With cost cutting a priority for most pension funds, providers of commission recapture programmes should have no trouble persuading funds to sign up. After all, commission recapture gives investors a systematic way of recouping some of the brokerage commission they pay.
But not all pension clients make use of it, and some say they find it a rather roundabout way to access discounted broker rates.
“We do use commission recapture,” says the manager of one major UK pension fund, “We’re able to negotiate that a significant part of what we pay is rebated…but it’s an absurd structure.”
The idea of commission recapture originated in the US, where it grew out of the practice of soft commission, or soft dollars. With soft commission, a broker executing trades for a fund manager agrees to pay for investment research services for the broker out of the commission they receive. The practice of soft commission has been criticised for its lack of transparency.
In the late 1990s, a report from the Securities Exchange Commission in the US said more disclosure was needed about the details of the business. The lack of controls may have allowed some money managers to use soft dollars for their own overheads.
But commission recapture is a far more clear cut practice than soft dollars, with rebated commission clearly quantifiable as a cash sum. In 1985, the concept of commission recapture crossed the Atlantic, with the first UK pension fund setting up a programme. Since then, numbers of investors using it has increased, though for the first decade or so, it was limited to subsidiaries of US companies.
Now, however, commission recapture is a popular product with many institutional investors whether they have links to a UK firm or not. Frank Russell Securities was the first provider in Europe, but there are several other firms which have been offering commission recapture to European clients since the early days, including Lynch, Jones & Ryan, Bank of New York and Northern Trust.
John Barlow, director, product management at Northern Trust Global Investments, says there is a widespread use of commission recapture by pension funds in Europe, though trustees and plan sponsors may not fully understand the mechanics in great detail.
“Most would have a reasonable idea it provides a vehicle for clawing back some of the commission that has been paid, but don’t necessarily understand the key drivers,” he says.
Self-managed pension funds have generally not used commission recapture, but there is considerable potential contained in the service for those managers wishing to better manage their commission flow, he says. “Through the flexibility it adds commission recapture is a good way to further add value to the fund, by actively managing effective commission rates, especially when trading volumes exceed original expectations with the brokers.
“Commission recapture has matured over the last few years into commission management,” he says. “It’s now being used much more by the industry to actively manage their commissions spend rather than as a method simply to claw back an arbitrary commission amount.”
Some trustees find it hard to see why it is necessary to have a relatively convoluted way of getting a cheaper price for securities trades. But Barlow explains that managers simply cannot negotiate commissions on only a certain part of their trading.
“Managers have many clients who they’re executing trades for at the same time. So trying to negotiate a rate for each and every client would be an impossible task. However, commission recapture is a tool that managers can use to manage this without affecting the trading relationships with the brokers.”
Natalie Pilcher, director of implementation services for Russell Investment Group, says one of the challenges providers have is still getting commission recapture onto trustees’ agendas. “They think, this sounds like a free lunch – and we all know there’s nothing like a free lunch,” she says. But this service, she says, is probably the closest thing anyone is going to get to having one.
Early in the summer, the Bank of New York bought New York-based commission recapture specialist Lynch, Jones & Ryan from Instinet Group for up to $159m (e122m). It now operates LJR as a subsidiary of its BNY Brokerage arm, and is consolidating its commission recapture business under the LJR name.
Ivan Royle, the Bank of New York’s European spokesman, said that the bank’s acquisition of LJR sends a strong signal that it is bullish on the prospects for commission recapture business this side of the Atlantic. “We think there’s a large future for it (commission recapture) in continental Europe, where we’re seeing much more interest in value-added services,” he says.
Ann Ellis, vice president of LJR, says the specialist firm has more than 2,000 funds worldwide in its commission recapture programme. “Our clients total assets amount to more than $3trn, making us a formidable player,” she says.
Commission recapture is, she says, an ideal way to reduce commission costs for pension funds. The reason behind this being when a pension fund outsources investments, it then has no direct say over what level of commissions are paid. “As soon as a pension fund outsources its investment management to a fund manager, they lose control of the commission costs,” says Ellis.
With a commission recapture programme, the fund manager continues to deal with its brokers to ensure that best execution is obtained for each trade, and commission continues to be charged to the pension fund directly. Part of the trade is directed to the client’s LJR account, and this forms the refund to the client. This helps unbundle the commission costs, she says.
“When a fund manager strikes a deal with a broker the level of commission has already been agreed. This will be for execution and research costs,” she says. “Commission recaptures allows the client to unbundle this cost to in effect achieve execution only on part of its trades.”
When a pension fund participates in a commission recapture programme through LJR, then whenever a trade is conducted through a broker on the LJR correspondent broker list, commission is paid as normal, but a proportion of it is rebated. This gives the pension fund an execution-only commission on a certain part of its stock trades, she says.
This is why commission recapture only works on segregated active equity mandates. Passive investment is mostly done on an execution-only basis anyway, any it is impossible for pension funds to recapture commission paid on their behalf within pooled funds.
As part of their current all-round vigilance over safeguarding the value of their assets, says Pilcher, pension funds are focusing mainly on performance, “because that’s the most quantifiable thing.” But they also see the cost of trading as key for them.
When the Myners’ Report in the UK investment industry came out, trustees were asked to find out what they could do to cut their commission costs, says Natalie Pilcher. Participating in a commission recapture programme is something they can do to achieve visible cost savings, she points out.
Generally, pension funds can receive between two and four basis points of the equities in the programme as rebates, she says. So if portfolios of e100m are involved, then the fund could receive e20,000 to e40,000 in annual rebates.
Most commission recapture programmes involve the setting of some kind of target for fund managers – that a certain proportion of all trades should be directed through the programme and therefore attract the broker rebate. But providers and consultants warn that there are dangers in going too far with this.
Normally a pension fund would opt to direct on average up to 25% of total equity trades through the commission recapture programme, but the proportion it chooses is flexible. “Some managers will participate below that and some will participate above… each manager will have their own view,” says Natalie Pilcher.
Russell is very conservative in setting targets, says Pilcher. “We don’t recommend a target at all,” she says. “But in our experience we have seen a proportion of 25% which works. That seems to be the level that works for the client, in that they make enough savings, and for the manager in that they remain an important client for the broker.”
Because fund managers have to be careful not to demand very heavy levels of commission rebate from their broker. The effect of this could be to brand them as execution-only clients, and they could then lose out on research information – which is the lifeblood of their success. They may find they no longer get the first call of the day from their broker, for example.
Sometimes, pension fund clients might be keen to direct a higher percentage into a commission recapture programme, says Pilcher. “We will clearly explain that that isn’t the most sensible strategy,” she says. In any commission recapture programme, there are three parties – the plan sponsor, the manager and the broker, and you have to be sensitive to the needs of all of them, she advises.
Ensuring that they get the best execution for any securities trade is part of a trustee’s fiduciary duty, and it is important that commission recapture does not interfere with this, she says. Managers must not be asked to change the way they execute trades.
Russell has 26 brokers on its list, says Pilcher. “We don’t have any affiliated brokers, because we don’t want to put in any incentive for the manager to use a broker that they wouldn’t ordinarily use.”
And if there is some part of the portfolio where particular local brokers ought to be used, it is wise to exempt that from the programme, she says.
Ellis sees Europe following the trend in the UK & US in terms of the use of commission recapture. “It’s hard to find a fund in the US that doesn’t have a commission recapture programme,” she says. “Now many UK pension funds run a programme.” As well as this, commission recapture is broadening out as a service which is not only used by pension funds to one that is used by anyone who is an asset owner, she adds.
This trend is likely to happen in the rest of Europe too, she says, adding that LJR already has clients in the Netherlands, Germany, Italy and the Nordic countries.
But some in the industry point to the way investors are reassessing asset allocation over the long-term. Equities are seen as a poor match for the long-term liabilities of pension funds, and if equities were to be used less, then inevitably, the use of commission recapture would shrink.
And while the FSA is speaking out against inflated commissions, if they are reduced, then there will be less room for brokers to make rebates to clients.