This article appears courtesy of Global Investor.
You get what you pay for is one of those unhelpful adages that is usually only employed when what you pay for is a disappointment. It can also be manifestly untrue. The intricacies of modern commerce can shield any number of material facts on how business is conducted on your behalf: how do you know what you’re paying for? Your chief interest may be in the outcome of the transaction rather than the processes that led to it, but do you really know how your money is being spent?
The first years of this century saw what was arguably a breakdown in trust between investors and their professional advisers. A succession of high-profile market scandals in the US led regulators to place a renewed focus on how and where investors’ money was spent. Much of this effort went into assessing what constituted acceptable management fees and investment costs.
In the UK, the Financial Services Authority tried to unravel commission structures and enhance disclosure standards for bundled brokerage costs and so-called soft commissions – those where no money changes hands, but services are provided instead.The industry also tried to put in place voluntary arrangements. In the US, the Association of Investment Management and Research (the former name of CFA Institute) issued its Soft Dollar Standards, based on three clear principles:
i) Soft dollars belong to
the client;
ii) Investment managers may only purchase research with client brokerage if the primary use of the research, whether a product or service, directly assists managers in their investment decision-making process and not in the management of the investment firm; and
iii) Investment managers are fiduciaries and therefore must disclose all relevant benefits they receive through client brokerage.
An additional piece of research conducted in the US and Canada in 2004 looked specifically at the issue of directed brokerage, whereby investment firms direct their trading to brokers as a reward to them for selling their funds. Some 61% of respondents supported mandatory disclosure of such arrangements; another 32% said they should be prohibited outright by regulation. When the FSA began to unpick the soft commissions in the UK industry, CFA Institute again advocated these principles and encouraged the FSA to address these. The FSA ultimately called for increased standards of disclosure of commission structures for its regulated firms, and also defined non-permitted services that could not be provided by soft commissions (such as computer hardware, seminar fees and travel or entertainment costs).
Bundling problems
The FSA also commissioned research from Oxera which showed that the practice of bundled brokerage not only impaired investors’ ability to see how managers were spending their brokerage, but that it also cost UK investors £500 million to £720 million each year through over-consumption of additional services, excessive dealing and poorer-quality investment decisions and execution. CFA Institute added that bid-ask spreads could mask what are in effect commission payments: while the manager requesting the trades may not pay an overt commission, from the broker’s perspective the spread accomplishes the same thing. And because alternative trading systems diffuse the overall market order flow it is becoming harder for regulators to track what portion of these spreads is a legitimate transaction cost and what is effectively brokerage.
Oxera also found that softing arrangements resulted in managers buying an estimated £120 million in market information and other non-research products and services, £48 million of sell-side research from brokers, and £40 million of third-party research. The argument could be made that these activities in some instances make the production of research into smaller quoted companies economically viable, for instance, and could allow smaller managers and brokers to participate in the market, increasing the level of competition for investment services, and promoting the use of third-party research.
These benefits are not consistent, however, and do not outweigh the benefits of greater transparency to investors. Studies have shown that increased levels of transparency provide significant benefits to investors and issuers alike, through increased trading volumes and smaller bid-ask spreads.The CFA Institute Code of Conduct for Asset Managers advocates clear standards of disclosure to clients. It requires fund managers: to communicate with clients on an ongoing and timely basis; to ensure that disclosures are truthful, accurate, complete, and understandable and are presented in a format that communicates the information effectively; and to include any material facts when making disclosures or providing information to clients regarding themselves, their personnel, investments, or the investment process. Disclosures must be meaningful – it adds nothing to the manager-client relationship to say that the fund manager may or may not hold shares personally in any companies. Clients must have full and complete information in order to judge the abilities of managers and their actions in investing client assets.
Specific disclosures called for in the Code are:
i) Conflicts of interests generated by any relationships with brokers or other entities, other client accounts, fee structures, or other matters.
Best practice is to avoid conflicts of interest where possible, but inevitably in the investment management profession such conflicts arise eg: soft or bundled commissions, referral and placement fees, trailing commissions, sales incentives, directed brokerage arrangements, allocation of investment opportunities among similar portfolios, and the use of affiliated brokers. When managers cannot reasonably avoid conflicts, they must carefully manage them and disclose them to clients.
ii) Regulatory or disciplinary action related to professional conduct.
Past professional conduct is an important factor in an investor’s selection of a manager. Information on investigations by regulators or other bodies and breaches of professional conduct standards must be disclosed.
iii) The investment process, including information regarding lock-up periods, strategies, risk factors, and use of derivatives and leverage.
This safeguards both parties to any client-manager agreement by ensuring there is agreement and understanding of how investment decisions are made and implemented. The Investment Policy Statement – an agreement between the client and fund manager covering such issues – should govern expectations of how the fund will be managed. Understanding the basic characteristics of an investment is an important factor in judging the suitability of each investment on a stand-alone basis, but it is especially important in determining the effect each investment will have on the client’s portfolio.
iv) Management fees and other investment costs charged to investors, including methodologies.
At a minimum, managers should provide clients with gross- and net-of-fees returns and disclose any unusual expenses, plus the methods for determining all fixed and contingent fees and costs that will be borne by investors and the transactions that will trigger the imposition of these expenses. This is in accordance with the internationally-recognised Global Investment Performance Standards (GIPS).
v) The amount of any soft or bundled commissions, the goods and/or services received in return, and how they benefit the client.
Commissions belong to the client and should be used in their best interests. Clients deserve to know how their commissions are spent, what is received in return for them, and how it benefits them.
vi) The performance of clients’ investments on a regular and timely basis.
It is reasonable for clients to expect to receive regular performance reporting about their accounts. Unless otherwise specified by the client, managers should report to clients at least quarterly, and when possible, such reporting should be provided within 30 days after the end of the quarter.
vii) Valuation methods used to make investment decisions and value client holdings.
Clients deserve to know if the assets in their portfolios are valued based on closing market values, third-party valuations, internal valuation models, or other methods. This disclosure should be made by asset class and must be meaningful (not general or boilerplate).
viii) Shareholder voting policies.
It is the responsibility of shareholders to engage actively as owners of companies in which they invest. Similarly, managers must vote with their shares in the best interests of clients. They must adopt policies and procedures for the voting of shares and disclose those policies and procedures to clients.
ix) Trade allocation policies.
Managers must give their clients a clear understanding of how trades are allocated and provide realistic expectations of what priority they will receive in the investment allocation process.
x) Results of the review or audit of the fund or account.
If a manager submits its funds or accounts for an annual review or audit, it must disclose the results to clients. Such disclosure enables clients to hold managers accountable and alerts them to any problems.
xi) Significant personnel or organisational changes.
Clients should be made aware of significant changes – such as personnel turnover and merger and acquisition activities – in a timely manner. Clients have a responsibility to monitor how their assets are managed, but in order to fulfil this responsibility they must be able to count on full and fair disclosure from their fund manager. By committing to a culture of transparency, fund managers can take an important step towards building the trust and confidence necessary for long-term relationships with clients.
Performance, people and process – the secrets of a successful manager/client relationship
Daniel Broby, ASIP, of the investment board of BankInvest Group in Denmark, and a volunteer member of the CFA Institute’s Capital Markets Policy Committee, says that five “soft skills” are vital in developing a successful relationship between manager and client.
1) The investment process is everything. It is what has been sold to the client. It is what delivers alpha, as opposed to beta. Alpha is the risk-adjusted return which is attributable to the skills of the portfolio manager. He or she can only do that through a rigid process that is repeatable in future. The portfolio manager who departs from this agreed process might still produce alpha, but if the process is not being followed then the client is not being given the service he or she has signed up to. The client has bought the process: performance, people and process are what this business
is all about.
2) Prepare the client for the scenarios under which your portfolio will underperform. This will happen at some point: it could be due to high interest rates, volatile markets or the outperformance of deep value stocks. But it will happen. Encourage your client to think for the long term.
3) Explain the difference between strategic and tactical asset allocation. In a bear market the portfolio is going to go down: it should not be expected to do otherwise. But it is always tough to tell a trustee, who may not have that much experience of the markets, that it is doing so. If tactics do not work in the short term, the long term strategy will deliver the required results. Clients should be shown the distinction between tactical and strategic approaches, and be encouraged to think long term – like their portfolio managers.
4) A common mistake of many managers on the soft skills side is to keep up contact in the good times and not the bad. The clients or plan sponsors are not as concerned about the good times – those can be taken for granted – as they are about the bad. It is in periods of underperformance that good communication is crucial. It is natural to prefer giving good news to giving bad news, but this is not what your client needs.
5) And finally, the portfolio manager’s dirty secret: we really do not like marketing ourselves. We do not like being rolled out to meet with potential clients. After the initial meeting it is the client services team that manages the relationship, not the portfolio manager. The portfolio manager’s job is to deliver alpha for the client, so the marketing team – and the client – should be content to let him or her get on with the
job and make no further demands on valuable time. Everybody wants to shake hands with the person managing the investments but, when you think about it, that’s the last thing you want the portfolio manager to be doing.
