Case 037Rebalancing, implementation and costsCore

A provident fund is moving Rs 1,500 crore from a terminated manager to a new one. Holdings overlap 60%, the rest costs 25 basis points each way, and a cash move leaves the money out of the market for five days at 18% volatility. Compare an in-kind and a cash transition.

The situation

Revakhand Dockyard Provident Fund has terminated one of its equity managers and appointed another. The mandate is Rs 1,500 crore. Measured holding by holding, 60% of the old portfolio is already in the new manager's target portfolio at the right weights; the other 40% must be sold and replaced.

Trading costs, including spreads and market impact, are estimated at 25 basis points on each sale and each purchase. The simplest route, liquidating everything to cash and handing the cash over, would leave the money out of the market for 5 trading days while accounts are closed and opened. The equity market's volatility is 18% a year. Ignore tax, since the fund is not taxed on these gains.

Your task

What does each route cost in trading and in exposure to the market, and which would you choose?

Quick check

Roughly what trading cost does the in-kind route save against moving everything in cash?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Move the overlap in kind and trade the rest quickly: it costs about Rs 3.0 crore against Rs 7.5 crore in cash, and avoids a five-day swing of about Rs 38 crore. Rs 900 crore transfers without trading. Only Rs 600 crore is sold and bought. The cash route's larger danger is not the fee but five days out of the market, which is a bet the fund never meant to make.

Step 1Why move securities rather than cash?

When you move house, you do not sell your furniture and buy the same pieces again at the new address; you move what you want to keep and buy only what is missing. An in-kind transition moves the holdings both managers want straight across, so only the difference is traded and the fund never leaves the market. Here that is 60% of the portfolio, Rs 900 crore, moved with no dealing cost at all.

Step 2What does each route cost in trading?

Count both legs of every trade. In kind, the Rs 600 crore that does not overlap is sold and replaced, 25 basis points each way, Rs 3.0 crore. In cash, all Rs 1,500 crore is sold and bought back, Rs 7.5 crore. The in-kind route is cheaper by the cost of trading the overlap twice, Rs 4.5 crore, or about 30 basis points of the mandate.

Step 3What is the cost of five days out of the market?

Being in cash is not safe for a fund whose members expect equity exposure; it is a bet that the market will not rise while you wait. Five trading days at 18% annual volatility is a standard deviation of about 2.54%, a one-in-three chance of the market moving more than Rs 38 crore either way on Rs 1,500 crore, and a one-in-twenty chance of more than Rs 75 crore. The expected cost is roughly zero; the risk is that the fund misses a rally and has to explain it. That uncontrolled swing is ten times the trading bill.

The relationship
σ5 days=18%×5252≈2.54%1,500×2.54%≈38 crore\sigma_{5\,\text{days}} = 18\% \times \sqrt{\tfrac{5}{252}} \approx 2.54\% \qquad 1{,}500 \times 2.54\% \approx 38 \text{ crore}
18%annual volatility of the equity market
5/252five trading days as a share of a trading year
1,500the mandate, Rs crore
What it says in wordsVolatility grows with the square root of time, so five days out of the market carries about a 2.5% standard deviation, roughly Rs 38 crore on this mandate.
Move what overlaps, trade the rest fast: the out-of-market window is the real costDay 0Day 1Day 2Day 3Day 4Day 5Day 6In kindcost Rs 3.0 croreRs 900 crore of overlap transferred in kind: no trades, always investedRs 600 crore tradedfully with the new managerfutures cover days 1 to 2All in cashcost Rs 7.5 croresellRs 1,500 crore out of the market for 5 daysone standard deviation swing: about Rs 38 crorebuyTrading days after the decision to move
Moving Rs 900 crore in kind and trading only Rs 600 crore costs about Rs 3.0 crore and keeps the fund invested, while moving all Rs 1,500 crore through cash costs Rs 7.5 crore and leaves it exposed to a five-day swing of about Rs 38 crore.
Rs croreIn kindAll cash
Transferred without trading9000
Sold and bought6001,500
Trading cost at 25 bp each way3.07.5
Days out of the market0, futures cover the gap5
One standard deviation market swing while out9.6 if not covered38.0
The in-kind route saves Rs 4.5 crore of trading cost and cuts the market exposure gap from about Rs 38 crore of one-standard-deviation risk to almost nothing.
Step 4How would you run it in practice?

Appoint a transition manager, a specialist whose job is to move portfolios between managers. They transfer the overlap in kind, trade the Rs 600 crore over a day or two, and hold index futures on anything in transit so the fund stays invested throughout. Even uncovered, two days of risk on Rs 600 crore is a one standard deviation swing of about Rs 9.6 crore. The limits: 25 basis points is an estimate, and small or illiquid holdings can cost far more to sell; the overlap figure must be measured on the actual target weights, not on shared stock names; and the fund's trustees should see a pre-trade cost estimate and a post-trade report against it.

Where candidates lose it

The common error is comparing only commissions and missing the five days out of the market. Being in cash feels like no risk, but for an equity mandate it is a large, unhedged bet against the market.

The second is counting only one leg of the trade. A sale and a purchase each carry cost, so a cash move of Rs 1,500 crore costs twice 25 basis points, not once.

What the interviewer asks next

  • The new manager's target overlaps only 30%. How do cost and risk change?
  • How would you size the index futures position that keeps the fund invested during the transition?
  • Why might a terminated manager's holdings be worth selling quickly even if they overlap with the new target?

Company names and figures are illustrative.