By Kristi P. Wetherington
With the Securities and Exchange Commission's adoption of final "soft dollar" guidelines, investment managers can maintain confidence in their ability to use commission dollars to pay for research and other services that facilitate their investment decision-making. But the SEC decision doesn't answer all questions involving the practice. Now it is time to turn to the topic of institutional brokerage commission transparency.
The next item, in fact, on the SEC agenda is this very topic: disclosure of how client commission dollars are spent. While it was not specifically included in the current SEC guidelines, the SEC has indicated that transparency and disclosure are important issues that will be addressed in a separate release. We expect initial guidance on commission disclosure by the end of 2006.
Instead of waiting for regulatory action, U.S. brokerage firms should jump on the bandwagon for transparency and disclosure of institutional brokerage commissions. Increasingly, independent directors and fund managers are taking a hard look at how their client commission dollars are spent. They are rightfully asking to know what they are paying for in terms of trading and research.
The issue has been simmering both here and across the Atlantic. In the United Kingdom, new guidelines that took effect July 1 require full disclosure of research and execution costs. Global investment managers that manage pension assets are already subject to these rules in the U.K., and it is only natural that they will begin seeking this type of disclosure from their U.S. brokers. If U.S. brokers are required to provide this transparency to U.K. clients, it seems logical that they could simply extend the service to all clients.
Competitive forces have already begun driving the market to create transparency and alternatives to the bundled pricing model. Managers can now choose to execute trades with an execution-only broker and use commissions to buy clearly priced research from an independent research provider. They receive monthly statements detailing each component of their commission spent: the type of research provided, its value and the amount paid. This begs the question: if independent research providers can attach a value to their product, why can't the big firms put a price tag on their proprietary research?
Fidelity Investments last year announced an agreement with Lehman Brothers Holdings Inc. to pay separately for trade execution and research. Fidelity now requires Lehman to price out the value of much of its in-house research, and Fidelity pays for a portion of Lehman's research with hard cash rather than client commissions. It was a drastic change for an industry accustomed to charging and paying a single bundled commission price that covers trading, research and other services.
The Fidelity-Lehman model has not been widely adopted. Practically speaking, only the largest of fund companies and brokers can afford to follow this model. In addition, the practice would put smaller companies at a competitive disadvantage, which could ultimately lead to less innovation in research services and compromise best pricing.
The industry may not be ready to embrace the full unbundling of research and trading costs, but it is time for us all to address it. I am not suggesting the bundled pricing model be abolished, just disclosed. Fully disclosed bundled pricing provides an environment that fosters ideas and choices where non-conflicted independent research can compete with Wall Street research; and small and midsize investment managers can provide alternatives to the largest fund companies.
Only 9% of total U.S. equity commissions ($970 million) were used to purchase independent research on a fully disclosed basis, according to a Greenwich Associates study. Much of the remaining 91% ($9.8 billion) was used for bundled research and execution, in which costs for trading and research are not broken out. Clearly the industry has a long way to go to improve commission disclosure.
The demand for increased commission transparency is not limited to the equity market. Traditionally, fixed-income fund managers receive bundled execution and research with bond trades. There is no commission, per se, as the broker's fee is wrapped up in the price of the bond. But we are beginning to see signs that fixed-income managers are seeking both an increased level of transparency and the benefits of research commissions. Just as their counterparts on the equity side have used commissions to pay for research for years, fixed-income fund managers are beginning to discover that paying fully disclosed commissions on their bond trades can help them maximize their research budgets and reduce the amount paid for execution. Today there are a handful of agency-only fixed-income trading desks that provide research commissions.
Regardless of the market, the trend is clear. Commission transparency is an unstoppable force. The brokerage industry has the opportunity and the responsibility to embrace this trend to help their clients make the best buying decision possible for investors.
Kristi Wetherington is president and chief executive officer of Capital Institutional Services Inc., Dallas, an institutional brokerage firm specializing in global trading on an agency basis and independent research distribution for asset managers and plan sponsors.