter to industry in October, State Street and Russell Investment warned that it should be noted that the T-Charter, in its current form, is a modified version of earlier attempts to create a much tighter, more rigid framework that was designed to protect clients by holding providers to the highest possible standards, to get the widest possible industry acceptance. Due to this, the letter urges prospective clients to continue to ask tough questions to prospective providers, and not automatically assume that the T-Charter will ensure they are covered with the fiduciary level of service and transparency they need.
It appears that the transition management industry is taking the lead in improving best practice, but the T-Charter is dividing the industry into those that do and those that do not believe that it is tough enough, and is throwing up more questions than answers about whether providers should be going above and beyond the code. Transition management is an overcrowded and highly competitive industry, and the T-Charter has put it firmly in the spotlight. If viewed as a valid starting point, the code of best practice could be the first step to maturity in the industry and lead to greater consolidation by raising the barrier to entry and slowing the stream of new entrants.
