The Costs of Changing Investment Funds

Institutional investors change the composition of their portfolios due to their funds' poor performance, style drift, change in key personnel, etc.  When a fund is replaced, securities will have to be sold and bought.  The investors will try their best to minimize any costs and manage any risks.  The costs can be split into these categories:

• Direct - fees to hire a transition manager, trading commissions and taxes
• Indirect - bid and offer spreads and market impact
• Opportunity - prices of held securities being adversely affected by other traders
• Administrative expenses - finding the replacement manager, legal fees, rewriting fund documents and marketing material and custody fees

It is suggested that a transition manager be used if 2 or 3 of the following criteria apply to the portfolio:

• Transaction volume is more than $50 million
• Complex transition across asset classes or with daily valuations requirement
• Investor does not have resources for executing transition
• Out of the markets risks are higher because of allocation or settlement cycle differences
• Low tolerance for out of the market risks

The manager is usually rated by "implementation shortfall".  This compares the target portfolio's performance against the transition portfolio's performance.  This shows actual return versus theoretical return if there was an instantaneous switch to the new portfolio.

The source for this article, written by Freeman Wood and Paul Sachs of the Mercer Sentinel Group, can be accessed here.