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.

what will a soft dollar-less world look like

Yesterday I wrote about an EU regulatory movement to eliminate the use of soft dollars by investment managers–that is, paying for research-related goods and services through higher-than-normal brokerage commissions/fees.

Today, the effects of a ban…

hedge funds?

I think the most crucial issue is whether new rules will include hedge funds as well.  The WSJ says “Yes.”  Since hedge fund commissions are generally thought to make up at least half of the revenues (and a larger proportion of the profits) of brokerage trading desks, this would be devastating to the latter’s profitability.

Looking at traditional money managers,

 $10 billion under management

in yesterday’s example, I concluded that a medium-sized money manager might collect $50 million in management fees and use $2.5 million in soft dollars on research goods and services.  This is the equivalent of about $1.6 million in “hard,” or real dollars.

My guess is that such a firm would have market information and trading infrastructure and services that cost $500,000 – $750,000 a year in hard dollars to rent–all of which would now be being paid for through soft dollars.  The remaining $1 million or so would be spent on security analysis, provided either by the brokers themselves or by third-party boutiques (filled with ex brokerage house analysts laid off since the financial crisis).

That $1 million arguably substitutes for having to hire two or three in-house security analysts–and would end up being distributed as higher bonuses to the existing professional staff.

How will a firm pay the $1.6 million in expenses once soft dollars are gone?

–I think its first move will be to pare back that figure.  The infrastructure and hardware are probably must-haves.  So all the chopping will be in purchased research.  The first to go will be “just in case” or “nice to have” services.  I think the overwhelming majority of such fare is now provided by small boutiques, some of which will doubtless go out of business.

–Professional compensation will decline.  Lots of internal arguing between marketing and research as to where the cuts will be most severe.

smaller managers

There’s a considerable amount of overhead in a money management operation.  Bare bones, you must have offices, a compliance function, a trader, a manager and maybe an analyst.  At some point, the $100,000-$200,000 in yearly expenses a small firm now pays for with soft dollars represents the difference between survival and going out of business.

Maybe managers will be more likely to stick with big firms.

brokers

If history is any guide, the loss of lucrative soft dollar trades will be mostly seen more through layoffs of researchers than of traders.

publicly traded companies

Currently, most companies still embrace the now dated concept of communicating with actual and potential shareholders through brokerage and third-party boutique analysts.   As regular readers will know, I consider this system crazy, since it forces you and me to pay for information about our stocks that our company gives to (non-owner) brokers for free.

I think smart companies will come up with better strategies–and be rewarded with premium PEs.  Or it may turn out that backward-looking firms will begin to trade at discounts.

you and me

It seems to me that fewer sell-side analysts and smaller money manager investment staffs will make the stock market less efficient.  That should make it easier for you and me to find bargains.

 

 

 

the demise of soft dollars

This is the first of two posts.  Today’s lays out the issue, tomorrow’s the implications for the investment management industry.

so long, soft dollars

“Soft dollars” is the name the investment industry has given to the practice of investment managers of paying for research services from brokerage houses by allowing higher than normal commissions on trading.

Well understood by institutional, but probably not individual, clients, this practice transfers the cost of buying these services–from detailed security analysis of industries or companies to Bloomberg machines and financial newspapers–from the manager to the client.  In a sense, soft dollars are a semi-hidden charge on top of the management fee.

In the US, soft dollars are reconciled with the regulatory mandate that managers strive for “best price/best execution” in trading by citing industry practice.  This is another way of saying:   whatever Fidelity is doing–which probably means having commissions marked up on no more 15%-20% of trades.

In 2007, Fidelity decided to end the practice and began negotiating with brokers to pay a flat fee for research.  As I recall, media reports at the time said Fidelity had offered $7 million in cash to Lehman for an all-you-can-eat plan.  Brokerage houses resisted, presumably both because they made much more from Fidelity under the existing system and because trading departments were claiming credit for (and collecting bonuses based on) revenue that actually belonged to research.

theWall Street Journal

Yesterday’s Wall Street Journal reports that the EU is preparing to ban soft dollars in Europe for all investment managers, including hedge funds, starting in 2017.

not just the EU, however

Big multinational money management and brokerage firms are planning to implement the new EU rules not just in the EU, but around the world.

Why?

Other jurisdictions are likely to follow the EU’s lead.  Doing so also avoids potential accusations of illegally circumventing EU regulations by shifting trades overseas.

soft dollars in perspective

in the US

Let’s say an investment management firm has $10 billion in US equities under management.  If it charges a 50 basis point management fee, the firm collects $50 million a year.  Out of this it pays salaries of portfolio managers and analysts, as well as for research travel, marketing, offices… (Yes, 12b1 fees charged to mutual fund clients pay for some marketing expenses, but that’s another story.)

If the firm turns over 75% of its portfolio each year, it racks up $7.5 billion in buys and $7.5 billion in sells.  Plucking a figure out of the air, let’s assume that the price of the average share traded is $35.  The $15 billion in transactions amounts to about 425 million shares traded.  If we say that the manager allows the broker to add $.03 to the tab as a soft dollar payment, and does so on 20% of its transactions, the total annual soft dollars paid amount to $2.5 million.

foreign trades

Generally speaking, commissions in foreign markets are much higher than in the US, and soft dollar limitations are    …well, softer.  So the soft dollar issue is much more crucial abroad.

hedge funds

Then there are hedge funds, which are not subject to the best price/best execution regulations.  I have no practical experience here.  I do know that if I were a hedge fund manager I would care (almost) infinitely more about getting access to high quality research in a timely way (meaning ahead of most everyone else) than I would about whether I paid a trading fee of $.05, $.10 (or more) a share.

We know that hedge funds are brokers’ best customers.  Arguably, banning the use of soft dollars–enforcing the best price/best execution mandate–with hedge funds would be devastating both to them and to brokerage trading desks.

translating soft dollars to hard

When I was working, the accepted ratio was that $1.75 soft = $1.00 hard.  I presume it’s still the same.  In other words, if I wanted a broker to supply me with a Bloomberg machine that cost $40,000 a year to rent, I would have to allow it to tack on 1.75 * $40,000  =  $70,000 to (the clients’) commission tab.

 

Tomorrow, implications of eliminating soft dollars

 

 

 

 

 

 

hedge funds and investment research

On Monday, the Wall Street Journal ran an interesting article, “Hedge Funds Learn Secrets Not So Safe.”  It’s about brokerage house research reports on individual companies.

Brokers provide research to customers either by giving them access to a research website, which contains all a broker’s research reports, and/or by responding to requests for specific research items, including meetings with analysts.  The problem with this is that brokers collect and analyze all their points of contact for the information they contain.  Conclusions will certainly wind up on the firm’s sales desk and can easily end up on the firm’s proprietary trading desk, too.

The same written  information is also available to authorized customers through third-party information services like Bloomberg.  I can use my Bloomberg account not only to call up a chart of a company’s stock price, see summary financial statistics and find out who a company’s major suppliers and customers are.  I can also read brokerage research from the brokers I do business with.  Not having read the service agreements they’ve signed, hedge funds have apparently assumed that if they read brokerage house report on a given target investment using a third-party information service, the broker never finds out.  By doing so, they’ve outwitted the broker and avoided information leakage.

Not so.

The third-party information providers supply such usage data to brokers, sometimes being as specific as what person at a given firm has accessed a report.  In fact, the article cites an instance of an unnamed analyst finding out his research wasn’t as stealthy as he’d thought when the broker whose report he’d been reading called him up and offered to arrange a meeting with the target company.

 

What I find odd is that there’s an obvious way to prevent information leakage–do the research yourself.  There’s a ton of relevent information available from the SEC’s Edgar site, as well as from government agencies and industry trade associations.  There are also suppliers and customers to talk to.  There’s gossip on the internet, too.

In my experience, except for a narrow set of highly technical areas (where you can always hire a consultant), the picture you create yourself will be more accurate, relevant and in-depth than anything a brokerage report can provide.  Yes, the brokerage analyst may be willing to say things on the phone or in person that he wouldn’t care to commit to paper, but that’s another issue.

Two issues:  compiling a thorough analysis of a company may take a week or two, as opposed to taking an hour to read someone else’s work.  Also, the analyst has to have the skill and experience to do independent work.

I can’t imagine that taking an extra week is the crucial variable.  That leaves the possibility that the firms the WSJ is writing about are so weak they don’t know how to do research themselves.  Hard to fathom.  I guess they’re just great marketers.