With the Securities and Exchange Commission expected to rule on the use of soft dollars in June, the securities industry is hoping that the SEC will clear up the uncertainties surrounding the controversial practice and determine once and for all who is responsible for placing a value on proprietary research. In anticipation of the ruling - which, at a minimum, likely will result in more transparency into how buy-side firms are spending investors' money - buy-side firms are beefing up their internal controls to track their commission payments for executions versus third-party research.
The challenge, however, is figuring out how much the sell side's research actually is worth. But the SEC may go a step further than just requiring increased transparency into brokerage commissions and force brokerage firms to "unbundle," or break out, the prices they charge for executions, proprietary research and capital commitment individually.
Generally, soft dollars refer to the portion of a brokerage commission paid by money managers that is used to cover third-party research services, such as market data and investment analysis tools. Under section 28 (e) of the Securities and Exchange Act of 1934, known as the safe harbor rule, a manager can "pay up" for a trade - pay more than the lowest price to buy or sell a stock - if the manager believes the research will add value to the investment process. Asset managers must be in compliance with the safe harbor rule to justify soft-dollar transactions.
Today, bulge-bracket firms charge a bundled commission - four, five or six cents a share, for example - that covers the cost of both the execution and proprietary research. If the SEC rules for greater transparency, the buy side will have to come up with a process to value the sell side's research. However, if unbundling is mandated, the burden will shift to the sell side, as it will be required to put a price tag on its proprietary research (which includes research reports, analyst calls and conferences to which brokers have access) before charging its buy-side counterparts. According to industry sources, a mandate to unbundle commissions could reshape the brokerage and money management landscapes.
Prepping for Transparency
Although the outcome of the ruling still is in doubt, most believe the SEC will rule in favor of soft-dollar transparency. As a result, the buy side is scrambling to get technology and processes in place to ensure that it can track trading commissions and come up with a process to value research.
Currently, to calculate their commission budgets, buy-side firms typically conduct what's known as a "broker vote," an internal process in which all of a firm's portfolio managers, analysts and traders qualitatively assess the value of the various services provided by different brokers and decide which firms' services they want to buy. Asset managers may develop their own voting system based on internally developed qualitative factors, using points or a ratings system.
For example, Darren Bodenhamer, head trader at JMP Asset Management, a San Francisco-based hedge fund, relates, "We have a quarterly voting process in which we quantify the value of research and execution from each broker. We're all involved in the process."
To augment the process, buy-side firms are ramping up their systems to help them track executions and value the research and other services they receive from brokers. Bodenhamer notes that his firm purchased Traders Console, an order management system developed by Boston-based Eze Castle Software, to track its commission payments to brokers. The system allows the hedge fund to break out commissions by using labels such as "r" for research, "e" for execution and others, he explains.
Another buy-side firm enhancing its technology in preparation for the SEC's ruling is The Boston Company Asset Management. To make its commission budgeting and allocation process more rigorous, the asset manager implemented Eze Castle's Commission Optimizer. The firm now is in the early stages of tracking and evaluating what it consumes from sell-side research.
"With the regulatory environment moving toward increased disclosure on third-party soft dollars and toward an unbundled structure on proprietary research, we needed to go beyond having an anecdotal, subjective assessment twice a year that didn't integrate the actual interactions we were having with our brokers and their actual inputs we were using from brokers as part of proprietary research," says David Brooks, head trader at The Boston Company Asset Management.
Now, the investment firm uses the commission management system to track all of its interactions with brokers more dynamically, notes Brooks. "We're trying to get a much better handle on what we're consuming and what is the value of what we're consuming," he says. To track the interactions that portfolio managers are having with brokers on a daily basis, assistants enter the data into Commission Optimizer. When a broker introduces the investment firm to a company's management, or a sell-side analyst stops by the firm, or the broker sponsors a conference, or the firm takes away ideas from a conference call, the information is logged into the system. The firm is not yet tracking written research, however, "because the volume of product is too immense to track," says Brooks.
Scrutiny from All Sides
Aside from regulatory pressures, buy-side firms are facing scrutiny from pension fund clients, independent boards of directors and trustees about why they are paying commissions to various brokers and whether they are getting value from the research, according to Donna Anderson, director of research at AIM Investments, a Houston-based mutual fund manager with about $141 billion in assets. "We're not necessarily setting a price on research - we're trying to quantify the value we get from research and we're trying to send it to our internal management and to our own internal board of trustees," she says, adding that "When it comes to firms that have a bundled execution and research product, we need a way to rate the information we're getting as well as the executions we're getting."
As a result, less than a year ago, AIM purchased a system called ResearchTrak from Cogent Consulting to help the firm understand its total commission picture. Prior to implementing the system, under pressure from the mutual fund company's board of trustees, AIM had revamped its voting structure for the purpose of more clearly differentiating its brokers, Anderson relates.
AIM is using its Web-based system to track proprietary research services down to the individual resource level, with the hope of placing a value on brokers and their research. A resource can be a specific analyst, a conference or set of conferences, a specific quantitative tool or a data set, Anderson says. The software provides a detailed menu of resources provided by every brokerage firm. The fund management firm populates the system with the names of all the analysts at every brokerage from a database provided by Starmine - a San Francisco-based company that measures the performance of sell-side analysts - and conducts a vote twice a year. The head of research administers the vote, which includes all the portfolio managers and analysts; the trading group conducts a separate vote on the execution and sales trading relationship.
How Much Is That Research in the Window?
By using the technology to create a more detailed voting process, AIM has been able to place a value of sorts on its brokers and thus on its research. ResearchTrak has allowed AIM to create a scorecard with which to identify brokers' strengths and weakness. The firm communicates to its brokers how individual analysts rank by sector or company versus their peers. This type of feedback is appreciated by brokers and helps asset managers work in partnership with Wall Street firms as it gives the brokers specific tips on how to improve their rankings to compete for more commission dollars.
Money managers use the voting process to set commission targets for each broker, and they may put brokers in different tiers. If the OMS system is feeding trades into the commission management system, a buy-side firm can see where a broker ranks on a commission basis against the targets and compare the broker's commission ranking to its research ranking, which asset managers base on quality or perceived value. "Clients look very closely at the disconnect there," says Robin Hodgkins, president of Summit, N.J.-based Cogent Consulting. "Better-rated brokers should be getting more of your commissions," he says. "If a broker is providing better service, their commission should be going up, and if they're providing worse service, their commission should go down."
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio