Investment managers rely on an array of high-fangled 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. The result: "revenue leakage" for both sides. That means fees going unreported and undelivered.
"Investment managers and program sponsors are too often using spreadsheets and emails to communicate with each other," says Sean Cunniff, a research director with Needham, Mass.-based Tower Group. "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 thousands 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 emails 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, chief executive of Redi2 Technologies, a billing software firm headquartered in Oakland, Calif.
"Without such transparency into how the program sponsor came up with its figure, the fund manager can only hope the sponsor is right," says Johnson. "Sponsors also have no effective way to determine if they are overpaying managers."
Just how big is the problem? A 2008 study of the managed accounts industry conducted by TowerGroup estimated as much as 1.7 percent of gross fees can leak out, in either direction.
That means about $241 million and $306 million in overpayments or underpayments annually. And that fee leakage ultimately translates into revenue leakage.
TowerGroup doesn't 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-based revenue management and fee billing software firm, showed that 30 percent experienced "fee leakage." And 72 percent of the respondents 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 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 its total holdings, or it might use one investment manager who in turn uses multiple subadvisors, 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," says Joe Mrak, chief executive of FolioDynamix, a New York-based 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."
One industry executive who works for a large Wall Street firm that relies on proprietary software to calculate billing fees says his firm often miscalculates fees with unified managed accounts because it hasn't been reprogrammed properly.
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 between their version of what the fee should be and the what the program sponsors think it 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," says Johnson. "That means understanding the data that goes behind the calculations so they can verify their accuracy. "
As a rule of thumb, one operations manager told Securities Industry News, 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," says John Bosley, chief operating officer of Bonaire.
While operations executives at several investment managers and sponsor firms also declined to quantify that discrepancy, one billing executive at an investment firm told Securities Industry News he typically includes at least half a percentage error rate for each $100 million in assets billed each quarter. That comes to about $50,000 per quarter or $200,000 annually. Another operations executive at a brokerage sponsor firm said that is a conservative estimate.
Here is how the fee billing process 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 do so on a quarterly basis And some sponsors prepay based on its 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 schemas and then create an audit trail that can be archived for the future," says Cuniff.
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.
"Our system is tightly integrated with the internal or external custodial recordkeeping system's data so the investment manager and program sponsor's fees can be validated and accurately calculated," says Bosley. Such recordkeeping systems typically store information on when an investor bought and sold shares and value of the shares. Barings Asset Management in London confirms that it has reduced its billing cycle from eight weeks to four weeks by eliminating in-house systems and spreadsheets in favor of Bonaire's Revport platform.
FolioDynamix's Mrak says his platform incorporates Bonaire for fee billing but still does some additional data cleansing to ensure calculations are accurate when it comes to unified managed accounts.
"Cash and securities are commingled in one account, and the custodian bank doesn't know which investment manager holds which securities and how much cash should be allocated to the particular manager's account," says Mrak. "Separate data is required from the FolioDynamix platform to properly pay each manager against their specific holdings."
Just as important to the process of calculating fees correctly and providing sufficient detail is communicating information in a uniform manner. When data is exchanged through emails, 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, says Redi2's Johnson.
It's akin to a Tower of Babel. But the MMI'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 two new 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 message includes the details needed to verify the amount the manager is being paid for each account.
Among those details are the identities of the sponsor, investment manager and account holder, the market value of the account used to calculate the fee, any adjustments to the fee based on previous billing errors and the time period used to calculate the fee. The messages rely on the Extensible Markup Language (XML), a set of rules for coding and tagging information.
The billing messages are being promoted by billing software vendors such as Redi2, Bonaire and Fiserv as well as a messaging hub provided by the Depository Trust & Clearing Corp. (DTCC) known as Managed Accounts Service.
That centralized Managed Accounts Service (MAS) platform, launched in 2008, streamlines communications among managers, sponsors and service providers on account openings also based on previously released XML-based messages the MMI created.
This allows the investment managers and sponsors to communicate on a one to many rather than bilateral process. The messages are also validated by DTCC, which provides an audit trail of when they were sent and who the senders and recipients were.
"We expect that incorporating the fee billing messages in the MAS service will help address the issue of billing fees and accelerate adoption of the MAS platform," said Ann Bergin, managing director of wealth management services at DTCC.
The organization won't disclose the volume of message traffic over the platform.
But it lists Smith Barney, UBS and Citigroup as users. Bergin predicts 25 more investment managers will sign up in the third quarter.
