Experts Predict U.K. Soft Dollar Regime Will Affect U.S. Institutional Managers
As of press time, there was no sign of the SECís proposed soft dollar interpretative release.
But consider this: a number of experts are predicting that regardless of what the SEC ultimately does in the soft dollar arena, the approach taken by the U.K. Financial Services Authority will affect U.S. institutional managers. In fact, panelists at the recent SIA soft dollar conference forecasted that the FSAís "unbundling-on-paper" disclosure approach could become a new, voluntary "best practice" here in the States.
Clearly, firms that do business in both the U.K. and the U.S. have good reason to implement the FSA standards across their businesses. "For firms that operate on a global platform, itís going to be difficult to not look at the FSA definition of research and consider it," said Mark Manley, deputy general counsel and CCO of Alliance Capital Management. "I know weíre considering it the new gold standard." Similarly, thinking of the FSA disclosure regime "as the highest common denominator" makes it "easier" for firms that operate on a global basis, he said.
Manley was referring to the Level 1 and Level 2 disclosures required by the U.K. Investment Management Associationís pension fund disclosure code, which has been endorsed by the FSA. The Level 1 disclosures are descriptions of firm-wide policies and procedures relating to management of execution costs for clients, such as disclosures of how brokers are selected and reviewed, and the firmís policy on purchasing research.
Level 2 disclosures are client-specific disclosures, delivered to clients twice a year, that provide information on the actual commissions generated by the clientís account and how those commissions have been used. Under the IMA code, each institutional client of a U.K. money manager will receive a chart that, among other things, breaks down full-service commissions into their execution component and their "Other" component. The "Other" component is further broken down into commissions paid to executing brokers and to third parties.
Manley said that his firm already is grappling with the question of providing U.K.-equivalent disclosures to U.S. investors. "Every place we enhance our Level 1 disclosure in the U.K., Iím thinking about corresponding revisions of Form ADV." And, he added, "as we get into more granular disclosures at the client level, in IMA Level 2 disclosures, Iím thinking about what it is we are going to be providing our U.S. clients that is comparable."
Heís not alone.
According to Christina Sinclair, head of institutional business policy at the FSA, many U.K. managers believe that it is "not appropriate to discriminate" between U.K. and non-U.K. clients in terms of the soft dollar disclosures they receive. Speaking at the SIA conference, she reported that many firms believe that their non-U.K. clients would benefit from receiving the same information as U.K. clients. "There are indications that non-U.K. clients are very interested in this additional information, which is not surprising," she said. The challenge, added Sinclair, is for managers to determine whether the FSA disclosures "would be valuable to all of their customers and act accordingly and apply these principals to all of their clients."
According to BNY president John Meserve, the top 30 money managers in the U.K. do plan on providing the U.K. disclosure regime to their U.S. clients. "You can expect that it will voluntarily be provided to the U.S. client community," he said.
Even institutional managers that are solely U.S.-based may find themselves urged towards the FSAís approach by clients that have received the U.K. disclosures from other managers, and like it.
"We manage many global pension fund assets that have U.K. counterparts," said Manley. "It wonít take long for a large global pension fund consultant to share the information they get from [U.K. managers]" with U.S. clients, since they can be "helpful and informative" when evaluating U.S. managers. He predicted that the "pressures" from U.K. pension clients will "spill over" into the U.S. marketplace.
To provide unbundled disclosures, of course, advisers have to sit down and discuss execution costs with their brokers. Managers and brokers, explained Sinclair, need to examine the nature of the services they are receiving. To that end, Sinclair said that the FSA would like to see a "clearly-defined service assessment process" between advisers and broker-dealers to agree on the commission rates to be charged and the services to be provided.
That process already is underway in the U.K., as the new FSA regime goes into effect January 1, 2006. "We are expecting brokers and fund managers to be having their conversations now about the first quarter next year," said Sinclair.
Of course, this means that U.S. broker-dealers could be caught up in the FSAís rules. "Where U.K. fund managers trade overseas, they will look to broker-dealers in other jurisdictions to provide them with information about the execution component of any bundled commission rate, so that they can fulfill their disclosure obligations to customers," said Sinclair. The FSA, she said, recognized that this would have an impact on overseas brokers and that "there may be some initial teething problems." However, she added that the FSA has been encouraged by initial feedback that many broker-dealers, including some U.S. broker-dealers, are doing their best to provide this information.
As Manley noted, providing unbundled disclosure to U.S. clients on European securities "is one thing," but providing it to U.S. clients on U.S. securities "is another." U.S. brokers, he said, have to be willing to discuss the cost of execution and their services going forward, so that the adviser can make comparable disclosures about the execution and research components of full-service execution of U.S. securities. He added that he knew of a number of managers "going down that path."
But Manley indicated that there have, in fact, been some "teething pains," as Sinclair put it. "I think the U.S. brokerage community will have to cooperate a little more before we have all that information [that clients need] and are able to create any kind of disclosure document to U.S. institutional clients."
Panelists also discussed the impact of moving toward an unbundled-on-paper approach. For one thing, they noted that it can significantly change the dynamic with institutional clients.
"Once you start putting disclosures out there" as to the cost of execution versus research, said Manley, "you have in effect given someone an opportunity to question the value" of what is being purchased with their commissions. "Clients are going to be looking at the amount youíve assessed for research," he said. If the client has acquiesced to the purchase of research with their commissions, they are going to ask whether the manager has paid more than the budgeted amount, he said. "Youíre looking at the client clearly being able to say, ĎOkay, youíve budgeted ĎXí for research, I assume thatís where you stopped paying for research. Show me the rest [of my commissions were spent] for execution, only for competitive pricesí." By providing unbundled disclosure, he added, "you clearly have educated the client" to ask "this series of additional questions."
And, of course, even if brokers sit down to discuss the components and cost of their services, reasonable minds will differ as to the value of research. "My initial concern, especially in the first year of this new disclosure regime, is that youíre going to get 1,000 different views and 1,000 different values as to what research is," said George Mix, chairman of Columbia Management Advisorsí trading oversight committee. Manley agreed that "itís very hard to put a number on bundled research services."
Another looming issue: clients might be surprised how much bundled research actually costs. Manley noted that some clients, including mutual fund boards, have been surprised that the amount of commissions spent to obtain independent research has been "very high." When the cost of proprietary research is finally unbundled, he predicted, "I think youíre going to find the number is far higher."
Lastly, hereís an interesting issue raised at a recent London soft dollar conference: Letís say a manager is trying to determine its soft dollar budget. It decides that 2 cents of every full-service trade represents bundled proprietary research. It looks at its historical trading volumes and finds that all those little 2 cents gross up to $150,000 annually.
But what if the firmís trading strategy changes and the volume of trades suddenly increases?
Think about it: the more trades, the more 2 centsí worth of soft dollars. What will that manager tell clients about the value of the additional research obtained when the soft dollars generated by their trading ends up being, say, $200,000 instead of the budgeted $150,000?