the death of research commissions?

Investors in actively managed funds pay a management fee, usually something between 0.5% – 1.0% of the assets under management yearly, to the investment management company.  This is disclosed in advance.  It is supposed to cover all costs, which are principally salaries and expenses for portfolio managers, securities analysts, traders and support staff.

What is not disclosed, however, is the fact that around the world in their buying and selling securities through brokerage houses, regulators have allowed managers to pay substantially higher commissions for a certain percentage of their transactions.  The “extra” amount in these commissions, termed soft dollars or research commissions, is used to pay for services the broker provides, either directly or by paying the bills to third parties.  Typical services can include written research from brokerage house analysts or arranging private meetings with officials of publicly traded companies.  But they can also include paying for third-party news devices like Bloomberg machines–or even daily financial newspapers.

Over the last twenty years, management companies have realized that instead of supplementing their in-house research with brokerage input, they could also “save” money by substituting brokerage analysts for their own.  So they began to fire in-house researchers and depend on the third-party analysis provided to them by brokers   …and funded by soft dollars rather than their management fee.

For large organizations, these extra commissions can reach into millions of dollars.  Yes, the investment management firm keeps track of these amounts.  But they are simply deducted from client returns without comment.

 

This practice is now being banned in Europe.  About time, in my view.  Strictly speaking, management companies may still use soft dollars, but they are being required to fully disclose these extra charges to clients.  Knowing that clients would be shocked and angered if they understood what has been going on, the result is that European investment managers are abandon soft dollars and starting to rebuild their in-house research departments.

What’s particularly interesting about this for Americans is that multinational investment managers with centralized management control computer systems–which means everyone except boutiques–are finding that the easiest way to proceed is to make this change for all their clients, not just European ones.

The bottom line: smaller profits for investment managers and their brokers; much greater scrutiny of soft dollar services (meaning negotiating lower prices or outright cancelling); and higher returns for investors.

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