By Chris Halverson, Senior Vice President, Sales
In recent years, the equity markets have been kind to the financial services industry. Returns have been generally positive, and assets continue to flow in the right direction. What’s gone relatively unnoticed, however, is the overall growth in “managed accounts” – specifically WRAP sponsors, custody platforms (think Schwab, Fidelity, Pershing, etc.), and unified managed accounts (UMA).
According to the Money Management Institute, “managed account assets crossed $10 trillion for the first time during the third quarter of 2021.” On the surface, this sounds great – investors are embracing new and innovative ways to increase returns. But there’s an “elephant in the room” that’s been causing problems for years: best execution issues with managed accounts.
A Multi-Tier Workflow
In the past, a registered investment advisor (RIA) might work with a couple of WRAP sponsors or custody platforms, representing 10-20% of its assets under management (AUM). Now, that same RIA might work with multiple WRAP sponsors or custody platforms, representing 30-50% of its AUM. This creates significant issues with respect to best execution.
To address the various directives associated with managed accounts, investment managers often rely on a “tier system” in which trades are executed sequentially based on an account’s respective tier:
- Tier 1 – Free-to-Trade Accounts
Clients that do not specify which broker-dealers to use for trade execution. The investment advisor has total control of trade execution.
- Tier 2 – SMA / WRAP / Custody Accounts
Accounts that direct the investment advisor where to execute. Trades for accounts held at specific custodians are expected to be executed with their respective sponsor broker-dealers.
- Tier 3 – UMA / Model Delivery Accounts
The investment advisor has no role in order execution. It simply provides the sponsor with updates to the model portfolio.
To address these differing needs, asset managers frequently employ trade rotation, whether across their client base or within each specific tier.
For managers who work with multiple sponsors and custody platforms (Tier 2 accounts), their efforts to treat each sponsor fairly mean the sequencing process is even more complex. If Sponsor A were to always go first, it stands to reason that it would consistently outperform Sponsors B, C, and D, especially when dealing with large (model change) trades or illiquid (micro- / small-cap) securities. This is a natural use case for trade rotation.
Trade Rotation: An Explanation
Trade rotation is exactly what it sounds like: sponsors, along with institutional orders, are put into a rotation either by numerical sequence or using a randomized process. The idea is that no one sponsor will have an advantage over another, and that any short-term performance impacts will even out over time. But while the intent of trade rotation is noble, the practice reflects the fact that the underlying system is flawed.
Who among us would accept a “luck-of-the-draw” approach when buying groceries, concert tickets, or, yes, stocks? It makes no sense. We want to be first in line, have the best seats in the house, and trade at the lowest price. Rotation is a Band-Aid, not a solution. It doesn’t address the root problem: best execution, which FINRA Rule 5310 defines as using “reasonable diligence to ascertain the best market…so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”
More often than not, fixed income securities and international equities trade away from WRAP sponsors for best-ex purposes. But what about domestic equities? Ask any buy-side firm if there’s a price difference between its larger institutional orders and the sequenced trades its WRAP sponsors get – the answer might surprise you. Spoiler alert: it’s more than a penny or two per share. To be clear, we’re talking about the more difficult trades (model change, illiquid names, etc.), as opposed to smaller “maintenance” trades.
Efficiency in the Aggregate
So why don’t investment managers aggregate their WRAP orders with their institutional flow? In many cases, it’s because they don’t believe they can. WRAP accounts are marketed as simple fee-based investments. Execution costs are bundled into these fees – as long as every order is executed with the sponsor broker-dealer. Should a manager trade with a different broker-dealer, its clients would likely incur additional costs (commissions, markups/mark-downs, etc.).
But what if managers could get a better average price for their WRAP accounts by trading them alongside institutional orders? What if they were free to source liquidity wherever they could find it? In an extremely fragmented market, where natural liquidity is increasingly hard to find, why limit where advisors can go? And why risk information leakage on large trades or illiquid securities when the liquidity might be readily available elsewhere?
High-touch institutional commission rates currently range from 1 to 3 cents per share. If you were a retail investor, would you pay an additional 2 cents in commission if it meant your average price were 10 cents better as a result? Clearly, the answer is yes. So why should an institutional investor think any differently?
Unfortunately, most RIAs operate under the false assumption that they can’t trade away from the sponsor broker-dealers, frequently citing the additional fees or expenses involved. In reality, that’s far from the truth. To be fair, some custody platforms still impose punitive trade-away fees, but those fees are shrinking and, in some cases, going away altogether, largely due to investment manager demand.
The good news is that every WRAP sponsor recognizes an RIA’s fiduciary obligation to seek best execution. Just look at the sponsors’ WRAP disclosure documents – while each firm has adopted its own specific language, this mandate to secure the best price available is always the common denominator. For example, according to a large sponsor’s disclosure brochure, “a money manager may execute equity trades through other broker-dealers…if (it) reasonably believes that another broker-dealer will provide better execution, net of any additional resulting transaction charges.” The document further acknowledges that some money managers, “especially small-cap or preferred strategies, execute most or all of their trades through (other) broker-dealers.” Translation: a money manager would trade away only when it thinks its clients will receive a better net price as a result. It’s not complicated.
What is complicated are the operational logistics involved in WRAP trade-aways. An institutional RIA with one or two WRAP sponsors can manage the process much more easily than an RIA with more than 10 sponsors. Working with multiple WRAP and custody platforms is exponentially more time-consuming and inefficient, and execution quality inevitably suffers as a result. Building trades using multiple wealth management platforms takes time, and not executing those orders with the institutional block is a major red flag in terms of best execution. The horror stories are endless. It can take days to execute trades in large-cap liquid names or weeks to execute orders in more volatile and illiquid small-cap stocks, all the while exposing portfolios to unnecessary information leakage and executing trades at vastly different levels.
Addressing the Flaws of Trade Rotation: Be Open-Minded and Embrace Partnerships
On the surface, the answer is straightforward. When possible, managers should combine their WRAP and institutional orders and trade away when they think their clients would benefit. Compliance shouldn’t be an obstacle in that equation. In fact, trading desks and compliance departments should be working together to force the debate internally.
From a compliance perspective, RIAs are required to seek best execution, track any trade-away activity, and disclose any additional costs to the WRAP sponsors and custody platforms. Although their methods may vary, sponsors are required to collect this information and disclose it accordingly. One of the larger managed account sponsors, for example, requires that fees associated with trade-away activity be disclosed on every transaction using the explicit fee field in ACT. Other firms rely on quarterly or annual questionnaires. Either way, the information is not difficult to provide if you have the right partner.
So where do we go from here? How do we address the elephant in the room? There are various approaches outlined in this article, with pros and cons to each. To address the flaws of trade rotation, some managers use step-outs to facilitate settlement with each sponsor. This may be an effective way to keep the block together, but it opens up another can of worms: research participation, different commission rates, one client paying for services used to support other clients, etc. Does it make sense that WRAP clients receive the benefits of research and brokerage services that are paid for solely by institutional clients? Other managers use platforms like CAPIS ARC to simplify operations and fully manage the process. Like most things in financial services, the best answer is typically one that is tailored to fit your needs.
In summary, while the sheer size and number of firms involved in the managed accounts space has created significant hurdles to achieving best execution, it doesn’t have to be that way. With the right combination of trading knowhow, transparency, and trust, advisors managing the assets can solve for operational complexities while enabling the end investors to benefit from the managed account structure. We can call out the elephant in the room, find the right partner, and take a new approach to execution. Everyone benefits in the long run.
