By Mark Viani, Director, Institutional Sales
A follow-up to The Elephant in the Room: Best Execution Issues in Managed Accounts
Some time ago, my colleague Chris Halverson penned an article on the growing managed account space and the best execution issues that this growth has created. At the risk of overstating the case, I’d like to reopen that discussion. Best execution, trade-away penalties, public disclosure vs. reality, payment for order flow, trade rotation – these are all big, touchy subjects to address. But we all have a vested interest in better serving investors and making our industry as good as it can be, so let’s dive back in.
First, some basic facts. As of EOY 2022, according to the MMI-Cerulli Advisory Solutions Quarterly, total AUM for the managed account space stood at $9.6 trillion. That’s a lot of mom-and-pop money. These assets generally are invested in equities, ETFs, and fixed income securities. Typically, fixed income securities are traded away from the WRAP and custody platforms, while equities and ETFs are not. Why? The answer touches on one of the worst-kept secrets in our industry.
In the simplest form of the managed account structure, asset managers are hired to sub-advise portfolios for retail-type accounts that custody with WRAP and custody platforms. These subadvisors make investment decisions, create orders, and route the trades back to each platform for execution. It’s a fairly straightforward model. The challenges begin to emerge when the widely accepted practice of trade rotation enters the picture.
Trade Rotation: A Flawed Process
Trade rotation is the process by which an asset manager (subadvisor), managing like portfolios for multiple platforms (and in many cases for institutional clients as well), creates like orders for these clients and executes them in a predetermined sequence. A typical rotation may first execute trades for Platform A, then Platform B, then Platform C, and so on. For the next trade or next day, the order changes – trades for Platform B are executed first, followed by Platform C, with Platform A going last. Not all subadvisors use the same method of rotation, but you get the picture.
So what’s the problem? As long as everyone gets their turn to go first, doesn’t it even out over time? In a perfect world, it would – but we don’t live in a perfect world. Trade rotation takes the inherent disadvantage of going last and replaces it with clients being disadvantaged at random. It might seem equitable, but it’s anything but. Performance disparities in the managed account space are common, especially when trading more illiquid securities. This means that unless all clients get the same exact execution price, rotation is always unfair.
If that’s the case, then why use this process? Why don’t subadvisors simply aggregate these like orders, trade them away, and step out the executions to the WRAP or custody platform? The answer goes back to misconceptions, arcane costs, and inflexible business models.
Let’s start with the subadvisors. Many of these firms are under the impression that they are not allowed to trade away. They truly believe that the end-client expects all executions to be completed by the platform for free. If this stipulation were included in their client contracts, then they would be correct – but in most cases, it isn’t. The published ADVs of both the subadvisors and platforms specifically state that subadvisors may trade away to achieve best execution when they reasonably believe they can get a better net price. Any extra costs or fees, such as broker commissions, are paid by the client.
Obstacles to Trading Away
So, if trading away for best execution is clearly described and identified as permissible in most ADVs, then why do most subadvisors avoid doing it? The answer is one of the worst-kept secrets in the industry. Let’s break it down:
- Subadvisors may be fearful that their clients will question why they are being charged extra for trading away
- Subadvisors may also be fearful that the platforms raising assets for them will take a negative view of trading away and divert those assets to other subadvisors that do not trade away
- Some platforms that publicly claim to allow trading away tell a different story in private and try to dissuade subadvisors from engaging in the practice (yes, this happens)
- The platforms tell the subadvisors the trade-away process causes too many fails (a poor excuse)
- The platforms want to retain these executions because they receive payment for order flow – just check their routing reports
- The platforms ultimately allow for trade-aways, but impose stiff trade-away penalties (as much as $25 or more per client, per allocation), making it impossible to justify the additional cost per trade and thus deterring the subadvisor from achieving best execution
- The platforms refuse to waive the trade-away penalty (another deterrent), and the subadvisors ultimately let the issue go because they don’t want to sour the relationship
What other practices are curtailing the ability of subadvisors to trade away?
- WRAP sponsors are allowing some but not all subadvisors to trade away, advantaging some subadvisors over others
- Custody platforms are charging trade-away penalties to some subadvisors and waiving the fee for others, creating another unfair advantage for those with clients paying no fees
Regaining Control: A Step-by-Step Process
So where do we go from here? What is the first step toward subadvisors having more options for seeking best execution and a more level playing field? It is important to note that most fixed income managers routinely trade away without penalty. If nothing else, this tells us that the practice is possible – but it requires subadvisors to embrace a new approach.
Step One: As a subadvisor, you need to take an honest, in-depth look at your current process and determine whether the aggregation and trading away of orders will help you achieve best execution. Do you manage institutional assets alongside multiple platforms? Do you occasionally have orders greater than 5% of ADV? Does it take hours or days to complete your rotation process? Do you have performance disparities among accounts? If you answered yes to any of these questions, your trade rotation process is probably the issue.
Step Two: If you come to the conclusion that your trade rotation process is a problem, you need to bring it up with the WRAP and custody platforms. Trade-away penalties should be waived, at least for trades over a certain percentage of ADV. In making your case, keep in mind that trading away from these platforms does not need to occur on every trade, just where aggregation will bring better results. These tend to be tough conversations, but if you make your points clearly and honestly, a reasonable compromise should result. It may take time, but don’t back down. Best execution is in the interest of all parties.
Don’t be afraid to ask the pointed questions. Subadvisors should ask custody platforms why their trade-away fees are waived for some but not for others. Likewise, they should ask their WRAP sponsors why some subadvisors are allowed to trade away and others are not.
Step Three: Once you successfully negotiate the elimination of trade-away penalties on all or at least some of your orders, you must find a way to aggregate the orders and report the executions to the platforms. This might sound simple enough, but many platforms do not make it easy. Some require “net” prices to be reported, rather than disclosing the execution price and the commission separately. One answer is to step out without commission, but this disadvantages your institutional clients that do pay commissions.
Experience the Difference
This leads to the one and only plug for my company, CAPIS. After 10+ years of trying to solve the trade rotation process at various industry firms, I landed at CAPIS and co-created a process that enables subadvisors to trade with any broker, settle DVP to a CAPIS brokerage account, and step out “net” with commission to WRAP or custody platforms. To simplify order creation and aggregation, we also use a few middle-office solutions specifically designed to support the platform management process. It’s a fairer, more efficient process from start to finish, and I encourage you to reach out, learn more and experience the difference for yourself.
Bottom line: the managed account space needs to see real change, and fast. There are solutions out there – they just need to be employed. Subadvisors don’t have to sit by and watch this happen. It’s time for them to trade away and step out the executions to the WRAP or custody platform, and for the platforms to waive their penalties and empower subadvisors to achieve the best execution possible. It’s time for transparency and for the industry to align its practices with the needs and interests of its clients.
All discussions on this topic are welcome. If you’d like to have a conversation on how we address the challenges of trade rotation, or on any other part of our business, don’t hesitate to reach out.
