Despite increased industry focus on trading costs in a volatile market, a sizable number of institutional investors admit they do not monitor best trade execution and transaction costs, a survey by Pensions & Investments and Lynch, Jones & Ryan shows.
In fact, 49% of those who don't use commission recapture say they are not familiar with the concept, and 45% said they do not understand the difference between commission recapture and soft-dollar transactions.
(Commission recapture is a method of unbundling commissions and obtaining institutional discount brokerage, with a portion of commissions rebated to the plan sponsor. Soft dollars are usually research credits used by managers to pay for research provided by a broker. The survey showed 56% of investment managers used by respondents currently use soft dollars to pay for research.)
According to the survey, 68% of pension, foundation and endowment executives currently use directed brokerage or a commission recapture program.
Yet 18% don't monitor transaction costs in their commission recapture programs and 19% don't monitor best execution performance of their fund. Most plan sponsors monitor transaction costs internally (37%) or use consultants (31%), according to the survey. For execution and performance, 36% use a consultant and 26% monitor internally.
Todd Burns, chief executive officer and president of Lynch, Jones & Ryan, a New York commission recapture brokerage firm, called the results "interesting," and said the finding that many plan sponsors don't monitor best execution is "reflective of our universe."
"It tells me that this is an honest look at the industry," said Mr. Burns.
Honest or not, the survey results run counter to claims by institutional traders that they are feeling pressure from plan sponsors to improve trading efficiency to squeeze out a few extra basis points of return (Pensions & Investments, Sept. 30). Traders claim that improving trade execution and reducing overall cost of trading has become a major imperative.
Surprising number
Richard T. McSherry, chairman of Elkins/McSherry LLC, a New York consulting firm specializing in trading cost analysis, said he was surprised at the number of plan sponsors who do not monitor trading costs. "You should not put in a commission recapture program if you don't intend to monitor it," he said.
One possible explanation, he said, is that plan sponsors are keeping a careful eye on their money managers' overall performance "and if they don't hit their performance benchmarks, they fire them. Instead of monitoring execution and trading costs, their (plan sponsors) primary measure is how well they (managers) are doing at stock picking."
Mr. McSherry said plan sponsors who fail to carefully monitor trading and execution are "losing out." During the last six years, he said, the 120 pension plans in the Elkins/McSherry universe of institutional trading reduced overall trading costs by 28% through "active monitoring and awareness."
Lynch, Jones' Mr. Burns said the lack of understanding of the difference between commission recapture and soft dollars "tells me that we have a lot of education work to be done ... We in the industry need to be making a bigger effort."
The issue is that soft dollars benefits the money manager and commission recapture benefits the plan," Mr. Burns said. "If half of the 32% (who don't use commission recapture) don't know the difference between commission recapture and soft dollars, again we need to be doing more" to explain the difference.
Thomas Mackell III, president of the Kamber Group, a Washington-based public affairs research firm, Washington, which helped conduct the survey, said pension trustees need to be educated. "Lots of trustees may be deferring to their service providers. And, if they aren't aware of it ..."
Large-cap focus
Pension plans focused their directed brokerage on U.S. large-cap equities, with 37% of brokerage directed to that asset class compared with 30% in midcap and small-cap domestic equities and 22% in large-cap non-U.S. equities, according to the survey. While not corresponding directly, a similar survey by Lynch, Jones in 2000 found that approximately 40% of commission recapture flows went to large-cap domestic equities and 35% to midcap and small-cap stocks (Pensions & Investments, Feb. 7, 2000).
Mr. Burns said small-cap and midcap stocks are more difficult to trade, although commission recapture is possible. There is a misconception, he said, that smaller stocks, usually traded over the counter, carry no commissions. "There are commissions on these stocks and we've been beating the drum with our clients. Again, it is an education issue," he said.
The average fund uses two commission recapture brokers, down from three in the 2000 survey. The new survey found 10% of plan sponsors said they directed more brokerage activity than one year ago, with 73% saying the amount of directed brokerage remained about the same.
Most plan sponsors reinvest the proceeds from their commission recapture programs (23%), pay internal plan costs (22%) or pay investment consultant fees (17%), according to the survey. Only 10% use commission recapture proceeds to pay investment management fees and trust/custody fees.
