New York, NY – In the past few years, the global financial markets have dedicated a great deal of attention and focus to the topic of soft dollars, commission transparency, and unbundling.
And while most regulators have agreed that it is allowable for asset managers to use client commissions to pay for execution services and external research (soft dollars), the issue of commission transparency and defacto unbundling has not been as widely accepted.
In fact, many brokerage firms and money management firms have vehemently argued that providing clients with information about how their commissions are being spent is not really in their best interests. The following article addresses the various reasons used to make this case.
I. Transparency Could Lead to Confusion
One argument used by some U.S. money managers about why they don’t think they should be required to provide clients with information regarding how their equity commissions are being spent is because they feel this information would 1) merely be a subjective estimate, 2) this estimate would take a lot of time and cost quite a great deal of money to produce, and 3) this information would not be understood by fund boards anyway (and worse yet this data could be misunderstood).
This first argument was made in an extremely concise manner by the Mutual Fund Task Force on Soft Dollars and Portfolio Transaction Costs in their November, 2004 report. The following quote sums up the industry’s views on this subject.
“The Task Force also considered whether it is possible for an adviser to provide the board with an analogous good faith estimate of the total dollar amount of proprietary research obtained with fund brokerage commissions. Ultimately, the Task Force was unable to reach a consensus on this point. The views of the Task Force members reflect a sharp disagreement on the value to fund boards, and ultimately to investors, of estimates of the amount of propriety research obtained with fund brokerage commissions.
A substantial number of Task Force members believe that the SEC should require an adviser to provide a fund board with a good faith estimate of the amount of proprietary research obtained with fund brokerage commissions. These members observed that a board might have an incomplete understanding of the amount of research obtained by the adviser through fund brokerage, unless third-party research figures are augmented by proprietary research amounts, even if the adviser derives the proprietary research figures, of necessity, from subjective estimates. These Task Force members are of the view that such estimates could be based upon, but not controlled by, any data supplied by broker-dealers with whom the adviser has a soft dollar relationship. They also noted that some advisers already provide fund boards with estimates concerning proprietary research, and that the SEC should endeavor to make this practice standard in the industry.
The views of these Task Force members were influenced, in part, by recent action of the UK Financial Services Authority (“FSA”). The FSA recommended that the boards of directors/trustees of fund management clients be given clear information about the respective costs of execution and research paid for on their behalf by their manager, and the overall expenditure on these services, and that fund managers be encouraged to seek, and brokers to provide, clear payment and pricing mechanisms that enable individual services to be purchased separately. The FSA intends to allow the securities industry time to implement these goals before considering regulatory intervention.
A majority of the Task Force, in contrast, strongly objected to a recommendation that the SEC require an adviser to provide a fund board with an estimate of the dollar amount of Section 28(e)-eligible proprietary research and brokerage services obtained. These Task Force members believe that it is illusory to conclude that such estimates will add value to a board’s oversight. They believe that most advisers would be forced to develop an arbitrary formula that could be applied to the total commissions. While a more accurate estimate could be attempted by examining each individual trade and estimating the value of each component of each commission paid, such an undertaking would be extremely costly and time-consuming, with no assurance that that the resulting estimate is any more accurate. These Task Force members also fear that the estimates, although inherently subjective and arbitrary, inevitably will be perceived as “hard numbers” by some. Moreover, absent a uniform methodology for valuing proprietary soft dollar services, the estimates will vary significantly among advisers. In light of these considerations, these members would object to an SEC requirement that an adviser provide proprietary research estimates to a fund board.”
It must be noted that in the past few years, the FSA has overcome the industry’s fear that this information might be misunderstood by mutual fund boards by bypassing mutual fund boards and mandating that UK asset managers report this data directly to their pension fund clients. Maybe pension fund and plan sponsor clients can understand this data better than mutual fund boards.
And while it still is too early to tell how this data is being used by pension fund clients, it is clear that customers have not been harmed by asset managers providing them with this information about how their assets are being spent.
II. The Current System Doesn’t Need Fixing
Another reason some money managers do not support commission transparency is their view that the current relationship between brokers and money managers is not broken and therefore doesn’t need fixing. The proponents of this argument suggest that the price they are paying for execution and research services is “fair” and that their customers are paying an appropriate amount for these services today.
However, this argument doesn’t make sense for a number of reasons. First, not all clients feel they are paying the “right amount” for research and execution services. In fact, one large money manager – Fidelity Investments – felt strongly enough that they were over paying for these services that they negotiated flat fees for their research with both Lehman Brothers and Deutsche Bank.
Actually, given the way that proprietary research has traditionally been bundled into commission payments, this has meant that asset managers with large commission budgets (significant AUM or high turnover), have actually subsidized the production of research for most small and mid-sized money managers.
In addition, we should remember that investment banks and brokerage firms are not charitable organizations. As a result, they would not continue a system where they thought they were being underpaid for their execution and research services. If brokers felt they were being underpaid, they would either give their clients a minimum fee they required to continue providing the services they received, or else they would limit the service they provided these clients. Interestingly, this is exactly what is going on today as many brokerage firms are reducing the services provided to many small and mid-tier customers.
III. Unbundling could lead to the loss of high quality research
One consistent argument that money managers raise when objecting to commission transparency is the fear that disclosure and unbundling will lead to the loss of funding for some extremely valuable research.
We must agree that commission transparency and unbundling could make it more difficult for some brokerage firms and alternative research providers to get paid. In fact, we have already seen this taking place in both the US and UK. However, the real question we must ask is, “Will this really be bad for investors?”
In fact, we suspect that the large number of research providers in existence today cannot really be supported by a rational and efficient marketplace. Our analysis suggests that there are over 600 to 650 investment banks, brokerage firms, and alternative third-party research providers in NORTH AMERICA ALONE. However, we are highly confident that clients will find a way to pay for great research that adds value to their investment processes.
The one area where we think that investors might suffer is the loss of research that might be good for the market, but which is difficult to pay for – a category we might call “research utilities”. Some research that falls into this category might be small cap research, economic research, portfolio strategy, quantitative research, and technical analysis.
Our contention is that the cost associated with losing some of these “research utilities” is significantly less than the benefit customers get from understanding exactly how their commissions are being spent – and the commission savings they will experience from a more rigorously managed research procurement process.
In addition, we have seen a number of innovative providers open up boutique research firms and develop new business models to support the production of small cap research, economic research, portfolio strategy, quantitative research, and technical analysis.
IV. The Real Fear – Informed Clients
The one argument that is rarely mentioned when asset managers discuss commission transparency and unbundling is that they are actually afraid of the potential consequences of promoting an informed clientele.
We have spoken of this issue in the past, calling it the “dirty little secret” of the asset management industry. Most money managers have convinced pension fund and plan sponsor clients that they (the money managers) produce most of the research required to support their investment process internally.
Unfortunately, if pension fund clients received information outlining how much of their commissions investment managers were spending on sell-side and alternative research providers, they would come to the conclusion that their asset managers are not primarily responsible for the research needed to support their investment process.
We think it would not take pension fund clients very long to jump to the conclusion that they have been overpaying their investment managers for quite some time, by supporting a manager’s research department through fees, and paying for external research using their commissions.
In fact, we have heard stories of this taking place in the UK where pension fund managers have told investment managers that they will only accept “execution only” commission rates. If their asset managers wanted to purchase proprietary or alternative research, they would need to fund this out of the fees paid to the manager by the pension fund – in other words, out of the money manager’s own pocket.
V. The Skinny
Upon a closer examination of the various arguments put forth by some buy-side participants, it becomes clear (at least to us) that many in the money management industry are trying desperately to fight a rearguard action to maintain the status quo. This is in direct contrast to regulatory developments taking place around the world in places like the UK, France, Canada, and even in the US.
Consequently, we believe that many money managers feel that an opaque research marketplace would be best for their customers. However, history has shown that consumers are best served when there are efficient, transparent markets that are supported by a free flow of information. As a result, we suspect that transparency will ultimately win out, regardless of what some in the money management industry might hope for.
Comment by Bill George:
Readers who are interested in the subject of brokerage commission disclosure and transparency might like to read the “Request For Rulemaking on Disclosure and Transparency In Client Commission Arrangements” which I filed with the Securities and Exchange Commission on February 10, 2007 file number 4-531.
This Request for Rulemaking can be accessed here. When the web page opens click on the file number (4-531).