Investment managers rely on an array of electronic tools to execute the most complex program trading and algorithmic trading strategies. And brokerage firms and banks can pretty much communicate with their institutional clients electronically in a matter of minutes if not seconds or even microseconds.
But such is not the case when it comes to managed accounts. There, where brokerages and banks sell customized investment services to wealthy individuals, investment managers and the sponsors of such programs rely heavily on paper to calculate and divide their cut of the fees involved. This results in "revenue leakage" for both sides. That means fees go unreported and undelivered.
"Investment managers and program sponsors are too often using spreadsheets and e-mails to communicate with each other," said Sean Cunniff, a research director with TowerGroup in Needham, Mass. "That makes the process highly prone to errors, which both sides must then correct."
Given the size of the separately managed accounts business — a $1.7 trillion market — spreadsheets won't cut it any longer. They may have worked when a sponsor had only a few thousand or maybe even 10,000 accounts, but anything above that number multiplies the potential for mistakes.
Sponsors do provide investment managers with a high-level analysis of just how they calculated their share of fees. But the granular details on the account level can get delivered in e-mails or faxes, a common occurrence, which makes it tricky. Operations executives at several sponsor firms say that even the largest, namely Wall Street's biggest names, depend on a combination of paper-based communications, legacy mainframe or proprietary platforms, which are also error-prone.
That could take the operations staff, meaning two or three employees, of an investment management firm several days or even weeks to find out if the sponsor made any fee-billing mistakes before they can even be corrected, according to Seth Johnson, the chief executive of Redi2 Technologies, a billing software firm in Oakland, Calif.
Just how big is the problem? A 2008 study of the managed accounts industry conducted by TowerGroup estimated as much as 1.7% of gross fees can leak out, in either direction. That means about $241 million in overpayments or $306 million in underpayments a year. And that fee leakage ultimately translates into revenue leakage.
TowerGroup does not have updated figures, but three operations executives at investment management firms contacted by Securities Industry News confirmed that leakage is still a pretty serious issue. "We are still battling with reconciling our calculations with those of the plan sponsors at least every quarter," says one operations executive.
A survey of 80 investment managers and sponsors conducted last year by Bonaire Software Solutions, a Boston revenue management and fee-billing software firm, showed that 30% experienced fee leakage. And 72% use up to five operations executives to calculate and reconcile fee discrepancies.
Those discrepancies can occur for several reasons. The most common scenario: "The fund manager and sponsor can disagree on the value of the assets under management," says Shaun McGee, senior product manager of investment services for the technology firm Fiserv in London.
Mistakes are even more prevalent when it comes to unified managed accounts. The wealthy individual investor might be relying on more than one investment manager to manage the total holdings, or they might use one investment manager who in turn uses multiple sub-advisors, otherwise known as sleeve managers.
"The sponsor must divide the investment fee among more than one manager, but the division isn't necessarily on an equal basis," said Joe Mrak, the CEO of FolioDynamix, a New York middle- and back-office processing firm. "Making matters more complicated if a dividend or income payment or even a corporate reorganization takes place, the sponsor could end up allocating the investment fee to the wrong manager."
While investment managers have always realized that "slippage" occurred, they have typically estimated the percentage by looking at random samples of accounts and historical billing records. But managers of the investment accounts and program sponsors are growing tired of the "back of the napkin" reconciliation of what the fee should be.
"Investment managers may have been willing to accept such slippage during a bull market. The financial crisis has prompted them to take a closer look at just how program sponsors are making their calculations," Johnson says. "That means understanding the data that goes behind the calculations so they can verify their accuracy."
As a rule of thumb, said one operations manager, investment managers are far more likely to be underpaid than overpaid. However, unless the amount is significant, the manager might decide it's not worth the time and effort to argue with the sponsor. After all, it's a partnership of sorts. So what's considered significant? "An investment manager might be willing to absorb a discrepancy of several percentage points depending on the size of the relationship with the sponsor," said John Bosley, chief operating officer of Bonaire.
The Nuts & Bolts of Fee Billion
Here is how fee billing actually works. First, sponsors must decide just how much to deduct from a client's account. That decision depends on the value of the assets and whether the account is invested in a fixed-income, equity, exchange-traded fund, indexed fund or foreign investment product. The fee paid to the investment manager might be reduced depending on the total value of the accounts serviced by the fund manager on behalf of the sponsor.
After that calculation is made, the sponsor must then determine how that fee is to be split with the fund manager for the separately managed account or, in the case of unified managed accounts, multiple fund managers for a single investor.
Then the fund manager must match its calculation with that of the program sponsor. Such a reconciliation process might take several hours at best or several days at worst depending on the number of investor accounts serviced by the sponsor and just how complicated the math is.
Some sponsors pay fund managers on a monthly basis, while others on a quarterly basis. And some sponsors prepay based on an estimate of the value of the assets under management only to adjust the amount during the next billing cycle.
The methodology used is determined by the terms of the contract between the sponsor and the fund manager. On average, sponsors can have up to 200 different fee schedules with investment managers.
According to Cunniff, few if any homegrown platforms offer a clear description of how fees are determined and divvied up — and certainly not with the scale needed. The investment manager and sponsor must be able to calculate and recalculate thousands of accounts under various fee plans and then create an audit trail that can be archived for the future," Cuniff said. By contrast, software platforms such as those offered by Redi2, Bonaire and Fiserv go a long way to reducing errors in fee calculations. These allow the sponsor to not only calculate the fund manager's fees in an electronic fashion but exchange details on what data was used to make the calculations.
Just as important to the process of calculating fees correctly and providing sufficient detail is communicating information uniformly. When data is exchanged through e-mails, a proprietary system or third-party vendor, sponsors and investment managers are relying on a myriad of message formats. That means sponsors and fund managers must spend extra time deciphering what the other side means, Redi2's Johnson says.
It's akin to a Tower of Babel. But the Money Management Institute's billing subcommittee, which Johnson co-chairs, has just come out with two new messages that will allow fund managers to better process the information they receive from sponsors and verify the fees they are paid.
One of the message standards provides investment managers with a summary statement of what they got paid and includes any adjustments or other fees that are being paid for. The second includes the details needed to verify the amount the manager is being paid for each account. The messages rely on the eXxtensible Markup Language, a set of rules for coding and tagging information, and are being promoted by billing software vendors as well as a messaging hub provided by the Depository Trust and Clearing Corp.