A follow up to “The Elephant in the Room“:
Best Execution, Trade Away Penalties, Public Disclosure vs. Reality, Payment for Order Flow, Rotation (the fairest way to disadvantage all clients equally)
Why write this article, you may ask? To quote from the 1976 movie, Network, “I’m mad as hell and I am not going to take this anymore!”
One may ask if I have a vested interest in making changes to this industry. My honest answer is damn straight I do, don’t we all!
Before I go into my diary of a madman, let’s be clear about the sheer size of the Managed Account marketplace. As of December 31, 2022, according to the MMI-Cerulli Advisory Solutions Quarterly, Managed Account AUM had grown to $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 Custodial Platforms (Platforms) while equities and ETFs are not. You may ask why that is? Well, this is where the worst kept secrets of this industry hide in plain sight.
Let’s take a step back and look at the industry from 20,000 feet. In its simplest form, asset managers are hired to subadvise portfolios for retail-type accounts that custody with these Platforms. These subadvisors make investment decisions, create orders, and route the trades back to each Platform for execution.
This sounds pretty simple and efficient until we look under the hood and see what is making the check engine light glow brightly. If I were to make a bet, I would say it is the widely accepted practice called Trade Rotation is causing the problem.
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 these orders in a predetermined sequence. A typical rotation may have Platform A execute, then Platform B, then Platform C, and so on. The next trade or next day, the order will change where Platform B executes first, C second, then A last. Not all subadvisors use the same method of rotation, but you get the picture.
So why is this a problem? As long as everyone gets a chance 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. While trade rotation is designed to smooth out the inherent disadvantage of going last, randomly being disadvantaged is not fair and not right. Performance disparities are common in the managed account space, and they are exacerbated when trading more illiquid securities. When using a rotation, unless all clients get the same exact execution price, rotation is always unfair.
Then why use this process? What is causing the subadvisor to employ this illogical methodology? Why don’t subadvisors just aggregate these like orders, trade them away, and step out the executions to the Wrap or Custodial Platform? Funny you should ask, but you may not like what I am going to tell you (although you already know the answer).
Let’s start with the subadvisor. Many are under the impression 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 is specifically expressed in the contract with the client, then they would be correct. However, in most cases this is not true. The publicly published ADVs of both the subadvisor and Platforms specifically state that the subadvisor may trade away to achieve best execution when they reasonably believe they can get a better overall net price. Any extra costs such as broker commission or other fees will be paid by the client.
So, if trading away for best execution is clearly stated and permissible in most ADVs, then why are subadvisors not trading away? The answer is one of the worst kept secrets of the industry. Perhaps bullet points will give a better summation of the discussions presently occurring:
- Subadvisors may be fearful their clients (Mom and Pop) will question why they are being charged extra for trading away
- Subadvisors may be fearful that the Platforms raising assets for them will look negatively upon trading away and divert those assets to other subadvisors that do not trade away
- The Platforms that publicly allow for trading away privately tell the subadvisor they will not allow trade aways (yes this happens)
- The Platforms tell the subadvisors the trade away process causes too many fails (very weak excuse)
- The Platforms want to retain the execution because they receive payment for order flow. Just check their routing reports (oh no, I said it out loud)
- The Platform allows for trade aways but imposes a stiff trade away penalty (sometimes as much as $25 or more per client per allocation), making it impossible to justify the added cost per client trade, deterring the subadvisor from achieving best execution (these fees are designed to deter trading away)
- The Platform will not waive the trade away penalty (another deterrent), and subadvisors don’t want to anger them with pressure to waive the fee for fear of retribution
What other practices are curtailing the ability of subadvisors trading away?
- Wrap Sponsors are allowing some but not all subadvisors to trade away, advantaging some subadvisors over others
- Custodial Platforms are charging some subadvisors trade away penalties and waiving the fee for others, again creating an advantage for those with clients paying no fees
Okay, Captain Obvious, you stated the issues and the common practices, but what are the solutions? Where do we go from here? What is our first step?
First, it is important to understand that most fixed income managers routinely trade away without penalties. If nothing else, this tells us that it is possible.
Step One: As a subadvisor, you need to take an honest in-depth look at your current process and decide whether the aggregation and trading away of orders will help achieve best execution. Do you manage institutional assets alongside multiple Platforms? Do you occasionally have orders greater than 5% of ADV (average daily volume)? Does it take hours or days to complete your rotation process? Do you have performance disparities among accounts? If you answer “yes” to any of these questions, the trade rotation process is probably the issue.
Step Two: If you come to the conclusion that your trade rotation is a problem, then ensuing discussions need to be conducted with the Wrap and Custodial Platforms. Trading away from these Platforms does not need to occur on every trade, just where aggregation will bring better results.
Trade away penalties must be waived, at least for trades over X% of ADV. These discussions tend to be the toughest, but if you talk them through honestly with the Platform, a reasonable compromise will result. This may take time so don’t back down. Best execution is in the best interest of all parties.
One question the subadvisor may ask the Custodial Platform is why are fees waived for some but not for others? Likewise, the Wrap Sponsor must answer a similar question. Why are some of your subadvisors allowed to trade away and not others?
Step Three: Assuming that you have effectively negotiated the elimination of trade away penalties on all or, at least, some of your orders, you must now determine a way to aggregate the orders and report the executions to the Platforms.
This seems simple enough, but some 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 pay commissions.
This leads to the one and only plug for my current employer, CAPIS. After 10+ years of trying to solve the trade rotation process, I landed at CAPIS and co-created a process that allows a subadvisor to trade with any broker, settle DVP to a CAPIS brokerage account, and step out “net” with commission to the Wrap or Custodial Platform. To simplify the order creation and aggregation process, we also work with a few middle office solutions specifically designed to support the platform management process.
If you noticed my tone to be that of a frustrated individual, then you are correct, and I didn’t even get into Model Delivery (that rant is for another day). A real change in this sector of the industry needs to happen and happen fast. There are solutions out there. They just need to be employed. You don’t have to sit by and watch this happen. It’s time to take a stand, and that’s precisely why this article was written. It’s time for subadvisors to trade away and step out the executions to the Wrap or Custodial Platform, and for Platforms to waive the stiff “trade-away” penalty, making it possible for 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.
The opinions expressed in this diatribe are those of my own and not of my employer or anyone else I know or have one degree of separation.
All discussions on this topic are welcome. It is now time to get mad as hell and not take this anymore!
Mark Viani | Director, Institutional Sales