Although some fund managers prefer to pay for their trade execution and research requirements separately in hard, rather than in soft dollars, many others rely on client commission agreements, also sometimes called commission-sharing arrangements, or CSAs, as evidenced by a recent survey of 214 mutual funds, hedge funds and pension plans.
Integrity Research, a New York-based research shop that evaluates providers of CSA services, says fund managers use CSAs to pay for 30% of research. "A side benefit of CSAs is increased transparency for what is spent for execution versus research services," said Ana Blanco, analyst and co-author of the report. "As CSA adoption grows, investors are placing greater emphasis on proactively managing their spending on research."
But with over 20 banks and broker-dealers offering CSAs, deciding who to use can be pretty hard. Agency brokerages won nine of the 15 spots as the most favored administrators of CSAs, with bulge-bracket firms garnering the remaining six. The reasons: execution quality, customer service, good recordkeeping and a solid financial footing. And that means CSA administrators had better be prepared to spend plenty on ensuring the best IT infrastructure.
"Technology is a key differentiating factor," said Tim Conway, director of commission management for Knight, a Jersey City, N.J.,-based agency brokerage. "That technology relates to not only how the trade is executed, but also how sound the recordkeeping practices are."
CSAs allow fund managers to consolidate trading with counterparties that can offer the best execution capabilities while directing commission payments to other sources of research. And that research can mean anything from analysis on stock picks to market data. The Securities and Exchange Commission first allowed the practice of soft-dollar commissions in 1975, and in subsequent years clarified which services qualified as trade execution and which qualified as research. The latest guidance came up in 2006.
Administrators of CSAs have two roles. They not only execute orders for the fund manager but keep track of just how much they spend on the orders and how much they have left to spend on research based upon the total amount of money the fund manager has allocated for its research budget. And based upon the automated instructions of the fund manager, the CSA provider sends the money to the research providers.
While money managers rely heavily on the word of research providers on which CSA provider to pick, they still have to do plenty of due diligence. For starters, fund managers have ask how decisions are made regarding which trading venue to execute and when. That means what smart order routing systems are used, how they work, as well as which algorithms and transaction cost analysis tools are used, said Jack Pollina, head of commission management for agency brokerage Investment Technology Group (ITG) in New York.
And that's the tip of the iceberg. The CSA provider must also be able to prove its calculations are accurate. It all comes down to the correct coding. Trades eligible for CSAs are tagged and move from the broker-dealer's order management system into the broker-dealer's clearing system. This, in turn, feeds into the broker's commission management system.
Automation alone doesn't prevent errors. Potential mistakes have to be manually corrected way before the research provider is paid either too little, too much or too late. "Its important to have accurate systems in place so that trades are recorded accurately for research credits," Conway said. "But it is also critical to have a client service team that works internally and with external customers to ensure 100% accuracy."
Next up: just how user-friendly is the CSA provider's customer interface. Nobody wants to log onto a system that is too difficult to understand. "The goal is for the fund manager's broker-liaison, portfolio manager, trader and other employees to be able to easily input the names of the research providers they want and when they want the providers to be paid," said Sean Steinmetz, director of commission management services for agency brokerage Instinet in New York. "They must also be able to understand the information on the number of executed orders, commission dollars and research credits remaining to verify its accuracy."
Typically relying on at least five CSA providers, some fund managers are turning to so-called commission aggregators to reduce the number of brokers with which they do business. Instead of the fund manager having to use individual connections to manage each CSA relationship they can consolidate the commission credits in one place.
But commission aggregation is no easy task. Only a handful of CSA providers offer it. At a minimum, it requires even more sophisticated data management and reconciliation capabilities than most CSA providers are willing to spend. "The same principles apply as if the fund manager were working with multiple CSA providers, but the aggregator needs to be capture trade execution information and calculate just how much money is left for each research provider," said John Meserve, executive managing director of ConvergEx Group, a New York agency brokerage and technology firm that in 2009 that purchased Summit, N.J.-based commission management software company Cogent Consulting.
ConvergEx does all of the calculations and reports to fund managers on their transactions with multiple executing brokers. "The accuracy and timeliness of those reports depends on the accuracy of the information provided by each of the underlying executing brokers and how quickly ConvergEx can consolidate the information and reconcile any discrepancies," Meserve said.
Yet another key selling point for some commission management providers: offering multi-asset class services. ConvergEx, for one, also administers CSAs for options and fixed-income trades. "Commission-sharing agreements in the U.S. fixed-income market are far less prevalent than for equities because fixed-income trades are typically executed by brokerage firms acting in a principal rather than agency role," explained Patrick Freeland, chief executive at brokerage firm Carolina Capital Markets (CCM) in Chapel Hill, N.C., a specialist in fixed-income trades.
Like ConvergEx, CCM can manage CSAs for fixed-income deals because it executes orders as an agency or "non-positioning" broker." That means it does not hold or trade the securities for its own account and it charges a commission rather than a mark-up.
While CSAs for fixed-income deals are still in the infancy, Freeland admits, he cites a recent study conducted by Professor Bruce Johnson of the George Mason University School of Law as pointing to the merits of fund managers using commission-management agreements for fixed-income securities research to improve their execution quality. The study was commissioned by CCM.