Investment managers – and not, as is customary, the clients of institutional investors – should eat the research costs generated by transactions in managed accounts.
It is a brave new world, but that is the conclusion of a controversial report on the U.K. pension industry, inked by a former chief executive of Gartmore Investment Advisers.
"Clients' interests would be better served if they required fund managers to absorb the cost of any commissions paid, treating those commissions as a cost of the business of fund management, as they surely are," declares Paul Myners, in the report commissioned by the U.K. government.
The conclusion is not surprising because there is a wide-spread perception that these costs, associated with soft-dollar practices, are prone to corruption. It has been an issue in the U.S. since the 1975 birth of negotiated commissions. An Act of Congress was needed back then to permit commission payments for research services. Indeed, the majority of plan sponsors instruct investment managers to trade through a selected broker. The broker agrees to rebate part of the commissions to the pension plan. That reduces commission pools available to the manager.
Still, eliminating soft-dollars risks serious market damage. It risks taking soft' expenditures out of commissions and putting them with the principal price.
In most scenarios, the clients of institutional investors, including pension plans, mutual fund shareholders, 401(k) participants, will not end up winners. Since 1975, the cost of processing an ordinary transaction has plummeted to around a penny or two per share. Yet, at the same time, average full-service commission rates remain about six cents a share. In other words, the charges have not come down in line with the cost of providing the basic service.
Sure, six cents a share may be justified for handling difficult transactions. Brokers earn this level of commission when they handle a large and delicate order. Still, no matter how simple the trade, the going rate for non-automated trading is still near six cents. No market force, buyside, sellside, nor even plan sponsors, seems to want to bring the price down. The reason: Sheltered under this six cents umbrella' is a host of institutional research and tools accepted as essential to asset management.
Vital Services
Most managers carefully budget their soft-dollar services. Many have administrators who see that soft-dollar standards are followed. Yet the heart of the Myners report notes that the services acquired are not adequately scrutinized to determine whether they are indeed vital.
Here's an example: In today's environment, a large manager is likely to receive a dozen or more research recommendations as brokers strive to display their competence. This sounds excessive, but the value of information is not as evident as suggested by Monday morning quarterbacks. Perhaps most of the important research is redundant, but who wants to disregard research by Ms. X under this arrangement? She might stumble across something important that is ignored by other analysts.
Suppose – under the Myners scheme – investment managers picked up the costs generated by commissions: How would pension management be affected? How would it affect trading?
Let's begin with a simplified example of a $100 million investment fund with a 50 basis point management fee. Assume annual turnover at a typical rate of 100 percent, with a five cent commission on an average $40 stock. Such an account would carry a $500,000 management fee and $250,000 in commission payments.
Everything else being equal, directly including the commission costs in the management fee would raise the fee 50 percent. Or would something else happen? Four alternatives are examined in the sidebars:
1. Fees rise to cover the increased expense transferred to the manager.
2. Managers drastically reduce research purchases.
3. Managers reduce commissions to reflect only trade costs.
4. Costs slide over from the all too visible commission to hidden transaction costs.
In 1989 this writer attended a conference on the state of the market. The head of one major sellside dealing desk warned the buyside: If brokers were not adequately compensated for their services, they would become more an adversary than a partner of the buyside. A move away from soft dollars could accelerate that trend.
You either believe that the research and market feel of the brokers are valuable or not. Those who see value would want to avoid a situation where the services become available only to those able to pay up.
Transferring the operational costs of active portfolio management to the manager, as Myners recommends, sounds good. Unless the costs of services are recovered through increased fees, the only alternative for managers would be to eliminate services or transfer costs in ways that risk reducing the value of active management.
However, the real question is whether soft-dollar practices are a problem that needs fixing. There is already effective low-cost competition to active investment management: The index funds serve investors who prefer this low cost, low turnover investment strategy. Still, active management continues to thrive as an option for those who prefer to place a sage in charge of their portfolios. And the sages do need the benefit of special knowledge.
The Myners report, nonetheless, deserves praise for its fresh look at an important issue. But the solution proposed doesn't seem to lead to the promised benefits. That, perhaps, helps explain why the soft dollar business has remained so resilient.
Wayne Wagner is chairman of the Plexus Group, a trade execution consultant based in Los Angeles.
The first reaction of managers, if commission costs were included in the management fee, would be a request for immediate fee increases. It is doubtful that most clients of institutional investors would accept this request carte blanche. They would demand: Show me why. Prove the research is really necessary. That might be an easy question to answer in an industry finely attuned to its cost structures. With the exception of the index funds, however, cost awareness is not a hallmark of current investment management.
Not all managers would face the same change. The table shows the economics depend on turnover rates, average commission levels, and typical management fees:
Increasing Fees
Clearly, there are strong differences in how individual managers would be affected. Movement away from highly affected funds toward those less affected might be expected. Indexing would look even more attractive, especially to those swayed by the inevitable argument that the competitive performance of index funds is enough proof that the value of research is over-estimated relative to the costs of acting on that information.
Reduce Research
Failing to increase fees, if commission costs were included in management fees, the managers' tendency would be to eliminate excessive' soft-dollar services. Presuming the research is worthwhile, how much value could be lost? The answer depends on style of management. Fast idea' managers – who use news, tips and other pointers – would probably be hurt the most. Valuable ideas would more likely flow to those not bound by the proposed structure – hedge funds, for example. Thus the pension system might be placed at a disadvantage to those who have more freedom to reward profitable ideas.
This is not a good outcome. Active portfolios frequently need more information. With average annual turnover for active portfolios around 100 percent, active managers are an important contributor to market liquidity and efficient pricing of securities. If the brokers could not find a market for valuable research, they would be tempted to internalize it. In effect, they would attempt to cut out the middleman' between the research- generating broker and clients of the institutional investor.
Eliminating the middleman could lead to the kind of market domination by big investment banks lamented in the German market. Germany has worked for decades to devolve into a more open market for investment services, but with only partial success.
Reduce Commissions
Surely, the Myners recommendation, highlighted at the start of this feature, is based on a belief that excess services are now bundled into the commission. Many observers believe that the managers' dependence on soft dollars has left them hooked' on high-cost transactions. Others, this writer included, see commissions differently: Commissions provide the buyside with access to the specialized knowledge that dealers gain because they are intermediaries. Like it or not, the brokers and dealers gain an edge through their feel of the pulse of the market. Call it the fingers of the invisible hand.' This stream of information is too expensive and too fleeting for anyone but a broker dealer to acquire and use profitably.
Suppose a broker has an order from a desperate seller willing to pay substantially for liquidity. Who is more likely to get an early call from the broker? The investment management firm that sends $50,000 worth of business a year or the $5,000,000 relationship? Despite appearances, a broker won't extend top-level service to a management firm that is not important to the broker's compensation.
Conversely, the only control the manager has is the threat to cut off a brokerage that fails to provide quality service. A manager who squeezes the commissions would reduce control over the broker. The lower the commission, the lower the leverage the manager has to reward or discipline the broker.
The bottom line: Power is transferred to the broker.
Transfer Cost to Broker
In recent years, the investment management industry has found a powerful new tool for improving performance through quantitative analysis of transaction processes. The iceberg' model divides costs into four components:
[1] Commissions – explicit trading and research costs.
[2] Impact – price premiums needed to buy liquidity.
[3] Delay – adverse price movements while seeking liquidity.
[4] Opportunity costs incurred as the manager abandons a trade when liquidity cannot be found at an attractive price.
What is most important to observe here is the fluidity of these costs: Any one component can be held down or even completely eliminated. However, traders have to be very careful that costs are not simply transferred from one category to another. For example, as spreads narrowed due to decimalization, impact and search costs rose.
Another, most relevant, example is that internal expenses can be reduced by transferring control of the trade to a broker. Recently, a French buyside head trader related to me how he used the standby resources of the broker: "If my staff is overwhelmed, I can give full orders to the broker and effectively increase my staff by a head count of ten."
Even in today's market, the broker maintains over flow capacity to take over excess workload from the buyside. A manager seeking to cut expenses would find this option attractive in a world operating as the Myners report proposes. Expenses would shift to the sellside. It would be more than willing to accept them since it reduces the ability of the buyside institution to enforce accountability for order handling. Here again, the result would be an increase of sellside domination. The costs haven't gone away; they've simply been transferred from the all too visible commission to the more hidden transaction cost components.
This means that costs would continue to be borne by the money owners. Unlike today, the costs would be embedded in principal prices and hidden in delays due to the increased difficulty of trading quickly at a low total trading cost. But those who focused only on commission savings would celebrate the incredible savings.
Note: All sidebars contributed by Wayne Wagner
