By Chris Halverson – January 2025
As we begin 2025, operational efficiency and the ongoing challenge of managing commission budgets remain at the forefront of industry concerns. At CAPIS, discussions on best execution issues with trade rotation and shrinking commission wallets dominate client conversations. The same was true at last fall’s 91st Annual STA Market Structure Conference, where multiple attendees asked me how CAPIS helps investment managers navigate these challenges.
The answer? CAPIS ARC.
Identifying the Problem
The growth of assets in Separately Managed Accounts (SMAs) is undoubtedly a positive development. However, this growth comes at a cost to the end investor — often referred to as “Mom and Pop.” While investment vehicles like SMAs and custodial platforms (e.g., Schwab, Fidelity) have democratized access to sophisticated institutional asset managers, they also present operational challenges for Registered Investment Advisors (RIAs) and raise critical best execution concerns.
The elephant in the room? Trade rotation.
Trade rotation has long been a visible yet inadequately addressed issue. RIAs managing assets across multiple SMA and custodial platforms face a unique challenge when implementing model change trades for their entire client base. The typical solution — trade rotation — poses significant risks to best execution, warranting closer scrutiny. Compounding the issue is the fact that many trades don’t pay commissions and thus fail to contribute to the manager’s research budget.
Understanding Trade Rotation Methods
RIAs typically employ one of two methods to execute model change trades across their client base:
Method #1: Tier System with Trade Rotation
Accounts are executed sequentially based on assigned tiers:
- Tier 1: Institutional accounts (usually one block trade)
- Tier 2: SMA/WRAP/custodial accounts (using trade rotation — one platform executes first, followed by others)
- Tier 3: UMA trades (where the RIA has no active role in trade execution)
Pros:
- Defined process aligned with the RIA’s control over execution
Cons:
- Accounts in lower tiers often experience worse pricing than those in Tier 1
- Sequential execution can lead to higher costs for accounts further back in the rotation
Method #2: Aggregation with Step-Out Accommodation
Institutional and SMA/custodial accounts are aggregated into a single block trade:
- Institutional accounts settle via delivery versus payment (DVP) with explicit commission
- SMA/custodial accounts are stepped out to their sponsors or custodians (typically with zero commission)
Pros:
- Uniform execution price across all accounts
- Minimizes information leakage
- Gives RIAs full control over trade execution
Cons:
- Institutional accounts subsidize SMA/custodial accounts, covering commissions and contributing to the research budget
- SEC compliance challenges due to prohibitions on systematic favoritism within block orders
The CAPIS ARC Solution
CAPIS ARC offers a superior alternative to traditional trade rotation. This post-trade allocation utility, designed by CAPIS Director Mark Viani, empowers RIAs to deliver best execution for all accounts while enhancing a manager’s ability to satisfy its research budget.
How It Works:
- Aggregates institutional and SMA/custodial accounts into a single block trade
- Institutional accounts settle via DVP (with explicit commission)
- SMA/custodial accounts settle through step-outs with commissions paid as markups/mark-downs
Benefits:
- All accounts receive the same average execution price
- Access to diverse liquidity sources
- Reduced market impact, timely execution, and enhanced performance
- SMA/custodial accounts contribute to the annual research budget
- Automated step-outs and email notifications reduce administrative burden and increase operational efficiency
- Comprehensive trade records and customizable reporting for disclosure and compliance
Challenges:
- Additional fees/expenses for trade-away activity require detailed tracking and disclosure. CAPIS ARC simplifies this by maintaining detailed records and offering custom reporting tools.
Conclusion: Beyond the Band-Aid
Despite the availability of solutions like CAPIS ARC, many RIAs continue to rely on trade rotation, which, at best, creates a mere perception of fairness. At worst, it results in inefficiencies, prolonged execution timelines, and increased market impact — undermining performance and best execution.
RIAs must fulfill their fiduciary obligation to seek best execution for all accounts, regardless of custodian or platform. Properly implemented trade-away strategies, when used judiciously, can address these challenges. However, they must be implemented correctly, and only when the money manager has a reasonable belief that its clients will be better off, net of any additional fees or expenses. When executed effectively, these strategies can create a mutually beneficial outcome for both managers and, more importantly, their clients.
The investment management community must move beyond antiquated methods like trade rotation and embrace solutions that prioritize efficiency, fairness, and compliance. It’s time to rip off the Band-Aid and address the underlying problem.
