Time to Rethink Client-Directed Brokerage Arrangements? (Part 1 of 2)
In light of recent industry developments, it may be time to sit down and have a frank discussion with your institutional clients about the quality of executions they are obtaining under their directed brokerage arrangements.
At the recent Investment Company Institute equity markets conference, industry panelists warned that the issue of client-directed brokerage has become increasingly complex over the past year, primarily because of rock-bottom commission rates and the fact that many correspondent brokers have exited the business. Some panelists even predicted that client-directed brokerage will significantly diminish or even disappear as an industry practice. "It does have the potential in this marketplace to become a convention that becomes extinct," said Mark Manley, CCO of AllianceBernstein. "Not today, but possibly in the future."
A bit of background: Institutional clients, particularly those in the ERISA space, have traditionally used directed brokerage arrangements as a way of supplementing their returns, by using the recaptured commissions to pay plan expenses. Typically, such clients direct brokerage subject to best execution. While that puts the manager between a rock and a hard place, managers may feel compelled to accept such a direction from an institutional client, because refusing it may mean losing the client. "There are very few clients out there that are willing to say ĎDirect my business to one firm and Iíll take the best execution responsibility off your hands,í" noted Manley.
Firms that have accepted client-directed brokerage arrangements typically make "Bailey-plus" disclosures, named after the SECís 1988 enforcement action against Mark Bailey. Such disclosures warn that the direction may cause the client to miss out on the benefits of bunched orders, may have its trades executed after other trades, and generally may find that its execution quality suffers as a result of the direction. The SECís 2003 case against Jamison, Eaton & Wood reminded advisers that they need to keep an eye on new trading venues and periodically assess the quality of executions provided under client-directed brokerage arrangements.
At the ICI conference, panelists warned that recent market developments may require advisers to forgo client direction that are subject to best execution altogether, or at least provide clients with stronger disclosures about the drawbacks to those arrangements. Manley noted that in the U.S., managers historically have faced fairly stable commission rates in terms of cents per share. In such an environment, directed brokerage was "something that money managers could in fact do for their clients up to a reasonable amount," he said. "In times past, where directed business would be done at the same four or three and a half cents a share that you might be doing for your non-directed clients, there wasnít a dispersion in cost for those directed clients." And, he added, "since you could do the business with correspondent firms, you were able to [direct the brokerage] without impairing the execution, he said. "You were able to get the business done."
Today, he said, client-directed brokerage is "not really feasible" in light of the availability of low-cost trading venues and other market developments. In recent years, Manley noted, the industry has seen new forms of "a la carte" pricing, low-touch trades, and direct market access trades. He also pointed out that a number of correspondent firms that used to do executions for directed brokerage or recapture sponsors have exited the business. "They just donít find it to be a profitable business anymore," he said. Consequently, "what you have is fewer opportunities to direct orders."
In light of these changes, managers that have accepted direction from a client subject to best ex may find it increasingly difficult to comply with the direction. "Most clients ask you to direct a percentage of their brokerage business but say itís subject to best execution," said Manley. A client might say, "Get me best execution on each trade. Donít interfere with your order flow but direct 40 percent of my business or 30 percent of my business to a particular broker-dealer," he said. Those limits, he said, are high even in an environment of stable commission rates. With al la carte pricing, he said, "itís much more difficult for a money manager to find order flow that can be done on that directed brokerage basis."
Manley reported that some managers are arriving at "blended commission rates," which he described as being based on a combination of full-service business, low touch business, and execution-only or direct market access business. The blended rate obtained by utilizing a combination of these trading strategies, he said, is "down much lower than the client-directed brokerage rates." He predicted that the lower blended commission rates will cause institutional clients to ask questions about their directed brokerage arrangements. "What I think youíre going to see, maybe this year, maybe next year, is a wave of institutional clients ó pension funds, public funds ó raising the issue with their money managers" as to why the blended rate is lower than the client-directed rate. Institutional clients that encouraged their managers to direct brokerage subject to best execution "would always seem to be very eager and aggressive to see you get to those target levels," he noted. However, he added, "what will be focused on soon" is the difference between the rates. "What you will see, I think, is clients raising the issue and saying, ĎWhy didnít you tell me this sooner?í"
Manley suggested that some managers have been reluctant to inform their clients that obtaining best ex on client-directed brokerage trades has become much more difficult. "I think itís one of those open secrets that many money managers do not want to present this issue to their clients," he said. "Fortunately," he added, "some very good, reputable, large, well-known pension consultants have raised the issue." And, he added, his firm has raised the issue and has seen clients raising the issue, as well. As plan sponsors see their commission recapture revenue go down, "the question will be raised," he said. "Hopefully, some money managers are being proactive."
How can a manager reset an institutional clientís expectations?
Morgan Lewis partner Steven Stone suggested that a manager could consider lowering the threshold of trades that it is willing to accept on a directed basis. For example, if a firm traditionally has taken the position that it is not willing to direct more than 20 or 25 percent of a clientís trades, going forward, the firm could lower that threshold. Alternatively, a firm could explain that no matter what the percentage threshold is, the client is going to get a lower payoff because commissions are lower and therefore there is less recapture available.
Manley reported that his firm has tried a combination of both approaches. When lowering the percentage threshold, "we say that beyond this limit, we do not believe we will be able to execute directed business without potentially interfering with our ability to get best execution." At the same time, he added, clients are put on notice that the firm may not hit even the lowered targets, "even though historically maybe we did."
Part of the client education process is explaining that the firm takes its best execution responsibly seriously. "In todayís environment," said Manley, his firm is reiterating that direction "is subject to best execution."
Manley also reported that his firm has asked some of the directed brokers to lower their rates. "We have said to a few of the directed brokers, ĎWeíll show you this order flow if you can do it at the same rate or if you can supply us with an algorithmic tool.í" He reported that one of the directed brokers has, in fact, developed an algorithmic tool that permits low-touch trades in a directed brokerage arrangement. "Thatís a new development and I think it remains to be seen how effective it can be." Generally, however, Manley reported that he has not found that directed brokers are willing to accept an execution-only rate.
OCIE associate director Gene Gohlke, also speaking on the panel, suggested that managers evaluate potential differences in execution quality between directed brokerage and "free" brokerage clients by looking back over a period of "six months or a year" and comparing the return for the directed clients to the return for non-directed clients that had the same strategy. If there is a significant enough of difference, he said, firms may need to point out to their clients that "Yes, you may be getting back a penny or two per share but look at the difference in performance."
Manley suggested that historically, such tests were not necessary. Until recently, he said, orders for directed clients and free brokerage clients could be aggregated and trade at the average price, at the same commission rate. And, he added, large financial service firms would be willing to give up their percentage of the commission for the directed brokerage client, for the credit of their directed broker.
However, in last twelve months, many of those relationships have ended, he noted, because brokers do not want to be in the correspondent business for directed brokerage purposes. "Thereís a few of them still out there but itís much more difficult today," he said.
In light of Manleyís remarks, Gohlke suggested that perhaps the forensic test he suggested could be performed on a "going-forward basis." Manley agreed. "I think itís essential that if you are going to continue to do directed brokerage, where you are going to be separating out client trades from your aggregated orders, youíre going to be using non-mainstream brokers to execute Ö trades and still representing to your clients that you are getting best execution, you best be doing that kind of analytic."
Stone pointed out, however, that a manager may not have all the information that would be required to fully evaluate a directed clientís performance. "You are not necessarily going to know the details of the recapture that the broker is providing," he said.
Next Week: Step outs and trade sequencing issues in the context of client-directed brokerage arrangements.