Reclaiming what is yours
Are brokerage commissions on securities transactions too high? Pension fund managers in Europe, who believe they are paying too much for transactions, are now more aware that there is something they can do about it. Setting up a commission recapture programme can rebate considerable sums in commission paid.
Russell Investment Group says the appetite for commission recapture services from institutional investors in Europe is still strong. Over the last five years, savings made by Russell’s programme have grown by an average of 15%. In the last year alone, the group delivered £12.5m (e18m) in savings to its European commission recapture clients.
“So the benefits are very tangible,” says Adrian Jackson, managing director, institutional sales at Russell.
In commission recapture, a portion of commissions is returned directly to the investment end user – the fund that owns the assets. When your investment manager or sub-adviser executes a trade with your recapture broker, part of commission or spread paid by that manager is recaptured and rebated directly to the fund, unusually as a hard-dollar cheque sent to your custodian. The rule for use of recaptured commissions is simple: they must benefit the fund. Thus, rebates may be reinvested or used to pay for authorised expenses, like actuarial, consulting or legal fees.
By contrast, soft dollars are research credits used by investment managers to pay for broker research. Soft dollars are a long-time industry practice and are sanctioned by law.
The idea crossed the Atlantic when a pension fund in the UK set up a commission recapture programme. For the first decade or so, in Europe, the practice was limited to subsidiaries of US companies.
Commission recapture is now a popular product among institutional investors in Europe, whether they have US links or not. The first provider was Frank Russell Securities. However, several firms have now begun offering recapture programmes to European clients, including Lynch, Jones & Ryan, Bank of New York (BNY), State Street and Northern Trust.
Jo Sellers, vice-president at BNY Brokerage, says the BNY arm sees continued take-up of commission recapture services in the UK and the rest of Europe. However, some countries, such as the Netherlands, Belgium and the Nordic countries, are moving faster than others.
However, some managers doubt that commission recapture will ever be as big a product in Europe as it is in the US, due to the European structure of the institutional investment market. The extensive use of pooled investment vehicles in Europe, where commission is paid on behalf of pooled vehicles, means it cannot be recaptured. This makes recapture programmes less economic, because only a proportion of portfolios are even eligible.
It is impossible for pension funds to recapture commission paid on their behalf within pooled funds. Only the investment managers could, in theory, do this, but they have no interest in doing so, says Nicholas Bonn, executive vice-president at State Street Global Markets. This is because the commissions are used to pay for their research.
This sort of bundling of commissions was criticised by Paul Myners
in his report, as vastly overstating
the value of broker research, but
Bonn doubts that the practice will change. It is simply too embedded in the way the industry works, and the change would be too radical. “But
I do believe that more transparency
is in the works,” he says.
In any case, even with segregated mandates, commission recapture does not always work. John Barlow, product manager, commission recapture and transition management at Northern Trust, says it is with traditional investment styles – active equity – that commission recapture works best, where there is a heavy reliance on information on the part of the manager. “With passive, it is pretty much all done execution-only,” he says.
There is a definite focus now on cost, says Barlow. “Brokers in particular are keen to make their relationships profitable, and managers are keen to do the best job for their clients. Also, they want flexibility about how they pay for the services their broker provides.”
Managers can work out with their broker how much they are directing into soft-dollar services, he says.
Although commission recapture lends itself to any type of active segregated equity mandate, Russell says that as a general rule, most pension funds interested in implementing a commission recapture programme have over £100m in segregated active equities.
Pension funds can choose to operate a commission recapture programme through any of the providers. It does not have to be through a brokerage group linked to their custodian. The products offered by the different providers can seem similar, but each one tries to differentiate itself to attract business.
State Street, for example, targets particularly good reporting, detailing for the client not only how much a particular manager has rebated, by showing what percentage of the total recaptured commission this represents, and how it compares against others on the list. “The information reported is getting much richer,” says Bonn.
When choosing a commission recapture provider, the main criterion for pension fund trustees should be the flexibility of the programme, says Bonn.This means, how many options there are through which to exercise the recapture progamme. “You can get concern about what that [the commission recapture_programme] does to their best execution responsibility,” says Bonn. “A good programme has 10, 15 or 20 different brokers to select from, so that their process doesn’t have to change.”
Jackson points out that it is very important that a funds investment managers are able to continue
trading in the same way and with
the same brokerage partners effectively as if no programme was in
place. So there could be potential trouble if the recapture provider was affiliated with a particular brokerage outlet in the programme.
“In our experience, managers can be incentivised to trade though affiliated brokers, which would inevitably impact their trading patterns,” says Jackson. “We manage this potential conflict by opting not to be affiliated to any particular broker.” Russell has 25 correspondent brokers that
participate in its commission recapture programme.
Barlow says pension fund clients initiate commission recapture programmes in order to cut costs as well as to increase transparency. Clients have joined Northern Trust’s programme in a number of markets, though how much the programme can be utilised depends on the use of brokers, and the fund manager. For instance, where a fund manager is operating in a local market, they may only use local brokers who may not be part of a programme.
In a commission recapture programme, 10-30% of trades are directed through it – typically 20%, says Barlow. It is also dependent on the various investment styles used, he says.
Sellers says funds using recapture programmes can expect to reduce their overall commission charges by 10-15%. “But it’s not as clear cut as that, because there are different rates in different markets,” she says. Apart from the savings, commission recapture does provide a lot of disclosure for clients, she says.
“It allows them to take more control of the assets of the fund. It provides some transparency over what the commission is used to paying for,” she says.