Time to Rethink Client-Directed Brokerage Arrangements? (Part 2 of 2)
For many years, step-outs have been viewed as a "panacea" for the problems associated with client-directed brokerage arrangements, according to Morgan Lewis partner Steven Stone. Speaking at the recent Investment Company Institute equity markets conference, Stone explained that a manager could aggregate its directed trades together with non-directed trades and send the entire order to its broker of choice, with a request that the broker step out a portion of the trade to the directed broker in order to satisfy the firmís directed brokerage obligation.
More recently, however, the use of step-outs has been viewed as complicated and controversial:
Information leakage. The more brokers that handle a trade, the more brokers there are who know what positions your firmís portfolio managers are taking. "When you step out a portion of the trade, somebody knows what you are up to," noted Carsten Otto, CCO of Morgan Stanley Investment Management.
Cross-subsidization. Thereís no such thing as a free lunch. Ever wonder why, exactly, brokers are willing to step out those directed trades? Could it be that the stepped-out trades are being subsidized by your firmís other clients, whose trades remain at the executing broker? "Thereís an implicit cost that is born by the shares remaining at the broker-dealer," noted Stone. That may create a situation where the clients that are being stepped-out are "free-riding" on the commissions being paid by other clients, he said.
On a related note, Otto said that his firm has a policy that it will seek to pay commissions on the stepped-out portion "if we feel that the execution quality of the portion that is not stepped-out would suffer."
Market data. There also is a concern, primarily on the sell-side, that step-outs "pollute" market data. If an adviser executes at one broker but directs that broker to step out a portion of that trade to a second broker that clears and settles that stepped-out portion, the second broker will be able to report the transaction as theirs for execution quality purposes. Stone noted that this practice may inflate the second brokerís reported execution quality. "Youíll have clients who say, ĎWait a second, why canít you trade through my designated broker-dealer? They have great stats for execution quality!í"
Conflicts of interest. Last but not least, step-outs may be scrutinized by SEC examiners. "We feel that the existence of step-outs can create a variety of conflicts of interest that the investment adviser directing the broker to step-out ought to certainly focus on by way of its compliance program," said OCIE associate director Gene Gohlke. "It is a compliance risk that should be captured within [the firmís] compliance policies and procedures." An adviser, he said, should disclose step-outs to clients "not only that the practices exist, but what impact [they] may have on both sets of clients, those being stepped out and those that are not being stepped out and [that] may bear the impact of the step-out arrangements."
Gohlke said that he was "quite sure" that examiners will ask advisers for a list of step-out trades, "so that as we work through what we call the Ďelectronic trade blotterí that we ask for during exams, we are aware of both the brokers that are being asked to step out as well as the stepped-in brokers, so we can look at potential impacts of these conflicts and get a sense then of whether the disclosures the manager has made and compliance programs in this area appear to be effective."
Trade sequencing issues. If a directed order cannot be stepped out, then the trade may need to be disaggregated and placed separately from the adviserís free trades. However, breaking up trades and sending them to different brokers can be problematic, because the orders will not reach the market at the same time, causing later trades to suffer market impact costs. "This has been a very tough issue for the industry," Stone noted. In fact, he noted that trade sequencing issues "may mean that you decline to take on certain mandates," because doing so would require the adviser to trade in sequence, creating significant market impact for the later trades. He gave the example of an adviser that is running a micro cap stock mutual fund and wanted to simultaneously serve as a wrap manager in the same strategy. "That might not make a lot of sense, because somebody is going to go to the end of that queue and you are going to have really poor executions," said Stone. "Maybe the better part of valor there is to decline certain relationships." He noted, however, that other trading mechanisms might address the issue, such as certain prime brokerage or DVP arrangements.
In any event, these and other trade sequencing issues are worthy of internal discussion. Model managers in a multi-style portfolio also need to figure out where their recommendations fall in the chronology. And what about non-discretionary trades? Do they get placed at the back of the bus, so as not to hold up discretionary trades, whether directed or not? The key, as Stone put it, is to "figure out a rotation process that makes sense."
Moreover, an adviser should confirm that its trade sequencing policy is clearly disclosed to clients, so that no client can assert that it was unknowingly put at the back of the bus. Ultimately, said Stone, it comes down to good disclosure in the advisory contracts, Schedule H brochures, and Form ADVs. "Tell the customer the implications of the trading arrangement," he said.
What about wrap? Challenges presented by step-outs and trade sequencing issues are particularly evident in the wrap context, where clients implicitly or explicitly direct the wrap manager to trade through the program sponsor. However, on occasion, a wrap manager may feel it can get better executions by trading away from the wrap sponsor. "As people are moving away from step-out trades, you sort of scratch your head as to how you are going to deal with that," said Dechert partner Jack Murphy. "Which again, brings disclosure to the forefront. You need to tell them the bad news."
Murphy gave the example of a wrap program sponsored by a mid-sized regional bank, with all brokerage in the program provided by the bankís broker-dealer affiliate. If parts of the program involve investments in small cap stocks, this could present a best ex issue, if the bankís BD affiliate has "no particular expertise" in executing trades in small cap stocks. If you canít step out, said Murphy, "all you can do" is tell clients "Look, this bargain that youíre getting by paying a wrap fee and having all your brokerage included is not going to be quite as much of a bargain as you may think."
Otto went a bit further and suggested that maybe the manager shouldnít accept that line of business (he added that as a compliance officer, that would be the last thing he would want to say.) Mark Manley, CCO of AllianceBernstein, agreed that it can be challenging to deal with wrap business. Although wrap accounts have "prepaid" their commissions, it may still be necessary to consider whether wrap trades should be executed through newer, low-cost venues. "When everything might have been done at four cents a share, you had a four-cent cushion, so to speak, with your wrap accounts, because they prepaid their commissions. If you traded away from the sponsor, you were going to most definitely incur increased commissions for that client," he said. Now, however, a wrap manager must consider whether the execution available on a low-cost venue is worth only the extra half cent or penny per share, rather than the historical additional four cents per share, on top of the prepaid commission embedded in the wrap fee.
Manley also noted that trading away from the wrap sponsor can raise prime brokerage issues, as well as Reg. T issues "that create mounds of documentation, particularly for those thousands and thousands of individual customer accounts that are custodied at the wrap sponsor."
To address these concerns, Manley predicted that some of the larger, full-service wrap sponsors may begin to allow their algorithmic tools to be used for wrap executions (presumably to allow managers to aggregate wrap and non-wrap trades). Currently, he noted, most wrap executions are done through a separate facility. "While they have gotten competitive executions," he said, his firm has been "looking at that," because "once you separate the order youíre at the mercy of timing, which from a traderís standpoint can be everything."
On a more general note, Gohlke noted that both the wrap sponsor and the wrap manager are advisers, and that they therefore both have an obligation to seek best execution with respect to wrap client trades. "One of the frequent failings we see in examinations of advisers that are part of wrap programs is that no one, neither the sponsor nor the money manager, is really doing a best execution analysis of wrap client trades," said Gohlke. "That is a fairly common deficiency that we cite in those types of exams."
Gohlke noted that some wrap advisers may argue that there is nothing to analyze, because wrap programs are structured so that brokerage is expected to go back through the sponsor. Still, he said, money managers have a responsibility "to compare the quality of execution that wrap clients were getting to those that its [non-wrap] clients were getting in the same strategy, and where there is a significant difference in the execution quality or cost, to make sure the disclosures in Schedule H [and Form ADV] talk to those differences, so that wrap clients are aware of what they are getting or they are not getting as the case may be."
Stone said that sponsors have gotten a little better over the years in terms of paying attention to the issue and have, in fact, tried to measure dispersion between the performance of the managersí accounts in their program and the accounts outside the problem "so they might see a blip." He added that this is an "evolving science" and firms may be grappling with systems "that simply are not as robust as you might otherwise hope for." For example, he noted that in some programs, managers do not have access to the time and date of execution, making it hard to analyze transaction costs. "It is something that the industry is trying to move towards," he said.