SMA Step-Outs Stymie Best Execution
April 19, 2004
Operational inefficiencies are nothing new for the separately managed account business. In fact, the lack of connectivity between its key players has stunted what has otherwise been rapid growth in recent years.
Indeed, assets held in separately managed accounts industry-wide ballooned to $506.63 billion at the end of 2003, eclipsing the half-trillion dollar mark for the first time, according to industry trade group the Money Management Institute. But like any business, with growth comes new challenges, specifically when it comes to technology and building infrastructure.
Trade order management, for example, has become a major cause for concern for both managers and sponsors because of the growing need for best execution for the client. In order to trade securities for their customers, sponsors must receive orders from the portfolio manager and deliver that information to a trading desk where the transaction will take place. The systems and software used to transfer the data are often incompatible or require extensive training. Due to that lack of direct linkage, it can result in much of the transaction being handled manually.
This problem is perhaps best illustrated when placing small orders or trading small-cap stocks. If a firm wants to blow out an entire position in a small-cap stock, it could really move the market completely away from them. As executions happen, the firm would get worse and worse execution on their orders. So in order to achieve best execution for the client on smaller, illiquid stocks, sponsors tend to go outside the normal rotation to get the best price or "step out" the trade. Essentially, stepping out has to do with liquidity or size of the trade.
Since many firms lack straight-through processing, these types of trades can be pricey and cumbersome. "Most of the sponsoring firms that are executing the trades don't really have electronic systems to handle the transference of the executed orders from step-outs, said Vincent LePore, senior advisor at the MMI "It's more of a manual process." On top of that, there may be some additional costs that go along with stepping out the orders that a client would have to absorb, he noted.
"The reporting process is outside of the norm and they have to have a way to come back and reconcile it to their accounts," said Jim Vitalie, president of Curian Capital of Denver. "That requires more work for the sponsor and the money manager."
The more hands trades have to go through to get completed not only slows down the process, but also makes them more susceptible to error. Anyone who has played the telephone game as a child knows that the original message gets distorted as it gets passed along to more and more people. With managed accounts, there is a similar problem of a communication breakdown between money mangers, sponsors, clearing firms and other participants.
Consider another example of trading inefficiency. Manager XYZ wants to sell all IBM positions for managed accounts, so it sends the order out at 9:45 a.m. to the big five Wall Street firms, all within three or four minutes of each other. Hypothetically, let's say one of the reps from Smith Barney is not available or the order is sent by fax and he doesn't receive it until 10:30 a.m. Meanwhile, three other firms got their order and executed it right away. Yet another rep was in meetings until early afternoon and didn't receive the trade order until 2:30 p.m.
This creates a disparity among the IBM orders, which further suggests that there is an inefficient link between managers and sponsors. Currently, managers are not receiving order confirmations on these trades within minutes of sending it to the sponsor, which creates a real problem for the manager and can prevent the client from getting the best price. The order placed at 2:30 may have missed the opportunity to sell at the desired price relative to other orders placed almost simultaneously. Or perhaps the first in line will have gotten the shaft.
Money managers use trading rotations to help them manage best execution issues, but they must have specific policies in place to make sure that rotation is followed. If it is not followed, they risk best execution for the client and may tip their hand when the orders hit the floor of the exchange.
"It is difficult for the managers because the industry doesn't have the greatest technology or connectivity," said Michael Evans, vice president, director of separate account research at Financial Research Corp. of Boston. "Some firms have 25 to 35 relationships, trading through all sorts of platforms using many different systems. They have to be careful that their clients get best execution," he said.