Institutional investors should review information that goes beyond the typical scorecard that they use, called the "implementation shortfall," when they gauge the success of changing the asset allocation of a portfolio or switching asset managers. That is one of the key conclusions of a new study from Mellon Transition Management (MTM), the transition management specialist for BNY Mellon Asset Management.
The report urges investors to break down the components of the implementation shortfall cost and focus on the implicit costs of their transitions.
The report, which recently appeared in the summer edition of the Journal of Investing, notes that the implementation shortfall includes both the implicit costs and explicit costs. The explicit costs include spreads, commissions, taxes and fees incurred in selling the securities in the old portfolio and buying the securities in the new one.
Implicit costs include the market impact of the trades and the price movements of the securities during the transition period. The price gap between the end of one trading day and the start of the next also could be a factor in the cost of a transition that extends over more than one day, the report said. A successful transition minimizes the impact of the implicit costs, which often are not as well understood by plan sponsors as well as the explicit costs, the MTM report notes.
"How the attribution of these implicit costs are calculated and presented can have a major impact on how the success of a transition is perceived," says Graham C Cook, vice president at MTM and the report’s author. "Implicit costs are difficult to separate out, but a careful analysis can reveal additional insights into the skills of the transition manager."
The report outlines several trading benchmarks and discusses their usefulness to institutions in both gauging execution performance and attributing between the implicit costs. These benchmarks can be based on the previous day’s closing price of the securities, the prices of the securities at the close of the transition, or the trading period average prices of the securities.
An important component in determining the success of the transition is how much of a trade off is made between rapidly trading the portfolio components versus making smaller trades over a longer period of time. Trading a significant portion of the portfolio over a compressed time period can quickly reposition the portfolio to take advantage of market opportunities, while making smaller trades over a longer period of time could minimize the impact of the trades on the prices of the securities being traded, the report says.
"Analysing the implicit costs and using the right benchmark can help to reveal whether the transition manager has made the most of the liquidity available during the transition, whilst managing risk," Cook says. "Achieving the optimal balance between the impact of the trades on the markets and the risk of prices drifting adversely is the key to a successful transition."