This month, following the Current Alert, you will find a press release introducing Benchmark Advisory Services, Inc., a newly-established registered investment advisor that offers three "emerging" manager, manager-of-managers Trusts. Please scroll down beyond the end of the Current Alert if you wish to see the press release.
Pensions and Brokerage: The Brokerage Battlefield Revisited
"Retirement assets are growing far more rapidly than our understanding of the fiduciary principles involved in managing those assets."
October, 1997 speech to National Council on Teacher Retirement at the Philadelphia Stock Exchange.
Brokerage issues can be especially thorny for pension funds. Commissions paid to brokers is one of the most significant expenses of funds. Pensions recognize that commissions are an asset of the fund and they have a fiduciary duty to investigate, to some degree, how commissions are used. Yet obtaining accurate information about brokerage practices is difficult. Some pensions choose to delegate most of the responsibility for trading, including fundamental issues of frequency and allocation, to the money managers they hire. They are certainly encouraged to do so by their managers. These pensions may only delve into brokerage issues in response to specific problems, such as significant trading errors, compliance issues or legal/ethical concerns. Pensions that believe their fiduciary duty includes getting involved in brokerage decision-making face a more difficult task.
In October, 1997, I gave a speech at the Philadelphia Stock Exchange for the National Association on Teacher Retirement entitled, "The Brokerage Battlefield." The title of the speech referred to the battle of competing forces or conflicting interests that collide when pensions, managers and brokers engage in brokerage matters. Each participant in this battle has different interests. Pensions are, on the one hand, concerned with reducing trading costs. This is a complex inquiry to begin with because much of this expense is obscured: fixed income and over-the-counter securities do not trade with a stated "commission." International trading costs are also difficult to ascertain because of the myriad fees involved. Another approach to cost reduction can be commission recapture, or entering into rebate agreements with brokers. While interested in reducing trading costs, pensions are concerned, on the other hand, that performance not be adversely affected. So when a manager says performance will suffer if the fund imposes some limitation on commissions, pensions listen.
Pensions may also seek to pursue other policy goals such as directing brokerage to minority, women and local firms. Some pensions, such as the Ohio State Teachers Retirement System, manage most of their assets internally and have their own trading desks. CALPERS has external managers to whom it delegates trading responsibility but the fund also manages and trades some assets internally. The Ohio Bureau of Worker's Compensation hires some of its external managers on a non-discretionary basis and requires that these managers call their trades into the fund's trading desk for execution. As a general rule, however, funds rely heavily upon managers for guidance on brokerage issues. How reliable is the information managers provide? To what degree is it self-serving?
There are few absolute truths in the money management business. Here's is one: All money managers are interested in controlling the brokerage related to the accounts they manage. There are reasons why a manager would want this control. Managers can themselves benefit in a myriad ways from client commissions. Managers often direct client commissions to brokers who have assisted their marketing efforts. Brokers are rewarded for bringing the manager money to manage. Managers also argue that allowing them to decide which brokers to use is crucial to superior investment performance. Better brokers providing better "executions" leads to better investment performance, the argument goes. Many of the larger managers have affiliated brokers; directing brokerage to an affiliate benefits the manager's overall bottom-line. Some managers with affiliated brokerages will actually bring a trader from the affiliated firm to meetings with the fund to explain why use of the affiliate is in the client's best interest. Some funds, especially those with their own trading operations or brokerage policies, find it offensive when managers attempt to persuade them to abandon the brokerage policies or programs they have established and allow the manager to use an affiliated broker instead. In such a case, the manager's self-interest may be so obvious that the manager's preference is viewed with suspicion and the strategy back-fires. However, usually pensions will accept the "compelling" reasoning of their managers as to why they should leave brokerage decisions to the manager.
Pensions accept what they are told by managers, in part because they are not knowledgeable about brokerage practices. This is not the fund's fault; the brokerage business is extremely confusing and may seem only ancillary, or of secondary importance, to the investment process. For example, investment managers have a legal duty of "best execution" when trading for a client account. Much confusion surrounds this term of art. If best execution were too stringently defined, managers would have to worry about the legal consequences of subsequently discovering a transaction could have been executed more cheaply or by other means. Since there is no agreed-upon legal definition of best execution and probably never will be due to the rapidity with which securities trading is evolving, it is obviously impossible to evaluate trading practices for compliance with the standard. Even experienced traders who would agree that factors such as the size and type of the transaction, the market for the security, and the speed and certainty of execution, are all relevant, would disagree as to the exact meaning of the term. Yet pensions are approached by "trading consultants" who claim to be able to test for it. When a pension suggests something as simple and straightforward as lowering commissions from six cents a share to five, the manager says "execution," whatever that is, will suffer. When the fund suggests directing brokerage to minority or local brokers, or entering into a commission recapture arrangement, managers emphatically state that performance will deteriorate. If the fund interferes in any way with the managers' trading decisions, trouble will ensue. What's a fund to do? When it comes to brokerage, it is no simple task to establish whether your manager is telling you the truth or has his own best interests in mind. Unfortunately, managers do not always tell the truth to their pension clients about brokerage matters.
Another reason managers are interested in controlling client commissions deserves special attention. "Soft dollaring" has got to be one of the most misunderstood and controversial practices in the money management business. The very term "soft dollars" suggests something shady and conjures up images of money exchanging hands in dark alleyways. Among laymen, soft dollars may be confused with "soft money" political contributions. There is a thin connection between "soft dollars" and "soft money." Since brokerage firms are not subject to the same rules pertaining to political contributions as municipal underwriting firms, large "soft money" contributions from owners of brokerage firms do find their way into politicians' coffers more easily than contributions from underwriters. However, it is important to not confuse the two terms.
So what is "soft dollaring?" Soft dollaring is the practice whereby money managers use client brokerage commissions to purchase investment research. When a manager pays for products or services with his own money, directly from the research provider, this is referred to as "hard dollars." Payment with client commissions, financed through a brokerage firm, is referred to as "soft dollars." Through soft dollar arrangements money managers are permitted to shift an expense related to the management of assets they would otherwise have to bear, onto their clients. The amount of this research expense the money management industry transfers onto its clients is in the billions annually. As a result, any analysis of the economics of the money management industry should include the effects of soft dollaring; however, we are unaware of any that has. In the institutional marketplace, strange as it may seem, it is possible for a money manager to profit more from soft dollars than from the negotiated asset management fee he receives.
The general rule under the federal and state securities laws is that a fiduciary, the money manager, cannot use client assets for his own benefit or the benefit of other clients. To simplify matters greatly, soft dollaring is a legally prescribed exception to this rule. Congress, the SEC and other regulators have agreed that as long as the research purchased assists the manager in making investment decisions, the clients benefit and its legally acceptable. A tremendous amount of strained analysis has gone into the precise policies and procedures that managers must follow in purchasing research with client commission dollars. Over the years a distinction has been made between "proprietary" research or in-house research distributed to brokerage customers without a price tag attached and "independent third-party" research or research written by a third party and sold to managers at a stated price. Third party research has been most frequently criticized because its cost is separately stated and the benefit to managers most obvious. In this latter case, a breach of fiduciary duty seems most glaring. However, it is well known that proprietary research, offered for "free," is produced to stimulate sales of dealer inventory. So presumably this research lacks credibility and is less beneficial to clients. There have been distinctions drawn between products and services, such as computers, which are "mixed-use," i.e., which may serve dual purposes, providing both research and administrative uses. An adviser must make a reasonable allocation of the cost of the product according to its uses, the SEC has said. Some portion must be paid for with "hard" dollars and the other with "soft." There are several articles in our Library of Articles that describe soft dollar practices, rule changes and our proposal to Chairman Levitt to reform the soft dollar business.
The issue that soft dollaring raises is: when is it acceptable for a manager to benefit from his client's commissions? For purposes of this article we would like to introduce a new and more useful perspective for pensions in their analysis of soft dollars or any other brokerage issue. That is, all brokerage commissions controlled by managers, benefit managers in some way. Brokerage decision-making by managers rarely, if ever, is simply based upon what firm can execute the trade at the best price. Brokerage is a commodity. Almost all brokerage firms offer reasonably competent, "best execution" services. If they didn't, they'd get sued and soon be out of business. Most savvy brokerage marketers don't even try to differentiate their firms with long-winded explanations about best-execution capabilities. Best execution is a given and impossible to prove. If you want to understand how your money manager allocates brokerage, study his business as a whole, including his marketing and affiliates-not just the investment process.
What would you think if a manager offered to manage your money for free-as long as you let him do whatever he wished with your commissions? There are managers who will do precisely that.
When pensions turn to brokers for information about brokerage practices, they get different answers, depending upon how the broker makes his money. Years ago I was advising one of the largest funds on selection of a central broker for all trades. We invited three Wall Street powerhouses to present proposals one day, one after another. The first firm offered to do the trades for eight cents a share; the second firm offered four cents a share. The final firm offered to do the trades "for nothing." The board members and I looked at one another in disbelief. For free? We didn't understand. We thought our job was to find the best broker, giving considerable, but not exclusive weight, to commission rates. What our final presenter had told us was disorienting. He had let the cat out of the bag. It really didn't matter what commission we paid, if any. He was going to make his money elsewhere-by crossing the trade, or selling our orders, or from "front-running" our trades. Oddly enough, we did not select this final broker. I say "oddly enough" because he was probably the most truthful. Yet we punished him for his candor; we viewed him as the least ethical.
There are major Wall Street brokerages that sell proprietary investment research, inventory blocks of stock to sell to money managers, and, because they profit handsomely from proprietary trading, pay their traders the highest salaries. They maintain they should be paid higher commissions for the superior service they provide to managers. (While these firms are Wall Street's most profitable, it is questionable whether their high-price talent benefits managers or pensions or, for that matter, anyone other than themselves.) They will argue to pensions that it is indeed best to leave brokerage decisions to managers. An alliance exists between these brokers and managers. The greater the commission rate the pension client approves, the more the broker gets paid and the more money the manager has to spread around to accomplish his multiple objectives. These brokers market their services to money managers primarily.
Then there are the soft dollar and commission recapture brokers who sell their services to pensions, as well as money managers. (Virtually every firm that offers soft dollar services also offers commission recapture.) These firms are far less profitable than the Wall Street power-houses because they rebate half or more of the stated brokerage commission to managers and pensions and do not trade stock for their own proprietary account. They encourage, and sometimes even intimidate, pensions to become involved in brokerage decision-making. Their marketing materials state that if pensions do not become involved in directing their brokerage, they are not fulfilling their fiduciary duty. These firms are responsible for getting the word out to the pension community that commissions are being left on the table and that pensions can get involved in directing brokerage without hurting performance.
Soft dollar and commission recapture firms have grown tremendously since the late eighties and have taken a lot of business from Wall Street firms. In 1993, Goldman, Sachs and Morgan Stanley, in their testimony before Congress, strongly criticized the soft dollar business. Byron Wein, chief investment strategist of Morgan Stanley, issued a report to clients stating that "one of the sinister aspects of the commerce of Wall Street is the concept of soft dollars." These firms urged Congress to put an end to the practice. Wein admitted in his report that soft dollar firms were taking business from his firm. The soft dollar firms formed their own lobby group, the Alliance for Independent Research, to counter the Morgan, Goldman initiative. In summary, the effort to eliminate soft dollars failed and we understand both Morgan and Goldman now offer soft dollar services to their clients. For further analysis of the 1993 push to eliminate soft dollaring see our report, "Is the SEC In the Twilight Zone: The Hard Truth About Soft Dollars."
Pensions should not be afraid to become involved in brokerage decision-making. Certainly a pension's fiduciary duty extends to brokerage, one of the largest expenses of the fund. Managers, consultants and brokers, including both soft dollar/commission recapture firms and proprietary trading firms all deserve to be listened to. They all have different perspectives and valuable insights. In conclusion, today there is ample evidence to support that pensions who do get involved in brokerage matters need not suffer disastrous consequences. Understanding the nature of the battle that rages when brokerage matters are being decided, the conflicting interests of the affected parties, is perhaps the greatest assurance that you will arrive at the right decision for your fund.
Press Release - For Immediate Release
Money Manager "Watchdog": Benchmark Emerging Manager-of-Managers Trust
Benchmark Advisory Services, Inc., a newly established investment advisory firm, announces a "manager-of-managers" trust product that will be offered to pensions, endowments and foundations. Assets of the Trusts will be managed by "emerging" managers, i.e., promising firms with less assets under management and shorter track records than managers generally hired by pensions. Inclusion of minority and women-owned firms will be a priority. Capital Resource Advisors, a leading investment consultant firm, will provide performance and monitoring and create and maintain the manager database.
Benchmark will utilize a proprietary heightened monitoring approach called the "Watchdog System" to evaluate the managers it hires. According to President Edward Siedle, a former SEC lawyer, the Watchdog System represents a revolutionary approach to monitoring money managers that goes well beyond the limited SEC disclosure requirements, to provide investors with new information about how their money is actually being managed. Siedle has been an outspoken critic of the SEC's lack of vigilance in regulating money managers and mutual funds. The Watchdog System addresses many of the loopholes in the current regulatory environment, says Siedle.
"We believe that by expanding the range of manager information reviewed to include material currently unseen or neglected, such as ethical standards and compliance histories, investors will receive a fuller picture of their managers' investment process, as well as superior returns. Investing with smaller managers also makes sense because they are not subject to the many conflicts of interest that compromise larger managers' performance or bureaucracies that only ensure mediocrity."
However, Siedle cautioned, "Smaller managers are more likely to encounter life-threatening organizational and compliance disruptions that larger managers. Its not that they make more mistakes, they're just less likely to have the resources to deal with them. We intend to be a resource to the managers we select, to guide them past the challenges they encounter, to even greater success. Hopefully they will be tomorrow's leaders."