Complexities in Transition Management

STATE STREET CORPORATION 1

Complexities in Transition Management

Abstract

Transition management involves the purchase, sale and transfer of assets, along with the appropriate operations to effect a

change in portfolio allocation. While the concept of selling and buying portfolios may s ound like a simple trading exercise, it is

important to recognize the wide range of intricacies accompanying many transition events.

This paper highlights a series of complexities that can arise in transition management. The topics discussed are not meant to

exhaust all challenges, but rather highlight frequently occurring circumstances. The following subjects are explored herein:

1. Hedging in transitions

2. Trading at the close and challenges in benchmarking

3. Funding/defunding pooled funds

4. Defined contribution (“DC”) transitions

5. ETFs: Create or Trade?

For each subject, we also offer an overview of some of the techniques a transition manager may use to manage risk. Figures and examples provided are theoretical and not based on any actual transition results. In addition, they do not purport to reflect any expectation of specific future outcomes.

PORTFOLIO SOLUTIONS STRATEGY: COMPLEXITIES IN TRANSITION MANAGEMENT


HEDGING IN TRANSITIONS

The Observation

Assume that a plan modifies its strategic asset allocation, creating a material variance in one or more broad

allocation categories. Examples of categories include asset class, country, style (value/growth), or market cap,

as well as duration and sector for fixed income transitions. For instance, the table below shows a target portfolio

invested entirely in US small cap equities and a legacy portfolio invested in US large cap equities. This scenario

is used for the remainder of this section to illustrate the transition risk and the impact of potential risk -

management techniques.

The Risk/Challenge

The difference between target and legacy portfolio returns from the benchmark pricing point, typically the market

close on the day prior to the start of trading (“T-1”), to the open on trade date (“T”), is termed “overnight gap”.

This may result in implementation shortfall which can be attributed to the divergence in returns between

respective broad market categories. If the overnight gap is positive (i.e., the target portfolio outperforms the

legacy portfolio), then the actual portfolio would have accumulated a relative unrealized loss before trading has

commenced.

Asset class risk, in this example, may not be limited to the overnight gap. Any security trades that require time to

complete on or after the open on T have the potential to contribute to implementation shortfall. In some cases,

illiquid positions may take days or weeks to execute, resulting in an overweight in large cap US equities and/or

an underweight in small cap US equities for an extended period of time. The issue of appropriate market

exposure can be further complicated when liquidity profiles are drastically different between legacy and target

portfolios. These variances force a transition manager (and trader) to consider both cash exposure and

participation rates in the context of market liquidity.

Legacy Portfolio Target Portfolio

Market Value $125 mln $125 mln

Names 500 1,983

Portfolio Beta 0.99 0.98

Benchmark Index S&P 500 Index Russell 2000 Index



The Strategy

Exposure risk could be reduced via a hedging program that employs futures, options or ETFs (considering plan

guidelines). For example, the transition manager could sell futures which track the legacy holdings (“legacy

futures”) and buy futures which track the target holdings (“target futures”). Assuming minimal basis risk between

the portfolios and index futures, executing these futures trades at the benchmark time and price will better align

the current portfolio exposures with those of the target portfolio. With the hedge, the transition account expects

to earn the target portfolio return as proxied by the target futures contract while offsetting the legacy portfolio

return via a short position in the legacy futures contract.

Below, we extend this strategy to the illustrative example (Legacy: S&P 500 Target: Russell 2000) based on a

hypothetical starting portfolio value of $125 mln. We also assume that each fund’s holdings mirror the underlying

indices (i.e., both funds are passively managed, fully replicated portfolios). The pricing data for equity indices

and futures contracts is provided at the bottom of the page for reference.

The first step is to calculate the number of futures contracts that will provide the correct exposure. This is done

by rounding down the quotient of the legacy portfolio value and the product of the index level and the futures

contract multiplier. For example, $125 mln / (1682.50 * 50) = 1485 contracts. At the market close on T-1 the

hedge is implemented based on the strategy described above, selling legacy futures and purchasing target

futures. On T, the hedge positions are closed via offsetting transactions as securities are purchased and sold.

Pricing Data

Index / Futures Contract

Equities

S&P 500 Index 1685.33 1690.47

Russell 2000 Index Close 1040.66 1044.92

Futures

S&P 500 E-mini Futures (ESU3 Index) 1682.50 1687.25

Russell 2000 Mini Futures (RTAU3 Index) 1040.40 1044.10

Futures Trades

Benchmark Date (T-1) Trade Date (T)

Short Sell ESU3, 1485 contracts @ 1682.50 = $124,925,625

Buy to Close ESU3, 1485 contracts @ 1687.25 = $125,278,313

Buy RTAU3, 1201 contracts @ 1040.40 = $124,952,040

Sell RTAU3, 1201 contracts @ 1044.10 = $125,396,410



Portfolio Market Value and Return Calculations

Target Portfolio = $125,000,000 * (1044.92/1040.66) = $125,511,695 (0.41%)

Unhedged Portfolio = $125,000,000 * (1690.47/1685.33) = $125,381,231 (0.30%)

Hedged Portfolio = Unhedged Portfolio + Hedge (below) = $125,381,231 + $91,682 = $125,472,913 (0.38%)

Hedge Return Calculation ($)

Cash P/L Calculation ESU3 = $124,925,625 – $125,278,313 = ($352,688)

Cash P/L Calculation RTAU3 = $125,396,410 – $124,952,040 = $444,370

Total Hedge Contribution = $444,370 – $352,688 = $91,682

125.51

125.38

125.00

125.47

124.9

125

125.1

125.2

125.3

125.4

125.5

125.6

7/29 Close (T-1) 7/30 Open (T)

Mil

lio

ns

Target Portfolio Unhedged Portfolio Hedged Transition Account



Trading at the Close and Challenges in Benchmarking

The Observation

Current transition management market standards dictate that a transition exercise is benchmarked to the market

closing price on T-1 prior to the start of trading on the following business day (T). We refer to this as “current

market standards” henceforth. The benefit of this “pre-trade benchmark”, in addition to facilitating comparability

across providers, is that trading from the open on T cannot influence the benchmark. However, in some

circumstances, transitions may benefit from trading at the market close on the benchmark date (a

“contemporaneous benchmark”).

With heightened fragmentation in equity markets and decreased

average block sizes, the industry has witnessed an uptick in bids

involving “Market on Close (MOC)” strategies and hybrid strategies

as a means to capture liquidity at the benchmark point. These

strategies often fuel the philosophical debate as to the most

appropriate performance attribution methodology when trading and

benchmarking occur concurrently.

The Risk/Challenge

Current market standards, when followed, offer a high degree of performance transparency. However, these

standards also limit a transition manager’s ability to capture liquidity that may be important in managing the risk

of a transition (given that the time-period prior to and including the market close has historically experienced a

significant portion of the day’s total trading volume). This dilemma is not limited to equity markets; it is also a

headline topic in the OTC foreign exchange markets with the WM/Reuters 4pm London Fix.

A case can be made for both trading at the benchmark and for waiting to trade to preserve the benchmark’s

integrity. We would argue that the optimal strategy is often somewhere in between and that it is more important

to recognize the benefits and drawbacks of each while demanding greater transparency in pre-trade cost

estimation.

From a transition bidding perspective, MOC and hybrid strategies can be difficult to compare with strategies that

assume trading begins at the open on T following the benchmark. Take the example on the following page.

Assume transition manager A submits a bid where trading begins at the open. Transition Manager B submits a

bid where 20% of volume is traded at the benchmark with the remainder beginning at the following day’s open. If

the decision to use one manager over another is purely quantitative, Manager B might be selected on the basis

Taking this debate further, one should

question whether the closing price is a

suitable benchmark at all. Please see

our paper dedicated to MOC trading,

“Trading Equities at the Close:

Considerations for Transition

Management”.



of lower mean and opportunity costs. Manager B quoted 25% lower bid/ask spreads and 40% lower market

impact as a result of trading at the benchmark.

Cost Component Estimated Cost (bps)

Transition Manager A Transition Manager B

Commissions 4 4.2

Bid/ask spread 2 1.5

Market Impact 5 3

FX Spread 0 0

Taxes/Fees 1 1

Mean Estimated Cost 12 9.7

Opportunity Costs 21 15

The Strategy

Clearly, the 2 bids presented above are not directly comparable, as Manager B plans to complete 20% of the

transition at the benchmark. One solution to clarify this ambiguity is for asset owners and/or consultants to

explicitly state whether MOC or hybrid strategies are permissible at the onset, allowing transition managers to put

forth their preferred strategy. Manager A may have been withholding a more optimal strategy, assuming that

benchmark preservation was paramount. A base case strategy, perhaps one that adheres to current standards,

could also be requested if a transition manager chooses to submit a MOC or hybrid strategy. In any case, a TM

should clearly outline the assumptions used in deriving a bid. Manager B could have submi tted the following:

Cost Component Estimated Cost (bps) Assumptions

Transition Manager B Bid assumes that equity securities trading in volumes less than 2%

of trailing 60-day average daily volume and w ith positive marginal

contribution to risk are executed at the benchmark close w ith no

market impact or spread. The remaining securities are traded

beginning at the open on T. As a result of these factors, 20% of

security trading (or $120 mln) is assumed to trade at the benchmark

close.

Commissions 4.2

Bid/ask spread 1.5

Market Impact 3

FX Spread 0

Taxes/Fees 1

Mean Estimated Cost 9.7

Opportunity Costs 15

Assuming the asset owner and/or consultant permitted MOC or hybrid strategies, this description provides more

information with which to compare bids. If the detailed assumptions are deemed appropriate, Manager B’s

strategy may be viewed as more optimal. Alternatively, the asset owner could determine that Manager B’s

assumptions are overly aggressive (e.g., high levels of MOC trading with minimal market impact) and request a

bid with more conservative assumptions. Finally, the asset owner could request a base case to facilitate direct

comparison with provider A.



Funding/Defunding Pooled Funds

The Observation

Transitions often involve funding or defunding pooled funds with potentially different settlement requirements. For

the purpose of this section, assume an asset owner is liquidating an actively managed separate account and

moving into a passively managed commingled fund that requires a cash contribution.

The Risk/Challenge

The risk is that the asset owner is not exposed to the market during the period between the sale of the legacy

securities and the contribution date into the pooled fund. The greatest challenge is presented when the pooled

fund requires cash on trade date (typically executed at the closing fund price). If the legacy account were to

liquidate with normal settlement (T+3) the asset owners would be out of the market for three days. Even if all

sells were short settled (T+1) the owners would still need to be out of the market for a full day: liquidation on T-1

at the close through contribution on T at the close.

The Strategy

One solution is to sell legacy securities in advance of the contribution date and purchase synthetic market

exposure. In the absence of liquidity concerns, the TM could liquidate all securities at the close on T-1, with 1-

day short settlement, while simultaneously purchasing futures contracts to maintain market exposure. On T, a

small portion of the short-settled cash could be used to fund the futures margin while the remaining cash could

be used to fund the pooled fund contribution. At the close on T, the point at which the pooled fund shares are

priced, the futures contracts could be sold and the pooled fund shares could be purchased. On T+1 the futures

margin could be redeemed, at which point a residual contribution could be made to the pooled fund.

If there is greater flexibility in settlement requirements (i.e., the target pooled fund allows for T+1 to T+3

settlement), the transition will have a greater chance to maintain market exposure without the use of derivatives ,

which typically introduce basis risk. For example, if the target manager permits T+1 settlement, the transition

manager could sell legacy securities for short settlement (T+1) at or around the close on the effective date of the

pooled fund contribution. Trades could settle in time to meet the pooled fund cash requirement.

When there are liquidity concerns, the transition manager or legacy manager may begin selling positions in the

most illiquid names several days in advance in order to complete all sales in line with the effective contribution

date. In the case where futures contracts are used to maintain market exposure, futures could be purchased in

line with these early sales.



Other Considerations

If there are several legacy and/or target managers with differing settlement timing, various strategies to gain

market exposure should be mapped out. As with most strategies, there are pros and cons to consider. The list

below highlights some major considerations when mapping a transition strategy.

1. Settlement timing – TM must ensure that cash obligations are met while maintaining market exposure

as best as possible.

2. Liquidity – Legacy assets may take several days to sell based on the liquidity profile which may

necessitate early trading to ensure that the liquidation is complete by contribution date.

3. Basis risk – Using derivatives to maintain market exposure introduces basis risk, the difference in return

between the derivative instrument and the underlying security or index.



Defined Contribution (“DC”) Transitions

The Observation

From time to time, defined contribution (“DC”) plans restructure their offerings. The restructurings often comprise

several tiers of investment options and various underlying managers and strategies. The structure may entail

some or all of the following: individual participants’ direct ownership of manager-level funds, individuals own

white label or core funds which in turn own manager-level funds, individuals own shares of target date or target

risk funds which in turn own shares of core-level funds and/or manager-level funds.

The Risk/Challenge

For DC transitions, operational risks are often more significant than portfolio risks. For example, the transition

account structure dictates the distribution of implementation shortfall among participants. Typically, one of the

most important issues for a plan sponsor is to avoid contaminating each individual participant’s performance with

the shortfall which is directly attributable to other participants. Additionally, there is the requirement to maintain

daily pricing in order to generate a NAV and provide participants access to transact on their investment options

during the transition period.

Aside from the operational risks are the typical transition portfolio risks. Portfolio risk is primarily a function of

opportunity cost risk, a result of the tracking error that exists between the starting transition portfolio and the

target portfolio (for any account structure). Other examples of contributors to portfolio risk may include, but are

not limited to, currency risk and market impact risk.

The Strategy

A defined contribution transition can be viewed from two distinct angles.

1. Structural perspective – Analysis of the hierarchical organization of the various plans and their

underlying core fund- and manager-level holdings.

2. Portfolio Risk perspective – Review of the anticipated investment and trading risks once we have

broken down the restructure into simplified buy and sell trade lists.

As the portfolio risks are not unique to DC transitions, we focus on the structural perspective below.



In evaluating a DC transition from a structural perspective a TM can add value in the account level organization

of the transition. Typically there are two options, though complicated circumstances often necessitate

customization:

Core Fund/Target Structure – As of the effective date, the legacy funds are mapped to the target funds

and transition accounts are set up for each target fund. Participants in the legacy funds are assigned

units of the new target investment options which hold the new transition accounts. Trading is then

completed in transition accounts and on funding/contribution date the assets are distributed to the

respective managers. The actual custodial/administration accounts used can be either target manager

accounts or newly opened transition accounts.

The implementation shortfall accumulates at the target fund level and is shared by all participants in each

target fund. This structure is typically used when the legacy to target asset class shifts are similar among

participant groups or for the consolidation of various legacy plans into a similarly allocated target plan.

Participant Account/Legacy Structure – Prior to the effective date, assets in the legacy funds are

segregated and placed into separate transition accounts or legacy separate accounts are reassigned as

transition accounts. Restructure trading will occur in each transition account as needed. As of the

effective date the fully constructed portfolios and/or cash from each transition account are mapped to the

new target fund structure.

The implementation shortfall accumulates in the transition accounts for each participant. This approach

is often used when the legacy to target asset class shifts are substantial thus necessitating net cash

outflows from legacy investment options.

Implementation Examples

In the following pages we describe a simplified defined contribution transition plan. Assume the plan sponsor is

combining two legacy plans into a single target plan. Plan A participant assets are spread across six core funds

and Plan B participant assets are spread across five core funds. The target structure contained six core funds

with new managers.



Target Structure Transition:

In this situation, the target core fund offerings are similar to the legacy core fund offerings with respect to asset

class. Additionally, the plan-level asset allocations appear to be consistent between target and legacy. For

example, the allocation to the target Large Cap Value (“LCV”) fund ($9.3 mln) is equal to the sum of the two

legacy LCV funds ($8.2 mln & $1.1 mln). Therefore, the target account structure could be used rather than the

legacy which would entail two transition accounts. On the effective date, the Plan A LCV and Plan B LCV could

be mapped to the target account and each participant would receive a pro-rata share of the new account with

Plan A participants owning approximately 53% and Plan B participants owning approximately 47%.

This structure is “fair” to participants because similar legacy holdings from Plan A and Plan B participants (“Fixed

Income” assets) are being transitioned to the same target portfolio. We can reasonably expect that costs would

be similar for each group if each Legacy plan was transitioned separately.

Core Fund Manager $mln

Fixed Income Manager A 2.5

Large Cap Growth Manager B 4.1

Large Cap Value Manager C 8.2

Small Cap Manager D 3.7 Core Fund Manager $mln

International Manager E 1.1 Fixed Income New Manager U 11.3

Global Manager F 2.4 Large Cap Growth New Manager V 11.8

Large Cap Value New Manager W 15.4

Small Cap New Manager X 9.5

Core Fund Manager $mln International New Manager Y 12.2

Fixed Income Manager G 8.8 Global New Manager Z 2.4

Large Cap Growth Manager H 7.7

Large Cap Value Manager I 7.2

Small Cap Manager J 5.8

International Manager K 11.1

Plan A

Target

Plan B



Legacy Structure Transition:

Below we show a transition plan where a large number of legacy fund offerings are being consolidated into six

target date funds (“TDFs”). Some managers will remain, others will be liquidated, and there are several “new”

managers. In this situation some of the legacy funds may not require any trading and will simply become

holdings of various TDFs. However, we note that the fixed income allocation will grow from $35.6 mln to $55

mln, thus shifting some of the equity funds to fixed income funds. In this case a TM could look at the TDF’s

manager-level allocations and structure the transition accounts by legacy fund. The transition will be traded

within the legacy account structure and the target manager values would be mapped under the corresponding

TDFs after the completion of the transition. Notably, net sell activity would occur in certain legacy equity

transition accounts in order to ensure adequate cash as of the effective date for redistribution to target fixed

income mandates.

Fund Offering Asset Class Manager(s) $mln Core Fund Asset Class Manager(s) $mln

Select US Short Duration US FI A 15.1 Equity H, K, L 13.3

Intermediate US Corporate US FI B 4.1 Fixed Income A, C, E, New FI1 3.3

Total Return Bond US FI C 8.2 Equity F, G, J, New EQ1 11.7

Global Strategic Bond INTL FI D 4.7 Fixed Income A, B, D, New FI1 5.0

Foreign Bond Fund INTl FI E 3.5 Equity H, J, K, New EQ2 8.3

US Strategic Income US EQ F 6.3 Fixed Income A, B, C, D, E 8.3

US Passive Equity US EQ G 16.8 Equity F, G, H, J, K, L 6.7

World x US Passive Equity INTL EQ H 7.5 Fixed Income C, D 10.0

Global Growth INTL EQ I 7.2 Equity G, H, K 3.3

Emerging Markets IMI INTL EQ J 5.8 Fixed Income A, B, C 13.3

Global REIT INTL EQ K 9.7 Equity F, G, H 1.7

Total Return Equity INTL EQ L 11.1 Fixed Income New FI2 15.0

TDF 2030

TDF 2035

TDF 2040

TDF 2045

Legacy Plan Target

TDF 2020

TDF 2025



ETFs: Create or Trade?

The Observation

ETFs are often part of an asset owner’s target allocation (directly or indirectly via sub-advisor portfolio holdings)

or part of an interim exposure strategy. When seeking ETF exposure, an asset owner may have several options,

summarized as follows:

1. Purchase ETF shares in the open market

2. Purchase the underlying basket of securities and create ETF shares via an authorized participant (“AP”)

3. Execute with a 3rd party, often a market maker in the referenced ETFs, to deal the ETFs at an agreed

upon benchmark (e.g., 3 cents away from the inside bid/offer)

The Risk/Challenge

The risk is that purchasing ETF shares in the open market may cause greater shortfall than one of the other

methods outlined above. Additionally, purchasing ETF shares also requires cash raised by selling legacy

portfolio securities. To the extent that legacy holdings are held in the ETF, those securities can result in cost -

savings in building a creation unit. Lastly, the relative size of the ETF purchase as compared with the daily

trading volume is often too large to complete within a single trading day, resulting in potential opportunity costs.

The Strategy

When evaluating an ETF purchase (or sale) a transition manager should estimate the total cost, both explicit and

implicit, of each of the available strategies. Below we show an example where a $100 mln legacy portfolio

containing the S&P 500 Growth Index securities is being transitioned into the SPY ETF. As shown in the table

on the following page, where there is a large amount of overlap between the legacy holdings and the ETF

creation unit, it is often less expensive to create ETF units.

Portfolio Characteristics Legacy Target

S&P 500 Grow th SPY

Market Value $100,000,000 $100,000,000

Underlying Securities 336 500

Shares 1,470,600 1,828,640



Only 1.3 million shares would be traded under the creation strategy (#2) as compared to 2.1 million shares in

strategies 1 and 3, resulting in significant savings. As this example demonstrates, the preferred strategy will

depend on various inputs, but most importantly on the composition of the legacy portfolio relative to the target.

LIQUIDATION LIQUIDATION LIQUIDATION

Traded Shares 1,512,594 Traded Shares 510,761 Traded Shares 1,512,594

Traded Market Value $99,984,406 Traded Market Value $33,674,968 Traded Market Value $99,984,406

Cash $15,594 Cash $15,594 Cash $15,594

Commission $15,126 Commission $5,108 Commission $15,126

Spread (est.) $24,996 Spread (est.) $8,419 Spread (est.) $24,996

Market Impact (est.) $12,998 Market Impact (est.) $4,378 Market Impact (est.) $12,998

ETF SHARE PURCHASE PURCHASE ETF SHARE PURCHASE

Traded Shares 552,486 Traded Shares 805,380 Traded Shares 552,486

Traded Market Value $99,999,966 Traded Market Value $33,660,237 Traded Market Value $99,999,966

Cash $34 Commission $8,054 Cash $34

Commission $5,525 Spread (est.) $8,415 Commission $5,525

Spread (est.) $18,000 Market Impact (est.) $4,376 Spread (est./quoted) $34,575

Market Impact (est.) $14,000 CREATION Observed Market Impact (est.) $0

TOTAL COST $90,645 Shares (unit size = 50,000) 550,000 TOTAL COST $93,219

Flat Fee (SPY) $3,000

AP Fee 0

RESIDUAL ETF SHARE PURCHASE

Residual Shares 2,486 1. SPY is fully replicated S&P500

Residual Shares Market Value $449,966 2. Commissions: 1 cps for US equity trades

Cash $34 3. bid/ask: 2.5 bps for legacy, 1.8 bps target

Commission $25 4. Avg MI: 1.3 bps for legacy, 1.4 bps target

Spread (est.) $81 5. All prices as of November 30, 2013

Market Impact (est.) $63

TOTAL COST $41,918

Estimated Implementation Shortfall Comparison

1. Purchase ETF Shares 2. Creation 3. Third Party Negotiated Deal

Assumptions



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Complexities in Transition Management