Four Dangerous Myths about Best Execution
For the first time in a long time, equity market structure has been a hot topic of debate and interest, reaching audiences outside of the financial markets. Critics of the current system often point to its unnecessary complexity, which creates potential for abuse that can hurt the investor experience. However, investors ideally ought to be able to take comfort in their asset managers’ duty of best execution, a fiduciary obligation that affords investors some measure of protection and assurance. Unfortunately, best execution is often invoked but rarely understood and frequently misinterpreted. As a result, four key myths about best execution have become widely believed. With a clearer understanding of the facts behind the myths, investors can (hopefully) rely on best execution for what it is intended to provide: a clear, unambiguous threshold for client service.
Myth #1. Choosing a broker who charges the lowest commission satisfies best execution.
When portfolio managers send orders to buy or sell securities to their brokers or directly to particular venues, they owe a duty of best execution to their clients. There is a common misperception that a portfolio manager’s only obligation when it comes to best execution is merely selecting a broker with the lowest commission cost. In fact, however, this belief is misguided. This duty requires that the portfolio manager use reasonable diligence to assess the quality of executions achieved at each venue. In addition to assessing the quality of a broker’s execution, a portfolio manager should recognize and consider the potential conflicts of interest the manager faces in directing client orders to a particular broker. The SEC recommends that investment advisers evaluate whether they are choosing a particular broker/dealer because of the client’s best interest or for other motivations.
Numerous cases have been brought against investment advisers for selecting brokers for conflicted reasons. In July 2013, the SEC settled a case against two investment advisers (Goelzer Investment Management and A.R. Schmeidler & Co.) for potential conflicts of interest because the fund managers allegedly put their personal interests ahead of those of the investors in three ways: (1) failing to compare the services its in-house brokerage division offered with those available at other brokerage firms, (2) failing to properly seek best execution of trades for certain advisory clients, and (3) failing to implement policies and procedures to ensure that the fund manager sought best execution as represented in its Form ADV. In 2013, the SEC undertook an administrative action against the investment adviser Fry Hensley & Company for allegedly failing to disclose three things to its clients: inflated commissions, markups, and markdowns charged by its affiliated broker/dealer. The firm subsequently agreed to a cease and desist order.
Downstream from portfolio managers, the brokers exercising discretion that they choose have both a fiduciary obligation and a regulatory obligation to seek the best execution reasonably available for their customers’ orders. According to FINRA (Financial Industry Regulatory Authority) Rule 5310, brokers must use reasonable diligence to ascertain the best market for their customers’ orders and obtain the best price available at submission while also considering other factors, such as the character of the market for the security, the size and type of transaction, the number of markets checked, the accessibility of the quotation, and the terms and conditions of the order that resulted in the transaction. The SEC has further stated that some of the factors a broker must consider when seeking best execution of customers’ orders include “the opportunity to get a better price than what is currently quoted, the speed of execution, and the likelihood that the trade will be executed.” (For further details, see “Best Execution.”)
Myth #2. Venue choice isn’t a best-execution consideration.
A portfolio manager must evaluate best execution as much more than simply finding the best price or lowest explicit costs. Today, fragmentation of equity markets has given investors many venue choices, including almost a dozen exchanges and more than 40 dark pools. These venues can vary greatly, with differences in available liquidity, transparency of operations and pricing, average trade size, implicit costs from market impact and information leakage, the amount of price improvement, the types of participants, the character of the liquidity, the opportunities to interact with natural order flow, and the extent of structural or latency arbitrage opportunities enabled by the venue. All portfolio managers should define what best execution means to the specific funds that they manage, including qualitative and quantitative measures of execution quality.
Regardless of which factors the portfolio manager deems most important, the quality of execution must always be viewed from the customer’s perspective, not from the firm’s point of view. The portfolio manager — as a fiduciary with respect to clients’ accounts — has an obligation to ensure that trades are executed in a manner that is optimal under the particular circumstances and to achieve the best result for the client in terms of both explicit and implicit costs. This obligation comes with an independent duty to conduct analysis of the quality of the executions achieved by the brokers. Factors that should be analyzed include the explicit commissions, the market impact costs, the opportunity costs of orders that are not filled, and whether the fill rates in the particular securities are satisfactory.
Investors may also seek best execution by trading in dark pools. One benefit of trading in dark pools is anonymity. An institution participating in a dark pool can trade without signaling to other participants that the institution is trying to establish or unwind a position. Institutional investors, such as investment advisers, tend to place even more weight on trading in an environment that not only provides anonymity but also creates as little information leakage as possible about their large trades, because opportunistic market participants with access to such information can shift a stock’s price to the detriment of the institution’s trade.
Low counterparty risk is another important factor to consider. The nature of the participants, liquidity, operations, and trading rules of a given dark pool combine to create a spectrum of liquidity and information leakage outcomes. As such, how a given venue works and who is trading on such a venue are important considerations for managers, and they need understanding and transparency in these areas. According to RBC Global Asset Management research published in 2010, “Traders should also consider execution capabilities such as liquidity, timeliness, clearance, settlement and responsiveness, as well as the overall financial solvency and risk associated with counter parties.” (The full RBC report, “Best Execution: Defining Best Execution in an Increasingly Complex Trading Environment,” is available at us.rbcgam.com.)
A hot-button issue these days is whether a conflict of interest exists for the venue receiving the institutional order, either in connection with the venue’s own proprietary order flow or that of the venue’s largest customers. In fact, FINRA, which regulates broker/dealers, is looking closely at best execution in the context of order routing. Part of FINRA’s focus is on conflicts of interest. Not only broker/dealers but also portfolio managers should analyze the venues where the trades were executed, the appropriateness of strategies used by the brokers (i.e., whether their algorithms and routers prioritize speed or whether the execution fees paid by brokers have an impact on their routing decisions), the performance of routers in liquidity capture, and information signaling. Portfolio managers should also consider the type of funds they are managing when selecting brokers. For example, perhaps a bulge-bracket broker is appropriate for an active fund, but specific instructions are more appropriate for less active funds.
Myth #3. Portfolio managers have no say with respect to venue choice.
Fiduciaries act as agents for their principals under the law of agency. In the case of a broker, it owes a fiduciary duty to its clients, both retail and institutional, and also must comply with SEC and FINRA rules, including FINRA Rule 5310, which (together with its supplementary material) addresses a broker’s best execution obligations. The rule generally provides that a broker must use “reasonable diligence to ascertain the best market for the subject security” and sets forth a list of non-exclusive considerations that may be considered in determining whether a broker has used “reasonable diligence.” The supplementary material to the rule addresses customer instructions regarding order handling and states:
“If a member receives an unsolicited instruction from a customer to route that customer’s order to a particular market for execution, the member is not required to make a best execution determination beyond the customer’s specific instruction. Members are, however, still required to process that customer’s order promptly and in accordance with the terms of the order.” (Emphasis added.)
Thus, portfolio managers also have the ability to direct orders to particular venues, and brokers following specific routing instructions to a particular market will be deemed to meet their best execution obligations by complying.
In fact, some asset managers deem execution venue as the key factor in meeting their duties of best execution. For example, consider how RBC Global Asset Management defined its approach to best execution in its 2010 “Best Execution” paper: “The determinative factor in best execution is not necessarily the most favorable price point or lowest commission cost, but whether the transaction represents the best quantitative and qualitative execution for the client account. … Determination should be given to the proper execution venue; direct order routing, ECNs, algorithms or alternative trading systems (ATS), such as dark liquidity pools, crossing networks and aggregators.”
New venues and new technology must be considered in the best execution analysis. Therefore, the more portfolio managers understand about each venue, the better they can make informed decisions about best execution and establish the most appropriate best execution policies for their funds. For example, considerations that should be evaluated include the order types offered by each venue, the toxicity of the venue, and book depth. Other factors, such as speed, trading strategies, and routing strategies, are also important when selecting brokers.
In 2014, the New York attorney general brought a case against Barclays Capital alleging that Barclays made false and misleading statements about its “Barclays LX” dark pool. When Barclays requested that the case be dismissed, New York Supreme Court Justice Shirley Werner Kornreich issued a ruling that stated, “Given the reality of how modern securities trading actually occurs — that is, how trading decisions are really made — the notion that the decision about where to execute a trade is not an ‘investment decision’ is unpersuasive because the choice of trading platform can have a significant impact on the outcome of the trade.” Investors that were allegedly harmed in the Barclays case chose to send their orders to the Barclays dark pool because of the advertised characteristics of that venue, and Kornreich further stated that “their decision to trade in the Dark Pool is very much an investment decision.” (For complex legal reasons, Kornreich ruled that Barclays’ motion to dismiss was “granted in part and denied in part,” allowing the attorney general to proceed with some of the complaint.)
Myth #4. Mutual fund directors are too far removed to have a say in best execution.
Another checkpoint on the duty of best executions lies with mutual fund directors, who similarly have a responsibility to oversee (at the fund level) the performance of the selected brokers (via transaction-cost analysis and other reports), analyze the trading data, discuss the data with the portfolio manager, and act on such information. SEC rules (in particular, Rule 605 and Rule 606) require broker/dealers to provide quarterly reports on routing of customer orders and require markets to supply monthly reports on execution quality. Although these reports could use some modernization and more stringent disclosure obligations, the directors should also take advantage of this data. The directors can help to determine how the adviser is monitoring the broker and whether the adviser is holding the broker accountable for execution results. Moreover, directors are in the best position to assess the potential conflicts of interest of individual brokers and should ask questions such as: How many of the orders are sent by the brokers to their own dark pools? What is the composition of the participants in these dark pools? Can participants opt out of interacting with certain types of order flow or counterparties? And what logic is used by the broker’s smart-order router?
Brokers, portfolio managers, and mutual fund directors each play a role in obtaining best execution for their investors (on whose behalf they are acting) and should use the necessary vigor to consider the factors important to those clients when shaping their best execution policies. With the right approach, investors can be assured that their interests are protected by the fiduciary duty of best execution. But if the common myths outlined in this article prevail, the result may be more prescriptive regulations. Establishing clear criteria for best execution is a critical step toward avoiding confusion as asset managers adopt prudent policies and procedures to meet their fiduciary obligations.
Sophia Lee, CFA, is general counsel for IEX Group in New York City. This article originally ran in the July/August 2015 issue of CFA Institute Magazine.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Photo credit: Illustration by Timothy Cook