In reality, things are not so clear cut.
Submitting trades into the closing auction the day before the transition is due to start will naturally affect the closing price on T-1 – increasing the price if it is a buy order or decreasing it in the case of a sell order.
“These trades will occur at the closing price, which will also then be set as the benchmark for the transition, and that suggests there is no implementation shortfall on the portion of assets traded in the closing auction,” says John Minderides, head of portfolio solutions group, EMEA at State Street. “However, they would have directly affected the benchmark price. Trading on T-1 therefore results in an unmeasured impact on the value of a client’s assets and, in turn, the cost of the transition. The fact that it is not measured does not mean there is no impact.”
Futhermore, the prices determined in the closing auction on T-1 carry through to the official start of the transition and inevitably push prices against the client on the day trading is due to commence. A buy order in the closing auction on T-1 would push the opening price on T up, a sell order would push the opening price down.
“This is a real cost to the client,” Minderides says, “but one that will be hidden in the movement of the benchmark price used to measure the implementation shortfall. If this is then used to measure the value of a transition manager, the client is not getting the full picture. It cannot rightly be argued that this is a more transparent strategy.”
DOUBLE-CROSSED?
This point can be particularly pertinent where a transition manager who is also an asset manager offers to ‘cross’ (or net out) transition trades with their asset management trades. Although it can be argued that by doing so those managers are providing liquidity and can trade at better spreads, saving the client money.
However, it is important clients understand the conflict of interest inherent in this strategy and are comfortable that it is not working against them.
Asset managers use closing prices in their NAV calculations and are therefore incentivised to limit sell order and boost buy orders. Netting transition and asset management flows does exactly that for the asset manager, who will have to execute assets on T-1 regardless of their transition management flow.
The transition client may be disadvantaged if they agreed to cross assets at the close of T-1 rather than wait until T, when the asset management flows would have pushed opening prices further in the TM client’s favour. Crossing would also move the benchmark for IS against the TM client.
HOW MUCH DOES IS REALLY MATTER?
All of the above only really matters if clients are focused on IS as the measure of value of a TM and there are plenty of times when it is not considered to be relevant.
For some investors, delaying trading to a defined time represents a risk over starting the transition immediately. Consider, for example, if a client had wanted to sell euros and buy Swiss francs on 14 January this year. Holding trading to the next day could have been very costly as the Swiss National Bank shocked markets by dropping its three-year peg against the euro on 15 January, which saw the Swiss franc soar 30% in value against the euro.
For some clients, the more important measure of a transition is what some have refered to as the ‘decision shortfall’ – the difference in performance between the legacy and target portfolios from the point the decision is made to effect the change.
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