Careful management practices can minimize the costs when switiching money managers and make the process less painful

April, 1996 Benefits Canada - There's a figure that's often bandied around in the financial industry. On any given day, 60% of Canada's major pension funds are searching for new money managers. It doesn't take a rocket scientist to then assume that, on any given day, a healthy portion of funds are indeed firing their investment managers.

Switching managers isn't a painless exercise. In fact, it can be downright expensive. While the costs of changing managers aren't usually a primary factor in the decision to change, there's no doubt that it can be pricey. It's in a pension fund's interest to minimize these costs. But what are these charges and how can they be minimized?

There are basically four costs linked with an investment manager change.

1. Advisory costs: includes the consultants' price tag to help ease in the new management.

2. Corporate management costs: really depends on how much in-house time the manager change consumes.

3. Investment management costs: the price paid to an investment manager to rebalance a portfolio.

4. Transactions costs: include market impact, commissions, custodial charges and opportunity costs, particularly for equity portfolios.

While some plan sponsors give new managers full responsibility for liquidating the old portfolio before reinvesting it into the new, others prefer to hire a third-party transition manager to oversee the process, particularly if it's an equity or balanced mandate.

An independent transition manager is especially helpful when it comes to liquidating equity portfolios, where the incoming manager has limited expertise in trading the securities from the previous portfolio. The transition manager's sole goal is to minimize the net cost of the transition.

Consultants can provide this service as well, sometimes being paid via "soft dollars." The soft-dollar trade is directed to a selected dealer who uses a portion of the commissions on the trade to pay-on behalf of the client-the consultant's fees. While such arrangements can offer convenience, the transaction costs associated are potentially higher than average.

Transactions costs depend upon a number of variables, including:

• asset classes involved;
• investment management styles of current and incoming managers;
• specific holdings in existing and new portfolios;
• timing; and
• market behavior during transition period.

• commissions and fees for broker, custodian and securities commissions to implement trades;
• market impact costs or how much the market moves as a result of trading; and
• opportunity costs to the portfolio as a result of being invested in securities other than those ultimately desired.

Chart 1
	COUNTING COMMISSIONS Each penny saved in average commissions incurred during a change in money managers translates into savings of over nine basis points to the portfolio. Equity portfolio value = $50 million Total value of sales + purchases (round trip) = $100 million TSE300 average price per share = $22 Number of shares traded = 4.54 million Average commission per share = $0.06 Total commissions paid = $272,700 Total value of each $0.01 of commission = $45,500 $0.01 of commission as a % of total portfolio = 0.09%

Commissions and fees are straightforward measurements, but equity commissions can vary depending on whether payment is for execution only, or execution plus sales and research. Full-service commissions on Canadian equities commonly average 5¢ per share. Specialized trades can be higher. Execution-only commissions can be under 3¢ per share.

It's clearly in a pension fund's best interest to minimize commission costs. (See chart 1) However, this doesn't necessarily mean the lowest possible commission should always be sought: good execution's worth paying for.

The second type of transaction cost (market impact), is usually estimated beforehand by examining the bid/ask spread for the securities in the portfolio. This spread captures information on the liquidity or supply and demand characteristics of a security.

For a broad-based Canadian equity portfolio the bid/ask spread is between 0.70% to 1%. Of course, a small-capitalization portfolio would have a much wider bid/ask spread and would cost more to liquidate. (See chart 2)

The quoted bid/ask spread, however, only tells part of the market-impact or liquidity story. The size of each holding relative to the average daily trading volume for that name gives a further indication of how easy or difficult a security will be to buy or sell.

Chart 2
	MARKET IMPACT COSTS A BUNDLE Different types of portfolios will yield varying bid/ask spreads giving an idea of the market impact costs, including the cost of liquidation and reinvestment. Asset Class Bid/Ask Spread TSE 300 0.80% TSE 100 (large cap) 0.60% TSE 200 (small cap) 1.50% Bonds 0.15% S&P 500 0.37% US mid-cap 0.73%

For example, if a portfolio's holding in ABC Corp. is 250,000 shares, and ABC Corp. has had an average daily volume of 50,000 shares, it's unlikely that you could liquidate the entire 250,000-share holding easily without making price concessions. Because of this liquidity constraint, it's very possible that the bid/ask spread will shift downward relative to the beginning price as you attempt to liquidate the entire holding-even if markets remain flat. Similarly, on the buy side, there will be upward pressure on the bid/ask spread as the manager builds positions in the new portfolio.

The third chart (see Chart 3) provides an example of the potential magnitude of transactions costs during a manager changeover. Even when some of the portfolio is retained by the new manager, the costs are substantial. Our experience has shown that approximately 40% of the portfolio is retained. A skilled transition manager will trade those securities strategically to avoid impacting upon the price, thereby realizing significant savings.

Chart 3
	SCRUTINIZE COSTS A careful transition should minimize transaction costs. Total value of portfolio = $100 million Value of original portfolio retained by new manager = $40 million Value remaining for liquidation = $60 million Value traded (sells + purchases) = $120 million Number of shares traded = 5.5 million Costs: Commissions @ $0.06 per share = $327,300 Market impact at 0.80% = $480,000 Total costs = $807,300 Costs as a percentage of remaining portfolio = 1.35% Transactions costs as a percentage of total portfolio = 0.81%

Later Measure
Opportunity costs are the third element of transaction costs and usually are measured after the fact. How much did it cost the portfolio to not be invested in the new portfolio? How would the portfolio have performed if it had been instantaneously transformed into the new portfolio on the first day of the transition?

The portfolio will be exposed to additional opportunity costs if market exposure isn't maintained. Thus, the sale of securities from the previous portfolio should be co-ordinated carefully with the purchase of securities for the new portfolio. While using the new manager to liquidate the old portfolio may help to reduce market exposure risk, it may, at the same time, incur higher transaction costs. The investment managers, consultant, custodian and sponsor should work closely together to minimize the impact of being out of the markets at any point during the transition.

Speed vs. Cost
While one goal of the plan sponsor is to minimize costs during transactions, very often the first concern is to change managers as quickly as possible. There's a tradeoff, however, between speed and cost. Implementing a transition quickly often results in price concessions. On the other hand, implementing the transition more slowly exposes the portfolio to the opportunity costs associated with not being invested in the new portfolio. A successful transition strategy can help manage this tradeoff.

Low Profile
If the transition manager is liquidating relatively large holdings, it's important that he or she does not signal the market. Maintaining a low profile is key: otherwise, other investors may take advantage of the situation to the detriment of your portfolio.

This problem can be exacerbated when an old manager is being terminated by several other pension fund sponsors around the same time and many of the same securities are being sold into the market, placing additional pressure on prices.

The transition manager is fully accountable for the performance of the portolio during the switch and this performance should be measured. Typically, the total pension fund's performance is measured. But scrutiny of the new manager's performance doesn't start until the portfolio has been reconfigured to fit the new style. Thus, transition performance often falls between the cracks.

Chart 4
	THE RIGHT BLEND Multiple asset class portfolios can be measured properly Return of portfolio = 1.25% Less return of Value Index = -1.35% "Opportunity cost" of being underexposed to value of stocks = - 0.10% Return of portfolio = 1.25% Less return of Growth Index = -0.90% "Opportunity benefit" of reducing exposure to growth stocks = 0.35%

There are a number of ways a portfolio transition can be measured to determine how costly the change of managers actually was. Implementation shortfall is one measure. Ideally, implementation shortfall is measured against paper portfolios that reflect the old and new managers' portfolios. Alternatively, the portfolio's performance can be compared against a variety of index benchmarks, such as the tse 300 or specialized style benchmarks that represent the old and new managers' styles. Multiple asset class portfolios should be measured against a blended benchmark. (See chart 4)

In addition, trading execution should be measured separately. For example, the prices where trades occur during the transition can be compared to a variety of benchmarks, including: average prices, daily high/low prices, prior or current day's closing prices, and opening prices

By using more than one benchmark, the plan sponsor can gain added perspective in assessing the success of a transition. In any case, careful transition management is key when it comes to minimizing costs during a manager switch.

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