Looking Out For Your Commission Costs
By: Darryl Tasios
The disappointing investment returns of recent years have made each and every basis point even more important for plan sponsors. Darryl Tasios, of CIBC Mellon Global Securities Services, examines how a commission recapture program can pay off.
Successful fund performance is the cornerstone of the securities industry and searching for ways to boost performance while reducing costs is the key to success in all sectors of the investment world. Since the plan sponsor is accountable for directed brokerage practices and cost strategies, it’s important for plan sponsors to understand how plan assets are being used and identify and implement cost control measures that facilitate strong fund performance and governance.
With many plan sponsors disappointed with their investment returns in recent years, the odd basis point boost helps make a noticeable difference to a fund’s performance. To gain these basis points, plan sponsors are beginning to look at how to reduce the small costs and inefficiencies to earn more points for their plan.
Faced with uncertain capital market returns, increasing expenses, and intense focus on the bottom line, plan sponsors are looking for effective ways to cut costs while enabling their investment managers to trade to their highest potential.
When execution costs, research costs, and other trading tool fees are priced into a commission, a plan sponsor can’t typically determine precisely the expenses paid for by the fund, nor the direct benefit of these expenses to the fund. Often the cost of execution is the smallest expense a fund incurs, which can leave a large portion of the trading fees unaccounted for as specific fund expenses. Unbundling traditional commission charges would reveal hidden fees for the services expensed to each fund.
A proven strategy to improve fund performance while reducing costs can be found in a commission recapture program. These programs provide plan sponsors with an effective way to decrease expenses and improve disclosure, without restricting their investment managers’ trading strategies.
Pension plans in the U.S. and Europe have increasingly turned to commission recapture programs in recent years as regulatory agencies continue to call for increased transparency of brokerage costs. Commission recapture programs are now on the rise in Canada as plan sponsors see how these programs are succeeding in other markets.
Commission Recapture Vs Soft Dollars
A commission recapture program enables a plan sponsor to direct their investment manager to trade through a predetermined network of brokers in exchange for a rebate on the commission paid on the executed trade. This rebate is then redirected back into the plan.
In a soft dollar trade, the investment manager usually receives a benefit from the broker. A fixed percentage of commissions paid is typically returned to the investment manager to cover expenses such as research reports, news service feeds, and equipment used in the decision-making process.
The dilemma for plan sponsors is to assess which option provides more value to the plan – commission recapture programs or paying higher trading fees for soft dollar credits.
In 2003, David Parsons, partner at Accountability Research, told the National Post that “if fund managers were forced to place a value or notional value on research that they receive from all sources they might become discerning with what they receive and ultimately pay for.”
Soft dollar commission fees are paid by the plan in exchange for information such as research reports and news feeds. However, the plan paying the soft dollar commissions may not be the only plan benefiting from the information received. Research provided to the investment manager based on fees paid from one plan may also benefit another plan that did not generate enough commissions to earn a report. In effect, one plan may be paying for information that benefits another plan.
Soft dollar arrangements are often criticized by industry stakeholders because they are unclear how soft dollars, although paid by a particular fund, expressly and exclusively benefit that fund. Further, investment managers are not required to disclose soft dollar trades nor the subsequent benefits received from those rebates. With the lack of transparency and control over fees paid in soft dollar arrangements, plan sponsors are looking for alternatives to receive better value for their commission expenses.
In a commission recapture program, the executing broker rebates a portion of commissions from qualifying trades back into the fund. For each trade, the broker retains a small percentage of the gross commissions, while the majority of the commission – sometimes as much as 70 per cent – is paid back into the fund. These rebates can be re-invested back into the fund to increase performance or pay for expenses in operating the fund including the commission recapture program.
Fees paid back into the fund through a commission recapture program are clearly identified on the balance sheet. This income is managed by the plan sponsor who decides whether to re-invest into the fund or to pay for fund expenses such as performance measurement services. This, essentially, separates and identifies fund management and operational expenses while improving transparency.
There are two key elements a plan sponsor needs to consider to make a commission recapture program successful.
First, the plan sponsor needs to assess which funds would benefit most from a commission recapture program. Typically, active funds and large cap funds are better suited to the program than passive funds, which already have pre-arranged commission fees/low rates in place and small cap funds that need specialized broker services.
Secondly, the plan sponsor needs to set target levels for the investment manager’s participation. Typically, at the onset, the investment manager is asked to direct eight to 12 per cent of their trades into the program. Over time, and as the participation increases, investment managers will be asked to direct upwards of 25 per cent of their trades into the program.
How It Effects The Players
It’s important for plan sponsors and investment managers to clearly understand the fiduciary responsibility of the plan sponsor, and how investment managers spend commission dollars. When a commission recapture program is implemented, the investment manager loses his/her ability to book soft dollar trades, resulting in the need to more effectively manage resources as a portion of his/her ‘comped’ services is lost. If the investment manager is part of a soft dollar arrangement, it may need to reassess the program to ensure the benefits are balanced across participating funds.
Commission recapture programs are beneficial for brokers as these programs can drive an increase in trading volumes. Typically, 25 per cent of trades are eligible for a commission recapture program and 75 per cent of trades are executed at the full price. Brokers need to maintain a balance in their trades, which means the more commission recapture trades a broker executes the more full priced trades are also executed.
The commission recapture program service administrator governs the infrastructure of the network and provides administrative expertise. The administrator arranges a selection of executing brokers who are prepared to participate in a commission recapture program, negotiate rates of rebates for the program, and reports the commissions captured to the plan sponsor. The investment manager is free to trade with any broker, with the condition that any trades made through the network of pre-arranged brokers qualify for commission recapture savings. The investment manager is not bound to deal all trades through the network, only trades for which it would prefer lower net commissions. The broker’s role is to execute as usual, as there would be no difference to the trade execution process.
Clearly, the commission recapture administrator with the strongest group of brokers provides an investment manager with the greatest trade execution flexibility. When considering a commission recapture program, a plan sponsor should work with both the investment manager and commission recapture administrator to discuss whether the network of executing brokers is sufficient for the trading style of the manager.
In 2003, the UK pension fund units of Deutsche Bank AG, Merrill Lynch & Co., and Shroders PLC caught the market by surprise when they each revealed an end to the practice of paying higher commissions in return for research and trading tools.
Last year, Canada’s Caisse de Dépôt et Placement du Québec announced it was ending its program of soft dollar commissions on equity and derivatives trading. The Caisse indicated it would increase the transparency of its trading costs. When services related to research or other trading tools are required, they would be paid out of the Caisse’s operating budget.
To facilitate a commission recapture program, a commission recapture administrator is recommended to streamline the process, provide program infrastructure, and administer the program.
The commission recapture administrator needs to have a strong network of high quality brokers, which enables investment managers to retain flexibility in decisionmaking without hindering trading targets. Adiverse broker network increases competition for the trade business and the likelihood that the investment manager can send commission recapture trades to brokers where relationships already exist.
There should be no expense or associated service fees to enter into a commission recapture program. The administrator negotiates commission recapture rates, which can vary but can be as high as 70 per cent of the gross commission. The administrator establishes the broker network, pays all infrastructure costs, and collects and reconciles all recaptured commissions. The program should be flexible, with no minimum volume requirements or trading commitments.
A well-run commission recapture program will be seamless and transparent to the plan sponsor.
Making The Decision
As the investment industry continues to scrutinize cost management and commission transparency, commission recapture programs can reduce plan expenses, increase fund performance, and improve regulatory disclosure.
By giving investment managers a quality network of brokers and flexible trading options, the plan sponsor and fund receive the benefits of lowering costs without compromising the investment manager’s ability to achieve best execution as well as improving the fund’s overall performance.
Darryl Tasios is director, capital markets, at CIBC Mellon Global Securities Services.
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