penned by Chris Halverson, Senior Vice President, Sales
Despite the pandemic, the equity markets were very kind to the financial services industry. Returns have been 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, custodial 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; but there’s an “elephant in the room” that’s been causing problems for years… best-ex issues with managed accounts.
In the past, a registered investment advisor (RIA) might work with a couple of WRAP sponsors or custodial platforms, representing 10%-20% of their assets under management (AUM). Now, that same RIA may work with multiple WRAP sponsors and custodial platforms, representing 30%-50% of their AUM. This creates significant issues with respect to best-execution.
To address various directives associated with managed accounts, investment managers often rely on a “tier system”, where 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 / Custodial Accounts
- Accounts that direct the investment manager where to execute. Trades for accounts held at specific custodians are expected to be executed with the respective sponsor broker/dealers.
- Tier 3 – UMA / Model Delivery Accounts
- The investment manager has no role in order execution. It simply provides the sponsor with updates to the model portfolio.
Asset managers frequently employ an overall trade rotation or within each specific Tier.
For investment managers who work with multiple sponsors and custodial platforms (Tier 2 accounts), the sequencing process is even more complex, as they attempt to treat each sponsor fairly. If Sponsor A always went 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 securities (micro / small cap). The industry’s answer? Rotation.
Trade rotation is exactly what it seems; sponsors along with institutional orders are put into a rotation, either by numerical sequence or using a randomized process. The thought being that no one sponsor has an advantage over another and that any short term (performance) impact will even out over time. While the intent of a trade rotation means well, its mere existence is an acknowledgement that the system is flawed. Which one of us would accept a “luck of the draw” approach when buying groceries, concert tickets, or even stocks? It makes no sense. We want to be first in line, have the best seats in the house, and pay the lowest price when buying stock. Rotation is a band aid, not a solution. It doesn’t address the root problem, best-execution.
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 trader if there’s a difference in the price its larger institutional orders receive versus the sequenced trades its WRAP sponsors get. The answer might surprise you. Spoiler alert… it’s more than a penny or two a share. To be clear, we’re focused on the more difficult trades (model change, illiquid names, etc.), not smaller “maintenance” trades.
So why can’t investment managers aggregate their WRAP orders with their institutional flow? In many cases, they don’t think that they can. WRAP accounts are marketed as a simple fee-based investment. Execution costs are bundled into the fee they pay, as long as every order is executed with the sponsor broker/dealer. Should a manager trade with another broker/dealer, its clients would likely incur additional costs (commissions, mark-ups/mark-downs, etc.).
But what if the investment advisor could get a better average price for its WRAP accounts by trading them with its institutional orders? What if they were free to source liquidity wherever it may be? In an extremely fragmented market, where natural liquidity is increasingly hard to find, why limit where the advisor can go? And why risk information leakage on large trades or illiquid securities when the liquidity might be readily available elsewhere?
Current high-touch institutional commission rates range between 1.0 to 3.0 cents per share. As 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 would an institutional investor think any differently?
RIAs have a fiduciary obligation to seek “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.”
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 custodial platforms (I won’t name names) still impose punitive trade-away fees, but those fees are shrinking and, in some cases, going away altogether, driven largely by investment manager demand.
The good news is that every WRAP sponsor recognizes a RIA’s fiduciary obligation to seek best-ex. To see it yourself, just look at the sponsor’s WRAP disclosure documents. While each firm has adopted its own specific language, the common denominator is always the manager’s fiduciary obligation to seek best-ex. 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 states 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 only trade-away when it thinks its clients will receive a better net price. 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. From an operational perspective, working with multiple WRAP and custody platforms is exponentially more time consuming and inefficient, and best-execution 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 huge red flag for seeking best-ex. 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 illiquid small cap stocks, all the while exposing portfolios to unnecessary information leakage and executing trades at vastly different levels.
On the surface, the answer isn’t complicated. 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 the equation. In fact, trading desks and compliance departments should be forcing the debate internally. Thankfully, WRAP sponsors and custodians all recognize the RIA’s fiduciary obligation to get their clients the best net price.
From a compliance perspective, RIAs are required to seek best-ex, track any trade-away activity, and disclose any additional costs to the WRAP sponsors and custodial 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 are 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 that difficult to provide if you have the right partner.
So where do we go from here? To call out the elephant in the room, you need a better mousetrap. There are various ways to address issues outlined in this article and pros and cons to each approach. To address the flaws with trade rotation, some managers use step-outs to facilitate settlement with each sponsor. Though step-outs may be an effective way to keep the block together, that opens up another can of worms… research participation, different commission rates, one client paying for the services used to support other clients, etc. Does it make sense that WRAP clients receive the benefits of the research and brokerage services that are solely paid for by its institutional clients? Other managers use platforms such as CAPIS ARC, to simplify operations and manage the process for them. Like most things in the financial services, the best answer is typically one that is tailored to fit your needs. In general, it pays to hire an expert.
On the bright side, the managed accounts industry offers benefits to the end investors. However, its growth has led to additional operational complexities for the advisors managing those assets. The sheer size and number of firms involved in this space has created significant hurdles to achieving best-execution and caused performance to suffer as a result. But it doesn’t have to be that way. We can call out the elephant in the room, find the right partner (someone you can trust), and use a better mousetrap. Everyone benefits in the long run.