This article was penned by CAPIS
With commission rates at historic lows, it seems reasonable to believe that commission recapture is no longer viable. However, most investment managers rely on commissions to acquire research, providing the basis for the commission recapture discussion.
At its core, Commission Recapture is a discounting mechanism for full-service/research rates and can be an effective strategy for reducing commission costs. In 2004, the SEC recognized the value of commission recapture programs stating, “Foregoing an opportunity to seek lower commission rates, to use brokerage to pay custodial, transfer agency and other fund expenses, or to obtain any available cash rebates, is a real and meaningful cost to fund shareholders.” SEC Release No. IC-26356. But do recapture programs still work today?
To find the answer, one must analyze the brokerage statistics for each sub-advised CIT. Funds that trade at sub-penny rates are generally not viable candidates for recapture and internally managed CITs tend to avoid directing themselves. Using a standard commission management template, we can identify the average cents per share (cps) and the percentage of “full-service” commissions, identified below using 2.0 cps or greater.
Based on the data above, the Sector Rotation and the SMID Equity funds would not be good candidates for recapture. Both execute trades at 1.0 cps and do not pay full-service rates (nothing at or above 2.0 cps). However, Large Cap Growth and Technology Sector are perfect candidates. A high percentage of commissions greater than $0.02 per share can lead to strong recapture benefits.
Next, one must ask the question, “is it worth it?” The answer depends on your perception of value. In the real-life example above, the funds generated ~$100,000 in shareholder benefit through recapture, with each fund directly benefiting from its respective recapture activity. In the case of Technology Sector fund, participation in the recapture program reduced their average commission rate from 2.8 cps to 2.4 cps. Note: In the case of small funds, such as the Mid Cap Value portfolio, it may not be sizable enough to benefit from recapture. As a rule of thumb, if the average trade size is less than 500 shares, commission recapture may not be possible.
If recapture does make sense, how do you avoid unintended consequences?
The most common concern is best execution. A poorly designed recapture program can create a trade rotation process that can negatively impact execution quality. In every case, this structure should be a non-starter. The good news is that most firms offering commission recapture programs provide a variety of execution alternatives, including full-service and electronic trading venues that allow investment managers to satisfy recapture requests without changing their current trading process.
Research access is another area of concern. Managers that pay commission rates eligible for recapture are often managers that use their commissions for research. Will recapture impact the manager’s ability to acquire the research necessary to maintain performance? When AUM is growing, commission budgets tend to be flush, and recapture is effective. Alternatively, when AUM is decreasing or turnover is unusually low, commission budgets may be oversubscribed, and recapture may be more difficult.
That being said, it brings us back to the original question, “does commission recapture still work for CITs?”
The answer… Maybe.
Although commission rates continue to trend lower, recapture may still be a useful tool, allowing CITs to reduce commission costs for their shareholders. However, one should do the analysis first, identify the opportunities and consider the overall impact. As long as investment managers continue to use client commissions to acquire research, commission recapture will remain a topic of debate.
If you would like more information, please contact Coleen Donohue at [email protected]. Follow us on Twitter (@capisinc) and LinkedIn for more updates and insight from our team.