SMA Step-Out Trading Trends in Managers demand automation amid inefficiency

Transcription

1 SMA Step-Out Trading Trends in 2009 Managers demand automation amid inefficiency

2 Following the inaugural FRC SMA Step-Out Trading Survey in March 2008, the investment management industry has undergone an extraordinary period of change characterized by unprecedented economic pressures and the consolidation of unlikely century-old Wall Street competitors. These changes have re-emphasized urgent issues in the investment advisory business in general and specifically, trading and settlement concerns and efficiencies for the separately managed account industry. As the distribution landscape of the retail SMA business continues to evolve, investment managers remain focused on building and improving the operational efficiency of their SMA trading practices. To assist managers in this effort, FRC was commissioned by Citi s Investment Administrative Services to re-engage the asset management community and further assess their retail SMA step-out trading practices. In this white paper, we review the motivations behind step-out trading (a.k.a. trading-away) and settlement processing, examine the results of a proprietary survey of investment managers regarding their perspective on step-out trading and settlement practice, issues and concerns, and forecast the future of step-out trading amid the changing face of the managed account business. Motivations Underlying the Desire to Step Out The trend toward increased step-out trading is clearly motivated by several factors, including a renewed focus on best execution, the expansion of sophisticated investment strategies desired within the separately managed account chassis, and the need to enhance growth in the managed account industry. Best Execution Meeting internal best execution requirements is especially salient in today s heightened regulatory environment. The SEC continues to focus greater attention on the managed account space while emphasizing the importance of providing best execution for all client accounts. In March 2008, Andrew Donohue, Director of the Division of Investment Management at the SEC, directly addressed the SMA industry by calling upon managers to detail and justify their best execution efforts to clients: Firms providing managed accounts should be attuned to how they are meeting their best execution obligations. If client trades will be placed with the managed account s sponsor, the adviser should be comfortable that this arrangement achieves best execution and that the client is informed of this arrangement and why it achieves best execution. Remarks before the IA Week and the Investment Adviser Association s 10th Annual IA Compliance Best Practices Summit 2008 Investment Strategy Sophistication While SMA assets have traditionally been sourced from large-cap domestic equity strategies, sponsors have been increasingly demanding a broader palette of SMA offerings from investment managers. As a result, managers have stepped up to offer an increasingly exotic mix of investment strategies that spans market caps and geographical boundaries. Along with this continued growth has risen the need to source liquidity from specialized brokers that either provide specialized trading platforms or specialize in specific security types. SMA Growth Prior to the credit crisis, SMA assets had been growing at a torrid pace from 2002 to 2007, SMA assets grew at a 21% compound annual growth rate. The major contributors to this growth going forward will come from outside the traditional wirehouse distribution channel. Increasingly, growth of SMA assets is driven by

3 State of the SMA Industry An unprecedented credit crisis coupled with a consumer-led recession in the United States precipitated a sharp sell-off in almost every global equity market during the past 12 months. Since March 2008, the DJIA and MSCI EAFE have declined 40% and 51%, respectively. The concentration of retail SMA accounts invested in equities (72%) has had a significant effect on industry assets. According to the Money Management Institute, SMA assets fell to $712 billion in fourth quarter 2008, representing a $330 billion decline from 2007 year-end assets. While overall managed account assets declined 29% year-over-year (2007 to 2008), UMA assets grew 15% to end 2008 at $45 billion. As UMAs continue posting market share gains, increasing the operational efficiency of traditional separate account business lines will serve as a competitive imperative for many investment managers in the coming years. sophisticated SMA wealth platforms housed within the bank, regional brokerdealer and independent channels. As a result, investment managers will likely have less confidence in the operational abilities of program sponsors other than non-wirehouse broker-dealers to meet their best execution standards. Step-Out Survey Overview To gain a more complete understanding of the challenges associated with step-out trades and to draw relevant comparisons to last year s survey, FRC launched a web-based survey of retail SMA investment managers during the first two weeks of March FRC received 23 responses to its investment manager survey. Mid-sized managers, those with 5,000 to 20,000 accounts, represented 43% of the respondent population, while small managers, those with less than 5,000 accounts, represented 43% of respondent firms. Due to the precipitous drop in equity markets and the resulting drop in industry accounts, large SMA managers, those with 20,000 or more investor accounts, represented only 14% of the survey response group. The investment managers in the respondent population represented a wide variety of investment styles. When asked to identify their three primary SMA styles, large-cap stock represented the predominant equity style (18 managers). Over half of the sample reported managing mid-caps (12 managers) while over 40% of managers ran SMAs in international ADR (10 managers) and all-cap (10 managers strategies). At the specialty end of the investment spectrum were convertibles (one manager) and preferred stock (one manager). Within the fixed-income disciplines, treasuries and agencies were the predominant bond styles (three managers) while three managers identified themselves as primarily multistate municipal bond managers.

4 Sponsor and Custodian Relationships We asked investment managers to provide us with details about the number of sponsor and custodian relationships they possessed. The data reveal that while some managers have clearly cast a wide net among sponsor firms, a number of managers target their distribution efforts toward a select group of the SMA sponsor population. Sponsor Relationships Accounts Managed Average # of Sponsors Maximum # of Sponsors 20,000 40, ,000 20, ,000 10, ,000 5, Less than 2, Overall Minimum # of Sponsors On average, manager respondents did business with 16 sponsors to support their SMA business. Motivations Behind Manager Step-Outs Step-out trading continues to be very pervasive among SMA investment managers. Nearly 90% of SMA investment managers in the FRC survey population responded that they conduct step-out trades. Slightly more than 25% of respondents indicated they always conduct step-out trades for investment model changes. While a quarter of surveyed managers stepped out trades depending upon the sponsor, a larger percentage (43%) indicated that step-outs were dependent upon the security type being traded. These responses were nearly identical to those we received in Managers indicating they never step out trades were either satisfied with their sponsor s execution capabilities or dissuaded by the costs or operational inefficiencies associated with stepping out trades. Those managers indicating that they never step out trades generally managed fewer accounts and had only a limited number of sponsors through which they did business. The Chartered Financial Analyst (CFA) Institute s trade-management guidelines define best execution as the trading process firms apply that seeks to maximize the value of a client s portfolio within the client s stated investment objectives and constraints. While most investment managers have established their own internal best execution criteria, the measurement and quantification of meeting best-ex continues to be an inexact science.

5 Reasons for not trading away I primarily trade only Opening and Maintenance trades with Sponsors given the small order sizes My system does not accommodate The operations process to support step-outs/trade-aways is too difficult and time-consuming For the securities we trade, Sponsors perform capable executions Sponsors charge a fee to process step-outs Most Sponsors won t let me/don t like it 0% 10% 20% 30% 40% 50% 60% When we asked managers to identify more specific reasons for stepping out, 80% of survey respondents specifically identified best execution/compliance requirements as the primary reasons for trading away. Additionally, 65% of managers indicated that step-out trading was spurred by the desire to block their retail order flow alongside their institutional flow. Other motivating factors included the desire to fulfill larger/faster executions (45%), a general dissatisfaction with sponsor execution capabilities (30%), and a lack of adequate security coverage at the sponsor (30%). Reasons for trading away Best execution/compliance requirements Block orders with other flow Larger orders/faster executions Dissatisfied with Sponsors execution capabilities Security Coverage Use a Super-Broker Other 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

6 Trade-Away Broker Attributes Specialized in certian security types Cover me institutionally as a major customer Provide ALGOs Have ECNs Provide electronic market making Provide auto-dr capabilities Other 0% 10% 20% 30% 40% 50% 60% 70% 80% Trade-Away Broker Attributes While the definition of best execution is anything but uniform, managers reaffirmed that step-out trading is an essential component of maximizing their trading efficiency. Over two-thirds of investment managers relying on third-party brokers to complete trades cited security specialization as the primary characteristic of their trade-away broker. Additionally, 42% of respondents noted that step-out trades were often directed to brokers that covered them institutionally as a major customer. Finally, a smaller percentage of managers cited auto-dr capabilities and access to ECNs or ALGOs as motivating factors. When asked how step-out trade orders were blocked, more than half of investment managers indicated that block orders were sent from SMA blocks merged with institutional trades 52% Handling of Trade Away Orders their managed account systems to their institutional trading system and executed together with other institutional business. Roughly equal SMAs traded separately, but in rotation with other business 20% Other 4% SMAs traded independently of other business 24%

7 camps of respondents indicated SMAs were traded separately but in rotation with other businesses (20%) or SMAs were traded independently of their other business lines (24%). Security Types Traded Away Step-out trades continue to be driven by security type as managers seek to place orders with third-party brokers that either specialize by security type or provide access to specialized liquidity pools not found at the program sponsor s trading desk. Fixed-income securities remain the most prevalent security type traded away from SMA platform sponsors. While the data was drawn from a limited number of managers who specialized in retail fixed-income SMA offerings, they uniformly indicated stepping out taxable/ high-grade and corporate securities. Within equity styles, small-caps (75%), all-caps (70%), and international ADRs (80%) were noted by a majority of respondents as representing the most prevalent security types to be traded away. Interestingly, we found that step-out trades are not relegated to specialty and illiquid corners of the market. A third of manager respondents reported stepping out large-cap equity trades from the program sponsor. In 2008, 44% of managers reported stepping out large-cap equity trades. International and global ADR managers have recently benefited from the SEC s relaxation of a paper filing requirement for foreign companies in October The rule change resulted in the creation of roughly 700 new ADRs. According to the Bank of New York Mellon, there are now more than 1,800 ADRs trading in the U.S. Trade-Aways by Security Type 0% 20% 40% 60% 80% 100% FI Corporates FI Taxable High Grade International ADR Small-Cap Equites All-Cap Equities Large-Cap Equities Balanced

8 Costs of Stepping Out Costs associated with step-out trades often depend on the scale of the trading relationship and any relationship/ enterprise pricing associated with the selection of a third-party broker. While most firms reported that the costs of step-out trades are netted up into the trade, nearly a third of managers indicated that trading on their retail managed accounts was free as part of a broader institutional relationship. Only a small fraction of managers reported directly absorbing the costs of stepping out. Those managers disclosing specific trading costs generally paid $0.01 and $0.03 per share. Costs netted up 52% Step-Out Trading Volume Expectations While account opening and maintenance volume is typically traded with the sponsor 70% of managers step out less than 10% of this volume Costs of Stepping Out Trading free with relationship 30% Commission passed to investor 15% Manager absorbs commission 4% given the relative size of the trades, model change/across-the-board volume is traded away much more frequently. Nearly a quarter of managers traded away more than 90% of their model change volume. Overall, 52% of Stepped-Out Model Change/Across-the-Board Order Volume >90% 75% 90% 50% 75% 30% 50% 10% 30% <10% 0% 5% 10% 15% 20% 25% 30%

9 managers indicated that more than half of their model change/acrossthe-board volume was traded away. The future volume of step-out trades will trend higher according to many managers. When asked to provide their expectations for future step-out trading, every manager indicated that SMA step-out trading would either remain at the current level or increase. Model Change/Across-the-Board Order Volume Trade-Away Expectations Increase 45% Stay the same 55% Account Opening and Account Maintenance Trade-Away Order Volume Expectations Desire for Solutions The overwhelming desire for automation is largely associated with the manual processes still required to process and settle trades with sponsor firms. Nine in ten managers we surveyed indicated a desire for automated step-out trading and allocation processing to sponsors. More than half of managers also desired more automation with regard to allocation and settlement services with custodians. Over two-thirds of investment managers indicated that they often assist the trade-away broker and custodian during the step-out settlement process with the Sponsor. The majority of investment managers indicated that their assistance was necessitated by the Sponsor s lack of understanding of the intricacies associated with managed accounts. Increase 36% Stay the Same 64% The growing demand for more efficient SMA trade processing is evident. As more solutions are implemented at the asset manager level, automation will clearly benefit the industry by reducing risks and costs, promoting a wider range of SMA investment styles, and increasing manager participation in the SMA industry.

10 Sponsor/Custodian for the block trade to the Broker Step-Out Manager Concerns Trade-away broker doesn t understand managed accounts 57% Trade away broker and custiodian, but we are not involved 20% Fax Phone Outsourcer handles the problem 12% My firm 10% Trade away broker and custiodian, but we often assist 70% I am unaware of settlement process problems; it seems to work without my intervention 31% Trade-Away Order Generation: Percentage of Managers Employing Manual Methods Reduce Risk/Costs There is a clear desire among managers to streamline the step-out process in order to avoid trade booking errors and increase the efficiency of step-out trades. In fact, almost half of the managers we surveyed still reported using manual methods (phone, fax, ) to generate and communicate step-outs. Ultimately, increased automation would allow managers to more effectively account for trades and improve the efficiency of the shadow-accounting process. Promote More Investment Styles The roster of investment styles managed in the SMA vehicle continues to expand beyond traditional U.S. large-capitalization products. As this growth occurs, demand for access to specialized securities brokers will increase along with the need to step out more trades. Encourage Manager Participation While the SMA industry has undergone impressive growth, the inherent operational complexities of managing retail separate accounts have served as a barrier to entry for many institutional investment managers. Automation and broader messaging standards will prompt more investment managers to enter the retail SMA

11 business, expand their participation on multiple sponsor platforms, and ultimately reduce their back-office overhead expenses. Future Trends Impacting SMA Step-Outs The operational hurdles associated with step-out trading continue to affect SMA growth. However, several trends will have an important influence on the future of SMA trading, including the growing influence of model management, the launch of no-fee mutual funds, the creation of non-adr strategies, and the growing influence of regulation. No-Fee Mutual Funds No-fee funds, which are specialized no-fee 1940 Act funds that sit along individual securities within a managed account, help add additional exposure to small- and mid-cap stock ranges within international equity mandates. Additionally, no-fee funds have helped drive down the investment minimums for fixed-income strategies. To date, approximately 20 investment managers have launched these products in the SMA space. Model Management/UMAs The industry continues to march slowly but surely toward the model managed or paper portfolio environment whereby SMA managers cede control of trading to the SMA sponsor. While Merrill Lynch is currently running its traditional and model-driven platforms side by side, the industry s biggest SMA sponsor is expected to transition its entire book of business over to the model environment in the coming quarters. Provided the other wirehouses follow suit, expect the overall volume of step-out trades to decrease in time. As of year-end 2008, UMA assets stood at $39.6 billion, according to the Money Management Institute. In recognition of the growing demand for unified product neutral wealth solutions, Citi recently announced the launch of its OpenWealth SM platform. The solution represents the first Unified Managed Household (UMH) servicing platform to provide automated household portfolio and tax optimization for investors serviced through distributors and sponsors of wealth management. TIAA-CREF recently chose OpenWealth as the operating platform for its fee-based wealth management solution. Non-ADR International Strategy As more investment managers offer internationally oriented SMAs that invest in securities across the globe rather than U.S.-traded ADRs, trading dynamics of these SMAs will change profoundly. MFS and Merrill Lynch combined efforts in July 2007 to launch one of the industry s first non-adr international strategies on Merrill s newly launched UMA/Unified Diversified Portfolios platform. Best Execution/Compliance Requirements As previously mentioned, best execution continues to be a focus of regulators. While some sponsors have instituted the practice of requiring clients to sign direction letters that waive best-execution requirements, most sponsors remain open to the practice of stepping out trades. Seven of ten program sponsors in FRC s 2008 SMA Sponsor Survey population indicated that while they preferred that trading volume pass through their desks, it s left to the investment manager s discretion if and when to conduct a step-out trade.

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