A New Fiduciary Duty:

Transcription

1 A New Fiduciary Duty: Approving your managers Research Budgets (and Soft-dollar unbundling) for State Association of County Retirement Systems (SACRS) May 17, 2017

2 Why are we here today? Massive new regulation in Europe and the UK known as MiFID II, has changed the permissible ways that managers can use commissions (from practices that have been in place for almost 50 years). Beginning in the second half of 2017 this will have a significant ripple effect for US asset owners (which many plan fiduciaries do not yet fully appreciate): New fiduciary duties (and risks), on an annual basis, for Fund fiduciaries and Staff. New investment risks for asset managers to be monitored closely by consultants and Fund Investment Officers. Much greater transparency into your managers processes (for those asset owners who care). Significant potential cost savings, for asset owners who pro-actively monitor and work with their managers to ensure full compliance with the new regulations. Zeno is therefore alerting its clients and other asset owners, so they will be prepared to make informed and prudent decisions. But before discussing each of the above risks/opportunities, a little background is needed

3 Brokerage Commissions: Their Uses Commissions are used for three primary purposes: Payment for Trade Execution: Brokerage firms are compensated for acting as intermediaries between buyers and sellers. Commission Recapture programs: Commission rebates are received by plan sponsors from brokerage firms engaged in the recapture program. Payment for research and services: Managers also use client commissions to purchase research from various 3 rd party providers (mainly Investment Banks).

4 What are Soft-dollars and what is their role re: Research? Managers execute the Fund s trades through certain brokers and pay a higher commission rate than normal (out of Fund assets). In return, the broker provides the manager with credits the manager can subsequently use to purchase brokerage and research services for the benefit of the manager (akin to frequent flyer miles ). Important! This is NOT Commission Recapture (where managers send trades to specific brokers so that the asset owner receives a commission rebate). In the US, Soft-dollars are permissible under Section 28 (e) of the Securities and Exchange Act of However, while managers are allowed the pay higher than normal commission rates (i.e. pay up ) for soft-dollar services, the managers overall costs must still meet best execution standards. Further, since commissions are considered to be Fund assets, asset owners have the right to monitor, limit, and/or prohibit the purchase of soft-dollar services with the Fund s commissions. Common examples of permissible soft-dollar services include: Macro-economic analysis Company-specific analysis Risk-management tools, and Order Management/Execution Management Systems (in the US) Operational, administrative, and marketing-related services are not permissible purchases.

5 Why do Managers need investment research? Investment managers globally invest approximately $12.5 trillion in AUM in active equity strategies. The estimated annual amount spent on external research is $20 billion (i.e. 16 bp of AUM). Active Managers are dependent upon research (to generate alpha). Even Passive Managers need some research (e.g. Index constituents etc.). Some managers use their own funds to buy research, but most pay with client commissions. Lots of factors determine each managers research needs. Important considerations include: Expected Return Universe of securities considered/tracked Investment Mandate Volatility and Liquidity risk. Frost Consulting

6 Historically, research spending was an inefficient Top-down Process Most Common Historical Approach: Broker Vote Process Manager personnel vote on the % of trade flow sent to each respective Broker/Dealer. Votes occur periodically, and are determined on a firm-wide basis. Provision of research (used by all of the manager s strategies) is just one, of many, factors that determine the final % of trade flow awarded to each Broker/Dealer. This Presents Two Problems: Waterfront research coverage often results in unnecessary research being acquired. Because each Broker/Dealer is sent a percentage of the manager s trade flow, the amount of commissions paid to each Broker/Dealer increases as the manager s AUM and annual trade volume grow, even though the value of research remains the same.

7 MiFID II changes everything! A Sea Change! What does MiFID II do? Soft-dollars are banned for all managers subject to MiFID II. Its always okay for managers to use their own money to purchase research. But, most managers can t afford to simply pay for their current research needs (studies estimate this could eat up as much as 40% of the typical managers profit margin). If managers want to use their clients money, MiFID II now requires that: Managers must identify specific research needs for each respective strategy. Total research costs are tallied up for each respective strategy, and allocated to those clients on a pro-rata basis (e.g. Portfolio AUM). Managers must annually obtain fiduciary approval from each client before using their assets to pay that research cost. Managers who do not want to request such asset transfers, may instead request a Mgmt. Fee increase. Important Note: while US managers providing US strategies are not subject to MiFID II, many global managers (who are subject to MiFID II for other clients) will use only one standardized policy for all of their clients! In those instances, US clients will likely be approached as well.

8 This is actually good news! While the new MiFID II regulations introduce new fiduciary duties and investment-related risks, they also foster greater transparency, more accountability, and potentially significant savings for Asset Owners! New annual fiduciary duties (and risks) for Fund Compliance Officers and plan fiduciaries. New investment risks for asset managers - which should be monitored closely by consultants and Fund Investment Officers. Much greater transparency into your managers processes and what they do with Fund assets (for those asset owners who care). Significant potential cost savings, for asset owners who pro-actively monitor and work with their managers to ensure full compliance with the new regulations. Taking each of these in turn

9 New Annual Fiduciary Duties and Responsibilities 4 Considerations Managers must annually obtain fiduciary approval from their clients before using Fund assets to buy research. Each client must be formally provided with: the list of research services which the manager intends to purchase in the upcoming year, the total cost of that research for the manager, and the client's pro-rata portion of that cost (i.e. which the manager is requesting to be transferred to the manager s Research Account). Each client, as the plan fiduciary, is thereby put on notice that the manager will take such amount from their Fund s assets, unless prohibited by the client. If not prohibited by the client, that amount will be transferred (either in lump-sum payments, or ear-marked commissions), from the client s assets into the manager s Research Account. Once you approve a manager s research request, that money becomes the assets of your manager! Beware of regulatory arbitrage! MiFID II prohibits using client assets to subsidize the research cost of another client. But asset owners should be on alert for managers potentially using the commissions of US clients (that may not be subject to MiFID II) to pay the research costs of European and UK clients (who are subject to MiFID II). Also be on alert for managers paying the research costs of those clients who object, with the manager s own money, but not paying your Fund s research costs. Be sure to collect any unused soft-dollar balances after January 3, 2018!

10 New Investment-related risks to monitor Investment Banks currently produce about 90% of the research consumed by asset managers. In response to the new regulations, Investment Banks are projected to reduce their research production by almost 60% (from their highs in 2008). Consequently, managers who historically obtained research from only a couple of providers are at risk! From a due-diligence and risk-management perspective, consultants and Fund Investment Officers should know whether their managers have diverse sources for their research needs. Aside from research provider-risk, managers who move quickly to adopt MiFID II s more efficient bottom-up approach for research budgeting, will enjoy a performance advantage (estimated to approach 10% CAGR), over those firms who lag behind.

11 Greater transparency and accountability into your manager s processes The Central Truth: As prudent fiduciaries, plan sponsors have a right to know how their managers are spending Fund assets; and whether the Fund receives value from those expenditures. In choosing their research services, managers must use robust criteria, that links each research service acquired, to the benefit received by each respective client. Managers must charge each client only the appropriate pro-rata portion of the full cost of each research service (e.g. based on the value of the research to the investment product used by the client). If research is paid for with client commissions (as opposed to lump sum payments from the client s Fund), the trade commission must unbundle the portion allocated for execution purposes, from the portion used to buy research. Any unspent funds in the manager s Research Account must be returned to the client (or used to offset the following year s research costs). When asked, managers must provide clients with a Written Policy demonstrating all of the above!

12 Potential Cost Savings! A Bottom-up Research-Budgeting Process Managers will be more efficient and judicious when purchasing research. Some studies estimate the new policies will reduce research-related commission costs by 15%! Managers currently spend about 16bp of AUM on research. Therefore, a manager with $400 million AUM will save almost $100,000 (of your Fund assets) each year, once they adopt the new procedures. Your Fund will no longer potentially subsidize the manager's other clients. Managers will allocate trades to brokers based solely on those brokers execution capabilities (i.e. not because the manager buys the broker s research). This can only help improve overall execution efficiency. Critically Important! The sooner your managers adopt policies compliant with MiFID II s new regulatory requirements, the sooner your Fund receives substantial benefits.

13 What are we seeing so far? No surprise, most managers are not yet compliant Initial findings (based on approx. 40 managers reviewed in 1Q17 on behalf of Zeno clients): Almost 80% of the managers reviewed used client money to purchase their research. About two-thirds of the managers ran Non-MiFID II strategies, of which 47% nevertheless indicated they intended to follow MiFID II s standards and apply those standards to their US clients. About one-third of the managers ran MiFID II strategies, of which 92% indicated they would apply MiFID II s standards to all of their clients (even if the US clients were not technically subject to MiFID II). 55% of the managers provided only Limited or Deficient levels of transparency (either because they were unwilling to disclose their policies, or their internal systems did not currently capture the data). Of the 17 managers who provided adequate levels of transparency, 59 potential violations were observed, including 13 managers who used funds from Zeno s clients to subsidize the research costs of their other clients.

14 Conclusion Bottom-line: Be prepared to make prudent informed decisions, on an annual basis, if/when you are approached by your managers to approve such research expenditures or fee increases. Recognize that most of your managers are not yet compliant with MiFID II s new regulations. But the sooner they do so, the quicker your Fund will receive the associated benefits. Anticipate some of your managers requesting formal approval of their research budgets in mid/late Recognize that approval of such requests means those amounts will no longer be assets of your Fund. Therefore, consider taking pro-active steps that enable you to prudently fulfill your new annual fiduciary duty (i.e. formally approve/prohibit Fund payments for your managers research budgets). Consider auditing your managers current Soft-dollar practices, to both: Establish a pre-change baseline; and Encourage your managers to comply with the new MiFID II regulations expeditiously. [N]othing of him that doth fade But doth suffer a sea-change, into something rich and strange William Shakespeare, The Tempest, Act I, Scene 2.

15 Appendix: Due Diligence Action Item Check-list Potential initial oversight should include: Determine which managers use Fund commissions to purchase Soft-dollar research services, and their dollar cost to your Fund. Identify the specific services purchased, the amounts paid, and whether those services were consistent with Section 28(e) and the Fund s Investment Policies. Determine whether the Fund received best execution on those trades. Begin discussing the manager s plan for bringing research practices in-line with the new regulations. Determine whether your managers have any unused soft-dollar credits (accumulated from Fund s commissions). If so, after January 2018 they need to return it to you! Additional areas of inquiry (beginning in late-2017): Description of manager s research budgeting process; and/or if they plan to increase their management fee. A comprehensive list (and description) of every research service the manager plans to purchase with Fund assets, and the cost for each service (both the overall cost and the Fund s pro-rata share). Assess whether such expenditures are in-line with what other managers (with the same Investment Mandate) pay? The methodology by which the manager determined the overall price of each research service, and the Fund s prorata cost (factoring in the strategy/product for which the Fund utilizes the manager). How does the manager: coordinate the trading of different accounts if some allow, but others prohibit, the use of Fund assets for the payment of research; and/or coordinate the trading of block-orders when some accounts have fully funded their RPA, but others have not

16 Appendix: Due Diligence Action Item Check-list cont. Monitor for potential longer-term fall outs within the financial industry (as a result of the new regulations), including: Lower Commission rates, but higher asset management fees. Smaller broker lists (since research will be paid for with hard-dollars). Smaller investment managers may become less competitive (due to fewer economies of scale ). Passive Index Managers my become more competitive (due to lower research costs). Research on smaller markets (and/or companies in those markets) may become less diverse, making it harder for managers to add value relative to their peers. Managers may refuse to accept clients who prohibit the use of Fund assets to pay for research (due to MiFID II s prohibition on cross-subsidization of client research costs).

17 For further information please contact: Steven M. Glass Brian Greene President Senior Vice President

18 The information contained herein has been taken from trade and statistical services and other sources we deem reliable but we do not represent that such information is accurate or complete and it should not be relied upon as such. No guarantee or warranty is made as to the reasonableness of the assumptions or the accuracy of the models or market data used by Zeno Consulting Group, LLC (Zeno) or the actual results that may be achieved. The screen shots provided in this presentation represent hypothetical examples of certain products available from Zeno. They contain sample data and are provided for informational purposes only. None of these materials is intended to be used for trading or investment purposes or as an offer to sell or the solicitation of an offer to buy any security or financial product. These materials do not provide any form of advice (investment, tax or legal). All trademarks, service marks, and trade names not owned by Zeno are owned by their respective owners. All functionality described herein is subject to change without notice. These materials are not to be copied, displayed or transmitted in any form without the prior written permission of Zeno.