Using Bond Trades to Pay for Research


New York – Can fund managers use commissions generated by bond trades to purchase third party research? An interesting white paper on this topic recently came to our attention. The paper, published in July 2010, is authored by D. Bruce Johnsen, Professor of Law at George Mason University School of Law, and is funded by CCM, Inc. The author argues that “money managers’ use of client commissions on bond trades to pay for fixed income investment research is both legally permissible and in their investors’ best interest as long as the trades are executed by a non-positioning broker-dealer on an agency or certain riskless principal basis.” To support this argument, the author makes the following observations:

  • According to a 1975 Senate Report on the use of client commissions to pay for investment research, “research [is] not an expense of management.”
  • Section 28(e) of the Securities Exchange Act of 1934, added by Congress in 1975, provides money managers with a safe harbor to “use client funds to obtain ‘brokerage and research services’ . . . without being presumed to have breached their fiduciary duties or violated federal law.”
  • An authoritative 1998 SEC report recognizes that “research is the foundation of the money management industry. Providing research is one important, long-standing service of the brokerage business.”
  • If money managers were required to pay for all research out of management fees they would very likely be under-researched according to a recent study by Horan & Johnsen (2008). They find that from 1979 to 1997 every penny money managers paid in premium commissions to obtain research increased investment performance by 4.3 basis points per quarter, holding other factors constant.
  • In its 2006 Guidance, the SEC stated that “the safe harbor encompasses third-party research and proprietary research on equal terms.”
  • The 2006 Guidance finds that transactions covered by the safe harbor must be sufficiently transparent to allow the manager to make a good faith determination that the commission premium is reasonable in relation to the value of the brokerage and research services received.
  • Bond trade reporting systems such as TRACE and MSRB provide sufficient transparency to fall within the scope of the safe harbor.
  • The 2006 Guidance finds that bond trades performed by non-positioning broker-dealers on agency or certain riskless trades are covered by the safe harbor. Yet only about 20 percent of money managers acquire fixed income research through client commissions on bond trades, while over 90 percent of money managers acquire equity research through client commissions. This is because most fixed income broker-dealers are actively engaged in positioning bonds.
  • Several non-positioning broker-dealers have recently entered the inter-dealer market to perform agency and certain riskless principal trades. Not only do these broker-dealers provide money managers with valuable investment research, but they provide full transparency that allows money managers to be certain of price improvement.

Continue to full paper (PDF)


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