Beat the clock

PAUL MYNERS HASN’T BEEN MAKING many friends lately among his compatriots in the money management business.

Two years ago the onetime chairman of Gartmore Investment Management scrutinized institutional investment in the U.K. at the behest of the British government. The conclusion -- that the way pension money was managed required sweeping changes to root out conflicts and inefficiencies -- caused a furor among fund managers, who complained bitterly that following Myners’s recommendations would cost them millions and overturn decades of tradition.

Backing Myners, the government gave the investment industry until next March to remedy problems. With the deadline fast approaching, Myners has more gloomy news for his former colleagues.

“The securities industry and the investment management industry are in denial,” he tells Institutional Investor. “They are just hoping this problem will go away. And it won’t.”

The “problem” is that the government will likely force changes on the industry after it reviews compliance with Myners’s blueprint in March. The government, which began its inquiries out of concern that pension fund practices might undermine retirement security, warned that if the firms didn’t restructure on their own, it might force them to do so by law. Its concerns have only become more urgent in the wake of a report late last month from Russell/Mellon Caps that U.K. pension funds in the third quarter posted their biggest loss since 1987.

The betting now is that the government will conclude that not enough remedial work has been done and will take action that could lead to substantial reforms in the U.K., which might lead to similar changes on the Continent. Such costly changes would come at a bad time for an industry that is already reeling from one of the bleakest downturns in generations.

“If we’re not careful, we’re going to wind up with legislation, and the one thing we want to avoid is legislation,” says Kenneth Ayres, of pension consulting firm Frank Russell Co., who headed an industry working group that called in May for more disclosure. “The industry would prefer that people were a bit more careful about what they did, rather than just applying rigid rules and saying, ‘That’s okay because it’s on the right side of the line.’”

In his March 2001 report, Myners found that the way pension funds’ trading commissions are doled out to brokerages by investment managers gave the managers no incentive to control execution costs. It also benefited these firms at the expense of retirees, who were footing the bill for services like research and market data used by asset managers for themselves and their other clients.

Myners’s solution? Fund managers should pay commissions themselves and try to reflect this cost in the management fee they charge pension schemes. Forced to reach into their own pockets, managers would have an incentive to negotiate lower rates, more thoroughly evaluate trading alternatives and, perhaps, demand that services be paid for separately. Big brokerage firms would be the likeliest losers; they would feel pressure from managers unable to easily pass higher management fees along to pension funds.

The U.K. Treasury put the City on notice in July 2001 that change was necessary, when it published ten questions that pension trustees should ask outside fund managers. These questions admonished managers to measure transaction costs and share the results with clients; demonstrate how they attempt to minimize costs; disclose to which brokerages and exchanges trades for the pension client were routed and why; show what other services, such as research and access to IPOs, the fund manager buys from full-service brokerages and how these benefit the pension fund client; and explain how they justify paying for sell-side research rather than using in-house analysis. Furthermore, the government asked money managers to justify “soft” commission arrangements, in which managers pledge a certain level of trading with a particular brokerage to earn credits for additional services, rather than paying lower commissions for clients.

With just four months to go, the industry has finally started to respond. Some managers have begun balking at charges from brokerages that bundle research and other services with trade executions and are looking at nontraditional means of trading. Alternative trading systems such as Instinet and E-Crossnet have doubled their market share, to around 10 percent of U.K. volume, traders say. Brokerages are offering low-frills, cheaper executions to keep business. And traders estimate that 15 to 20 percent of institutional trades in the U.K. are now executed via program trading, in which a portfolio of stocks is bought or sold at once for a discounted commission. That’s up from 10 percent two years ago.

The Investment Management Association, the U.K.'s main trade group for money managers, teamed with the National Association of Pension Funds to issue detailed -- but entirely voluntary -- disclosure guidelines on commission and trading arrangements. And some buy-side shops are building elaborate brokerage review systems, enabling them to assign a cash value to the various services paid for with commissions and to share the results with their pension clients.

Soft arrangements are being scrutinized as well. At the Treasury’s request, the Financial Services Authority has accelerated its study of soft commissions. It’s now expected at the start of next year. Already, in a big break from traditional practice, some firms, led by Axa Investment Managers, Fidelity Investments and Gartmore, have abandoned the use of soft commissions for U.K. pension accounts.

“It has taken us quite a long time to work through the issues in this area,” says Ashley Kovas, head of asset management policy at the FSA. His team pored through a substantial volume of research on soft dollars in the U.S. market, but it commissioned its own study of the U.K. market. “We will have to keep close watch on whether the IMA disclosure code is successful. If the market can devise a solution to the problem, then there would be no basis for regulation,” he says.

These efforts appear to be having a positive effect. According to Elkins/McSherry’s sixth annual survey of global transaction costs for this magazine (see table below), the average cost of an institutional stock trade in the U.K. last year declined 7.4 percent from 2000, falling from 38.81 basis points to 35.93 basis points (this figure does not include stock purchases, which carry a mandatory 50-basis-point stamp duty that artificially inflates cost measurements).

“The investment managers don’t want to see legislation come March, so they’re doing everything they can now to address the concerns raised in Myners,” says Elkins/McSherry chairman Richard McSherry. “That’s a big reason why you see costs going down in the U.K. but not in other big markets.”

That’s progress, but much more needs to be done, says Myners. A surprisingly large number of firms are not even measuring transaction costs yet. A recent survey by pension fund consulting firm William M. Mercer of 29 fund managers with a total of £500 billion ($780 billion) in assets showed that 45 percent did not monitor trading costs. Some experts say that the figure is probably much higher for the industry as a whole, as some firms that do not measure aren’t likely to admit it. It’s hard to unbundle what you are not measuring.

Myners says that anecdotal evidence points to “softing” actually being on the rise -- it’s just being shifted from pension accounts to mutual funds. He says that both investment managers and brokerages are resisting change because it will cost them money at a time when their margins are under greater pressure than in any period in recent memory.

“The guts of what Myners was getting at, really, is unbundling -- that the fund managers as agents aren’t properly controlling client money in buying research services,” says Gartmore COO Barry Marshall. “And it strikes me that nothing has changed on that. I’m no political expert, but my reading of the situation is that the Treasury, and Myners himself, would say that things aren’t moving fast enough.”

An outside consultant, not Myners, will conduct the government’s two-year review. But Myners’s opinion wields a great deal of influence with the government, and he says he still believes that fund managers should pay for execution, research and other services separately rather than with client commissions. The issue, he says, is more relevant than ever after the past year of conflicts of interest in the securities business.

“Everything that we’ve heard coming out of Wall Street is entirely consistent with asking the question, ‘What value was achieved in exchange for the huge amounts that are paid in brokerage costs, and indeed, what evidence is there that this obsession with transactions is capable of being converted into real value for clients by the massive fund managers?’” Myners asserts. “I accept that there are some fund managers who have trading skills. The vast majority don’t. And yet too many of them continue to behave in a trading way, often at the expense of their clients.”

All of this paints a dreary picture for already gloomy fund managers, say analysts who see several possible outcomes after the government finishes its review. The government, following Myners’s lead, could require fund managers to pay commissions out of their own pockets. It could mandate that sell-side firms unbundle nontrading services from commissions. Or it could merely require more disclosure of where client commissions go, what they pay for and how managers act to minimize costs.

Any of these options would hike costs for money managers. Officials at investment management and brokerage firms estimate that the biggest fund managers typically pay between $300 million and $600 million in commissions annually on behalf of clients. Were the firms forced to pay these sums out of pocket, their costs would soar. Higher management fees wouldn’t compensate. A drawback to this approach is that it might encourage managers to curtail trading so much that performance could suffer. That’s the opposite of what critics say is the current incentive of managers: to generate more “free” sell-side services for themselves by churning client accounts.

One way around that issue would be to unbundle services and require fund managers to pay for nontrading services. This option has a logical appeal. After all, research is aimed at improving managers’ investment performance, and the pension plans are already paying for that with their management fees. But the bill for doing this would also be staggering -- at least $100 million annually for the biggest firms, say officials.

“At the moment, fund managers in general are not making a lot of money. And in this environment to say you’ve got to pay directly for research is going to cause them to make even less money, and even make losses,” says Richard Semark, head of equity trading at Axa Investment Managers in London.

Even if more detailed disclosure is all that’s required, firms will have to build systems that allow them to independently value the different services now bundled into commissions. That kind of technology can cost at least $2 million to $3 million to implement -- not exactly what beleaguered fund managers have in mind in times like these.

Firms will cope with these additional costs in a number of ways. The most tempting: Raise annual management fees from the current standard of roughly 1.5 percent of client assets. But pension trustees have long scrutinized management fees closely and shop for the lowest they can get without sacrificing performance. Investment managers may be able to add a few basis points, but only when performance warrants it.

A more likely scenario is that fund managers will drastically cut their use of sell-side research. That, in turn, will free them to experiment more with execution-only brokerages and alternative trading systems that compete with full-service houses solely on the basis of execution quality.

The big winners, if investment managers can still deliver performance, would be the pension funds, which would benefit from more efficient trading and higher returns. Apart from the big brokerage houses, which could see hundreds of millions in commission revenue wither, another likely loser could be the London Stock Exchange.

An unintended consequence may be less competition in the U.K. investment management industry. Smaller investment managers, after all, often lack the resources to employ large internal research staffs and build sophisticated brokerage-evaluation systems. Thus they would be at a competitive disadvantage to large, global organizations with hundreds of billions under management. One exception, money management officials say, might be niche firms that specialize in a particular asset class or investment style, including hedge funds. They need fewer of the services traditionally provided by big brokerage houses to produce winning investment ideas and have the rich fee schedules to pay for what they need.

Market forces, not legislation, have been ushering in similar changes in the U.S. for some time now. Money managers, frustrated in a wrenching bear market, have woken up to how big a drag transaction costs can be on performance. Powerful firms including Fidelity, MFS Investment Management and Putnam Investments have put brokerage firms and exchanges on notice: Shape up or we’ll dump you. They have backed their threat by pursuing numerous lower-cost alternatives to the traditional broker-exchange model for executing block trades. Program trading -- traditionally a tool for passive managers -- is being more widely embraced; a program typically costs 1 to 3 cents per share to execute, versus 5 cents for a traditional, single-name trade. More than one third of New York Stock Exchange volume is now executed through programs, double the level of 1999.

Funds are increasingly seeking to trade directly with one another using low-commission electronic platforms, such as Investment Technology Group’s Posit crossing network and Liquidnet, an institutions-only system that allows traders to find natural counterparties and negotiate prices for block trades. Even more threatening to Wall Street: Some funds are forming “capital markets” desks to trade big blocks of shares directly with issuing companies or other big investors.

The Elkins/McSherry numbers reflect the impact of these efforts, although costs in U.S. stock trading rose significantly in 2001. The average trade on the New York Stock Exchange cost institutions 32.18 basis points in 2001, up 13.3 percent from the previous year, but still well below the LSE. A typical Nasdaq trade cost 38.6 basis points to execute, up 6.2 percent. U.S. traders continued to have a tough time negotiating wrenching market volatility, which makes it far more difficult to efficiently buy and sell large blocks of stock.

Costs in the largest continental European markets, France and Germany, also rose slightly. In continental Europe there is far less focus on reducing transaction costs than in the U.K., although that may change once the European Commission strengthens its Investment Services Directive. The ISD was designed to allow financial services firms based in one European Union nation to do business in another without setting up a local office there, but has not been totally effective. Some observers believe that the revisions scheduled for early next year will foster greater competition for trade execution services and help bring down overall costs. But the Continent still has a less-developed equity culture and fewer big pension schemes that hire third-party managers. As a result, says Graham Bishop, a consultant who is advising the European Parliament on the implementation of the ISD, “there isn’t this feeling that the returns of pension funds are being frittered away by investment managers not taking care of other people’s money, which is really the core of what Myners is looking at.”

MYNERS’S REPORT FOCUSED mostly on pension trustees, whom he urged to learn more about the markets to make informed decisions on behalf of workers. It also chided institutions for focusing too much on short-term returns and not taking an active enough role in overseeing the governance of the corporations they own. But the few passages relating to transaction costs, buried within the report’s 199 pages, have become its most influential. In addition to the conflict inherent in managers’ allocating the fees paid by pension funds, Myners found that the disclosure of these payments by managers to the pensions was “far from transparent,” occurring on a trade-by-trade basis rather than in aggregate. This buries pension funds in paper and ensures that they cannot be certain that the services paid for with their commissions actually benefit them instead of the investment management firm or its other clients.

The fund management industry clearly prefers additional disclosure over Myners’s proposal that they pay commissions out of their own pockets. This May’s voluntary IMA-NAPF guidelines call for better disclosure to pension fund clients of items such as the different brokerages and methods of trading used, how brokerages’ competence in executing trades is determined, whether and why soft commission programs are implemented and how managers attempt to control transaction costs while maximizing execution quality.

Before managers can provide detailed disclosure of costs to clients, however, they must measure them effectively. This goes beyond simply gauging commission rates to also measuring implicit costs such as “market impact” (the effect that large orders to buy or sell have on a stock’s price) and “opportunity cost” (missing the chance to trade at better price levels when working a large order). After all, a brokerage that discounts commissions may do a horrible job of managing implicit costs.

Some money managers and pension funds have been using third-party cost analysis, provided by firms such as Abel/Noser Corp., Elkins/McSherry and Plexus Group, for years. But the most sophisticated investment managers are either building their own cost-analysis systems or working with outside providers on custom platforms. Axa, for example, hired a London-based firm, Global Securities Consulting Services, which helps Axa to analyze its performance against 45 cost benchmarks depending upon the style of investment.

Armed with this data, money managers can better control costs by actively directing their trading business to low-cost venues. Increasingly, big brokerage firms and the LSE will no longer be the guaranteed destinations for the vast majority of trades, as pension funds and their investment managers demand best-of-breed execution services provided by alternative sources, such as electronic crossing networks and boutique brokerages that do not offer research and investment banking.

“What you’re not going to see is people using brokers for plain-vanilla trades that they can execute on other markets themselves or with another buy-side firm,” says Axa’s Semark. Trades being executed without traditional brokerages or exchanges “could easily be 25 or 50 percent,” he says. “Whether the timescale on that is one year or five, I don’t know.”

Already, electronic platforms such as Instinet and E-Crossnet provide alternatives for investment managers to the traditional broker-exchange model in Europe. This month Liquidnet launches in the U.K. Axa, Baring Asset Management, Morley Fund Management and Schroder Investment Management are among the inaugural participants.

Some fund managers are also evaluating the quality of other services covered by commissions, such as research, and using the data to press for the unbundling of these services. Deutsche Asset Management, for example, has built an internal brokerage-evaluation program, which assigns a score and a ranking to every sell-side product and service it uses. The results are used to determine how much of Deutsche’s commission flow goes to each provider and to weed out unwanted services that sell-side firms bundle in with trade execution.

“The buy side for years has effectively been buying a brand-new, fully specced automobile from every provider out there, when our responsibility is to source the best components from each provider and build it ourselves,” says DeAM global head of equity Gunner Burkhart. “It might be that a fully integrated house provides us research across 15 different sectors around the world and that we value only their automobile analysis, but they continue to flood us on a daily basis with product on the other 14 sectors. We’re making it very clear to them that not only do we not value those other 14 sectors but that we don’t want to receive them and we aren’t going to pay for them.”

One decision he has made is to direct more commissions to independent research firms. As other investment managers adopt similar systems, the sell side may be forced to unbundle its services.

IN THE END, THE COLLECTIVE efforts of the private sector and the government appear likely to substantially alter the competitive landscape for investment managers, brokerage firms and exchanges in the U.K.

To compete with direct-access systems, all the major traditional brokerages in the U.K. have begun offering “low-touch” trading over the past several months. The low-touch arrangement allows buy-side clients to use a brokerage’s exchange seat and communications lines to execute trades on their own, at discounted commission rates. This not only reduces explicit transaction costs but could minimize market impact and other implicit costs, because there is less chance that an investment manager’s strategy will become known to other market participants.

But there’s another possible result: less service. “If you look at the earnings of investment banks, there is not a lot of room for incremental service when customers are reducing commission rates,” says Daniel Hegglin, head of European equity distribution at Morgan Stanley in London. “Client segmentation will become a lot more important, and both the buy side and the sell side have to make important decisions. It’s only natural for the sell side to shift the emphasis of their service to the people who will pay for it, to try to preserve their earnings power.”

The LSE is also responding. “Some of our product people have been in a dialogue with some of the institutions here about how they can manage transaction costs,” says an exchange spokesman. “Nothing concrete has come out of that yet, but there may be some updates in a few weeks.” Some form of direct access for institutions, possibly bypassing
the brokerage community, has been broached, say people familiar with the discussions.

London has been a center of expansion for the brokerage industry -- especially for American megafirms pursuing global domination -- for much of the past decade. Once the dam breaks in the U.K., global organizations on both sides of the trade ticket will have to evaluate similar restructuring elsewhere.

“The role of the broker is going to change dramatically,” says DeAM’s Burkhart. “The world will move away from a fairly opaque, very bundled-up relationship into one that is far more granular, far more defined and, ultimately, far more profitable, I think, for both parties concerned. Most firms on both the buy and the sell side have found that they are highly inefficient. This process may be painful in the short term, but in the long term it will encourage everyone to allocate their resources more efficiently -- and that’s very healthy.”