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Portfolio > Portfolio Construction

Pension Portfolio Changes Get Complicated

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NEW YORK (–A retirement system decides to fire a manager and invest with someone else. Or it is putting more money into alternative investments. Or it needs to liquidate assets to pay benefits.

Making such moves may not sound difficult, but as portfolios grow more complex it has become a challenge to implement decisions without incurring high costs and losing returns.

A growing number of banks and brokerages, including Goldman Sachs, are offering transition management services to plan sponsors. But the expansion in these services comes with conflict of interest concerns.

Managing transitions now requires portfolio skills as well as trading capabilities, said Nick Bonn, executive vice president at State Street Global Markets, part of the institutional asset management company.

He and State Street entered this niche early, starting in 1992. “The business has got quite a bit more sophisticated, especially in the last five years,” he said, talking at a briefing.

Assets need to be liquidated and reinvested in ways that minimize expenses and shield performance during the transition. For instance, a pension may make a large commitment to a private equity fund that requires infusions of capital over time in unpredictable amounts. The money has to be readily available, but keeping it in cash brings a meager return.

Instead, a derivative may be used to gain exposure to a market where returns look promising. The transition manager sets up the derivative and unwinds it as the private equity fund calls for capital.

The State Street group’s mandates for transitions in bond portfolios have been doubling annually in the past several years. Pensions see more need to get assistance as these portfolios become more complex. Mortgage-backed assets, junk paper, distressed debt–with illiquid securities, a specialized trading desk that knows where to find buyers and sellers can get better terms.

Many plan sponsors are redeeming long-only investments and shifting to a portfolio of indexes and hedge funds, an approach known as portable alpha. The first step in the process is to match what the pension has with what it wants to get, said Ross McLellan, senior vice president at State Street Global Markets.

If there is any overlap between the current portfolio and the target portfolio, those securities can be transferred without any trading, thereby reducing transaction cost. But to determine the overlap, the transition manager needs to know the composition of the investment that is being bought–the “buy list.”

That’s where potential conflicts of interest crop up. Anybody who has access to the buy list can trade off the information. Consider what the proprietary trading desk of an investment bank can do with detailed knowledge of a large hedge fund’s current positions.

“Hedge funds want a neutral pair of hands,” said Mr. Bonn, adding that funds are willing to work with State Street because they know it does not make markets or trade on its own account. The transition manager should sit on the same side of the table as the client, not act as a self-interested counterparty or adversary, he said.

But investment banks and brokerages have different business models that do open the way to conflicts, he and Mr. McLellan argued. As they see it, the solution is a fiduciary approach that requires the disclosure of any revenue the transition manager makes through the process, however the gain comes about.

There is an ongoing effort to develop standard benchmarks in this area so that transition managers’ success in reducing costs and protecting performance can be measured in a comparable way.

Differences in business models get in the way of an agreement between service providers as to best practice or common performance measures, according to Mr. Bonn. But industry standards are probably in the future of transition managers.

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