Fund managers must now take note of execution quality. Nicholas Pratt examines the implications ...
When the EC’s Markets in Financial Instruments Directive (MiFID) was introduced in November 2007, one of the most anticipated aspects of the legislation was the ruling on best execution. The best execution concept has been much maligned over the years, particularly before the ubiquitous emergence of automated trading and electronic marketplaces.
Best execution has been jokingly referred to as the sensation that portfolio managers get just before the axe falls on their career after a sell-side counterpart has persuaded them into buying a non-performing stock which the portfolio manager has sent to his trading desk, along with a request for ‘best execution’.
Putting sarcasm aside, fund managers and brokers alike will maintain that they have always sought best execution for their clients and taken an interest in ensuring this was always the case, but there has never been any explicit obligation placed upon them before MiFID. Equally there has been a general lack of agreement on what defines best execution and how it can be measured.
But with the EC’s inclusion of Article 21 it laid down a series of stipulations regarding best execution, designed to bring some kind of consensual market practice to the task. The guidelines contained within Article 21 include the following stipulations for fund managers:
• establishing an execution policy, which must contain information on the venues firms used to execute client orders. Those venues must allow it to consistently obtain the best possible result for execution for their clients;
• disclosing the policy to clients and obtaining their consent to that policy;
• monitoring the effectiveness of arrangements in order to identify and correct any deficiencies and review the appropriateness of the venues in its execution policy at least yearly;
• upon client request, being ready to demonstrate that the client’s order has been executed in line with its execution policy.
In the ten months since these guidelines became effective, has there been a wholesale change in the way best execution is being considered by fund managers? More importantly, has the lack of a standard approach and a general market consensus been addressed?
“Best execution by and large did not change with the introduction of MiFID because we always acted in the best interests of our clients,” says Tim Tanner, equity business manager at Morley Fund Management.
“MiFID did, however, provide us with a more comprehensive list of exactly what constitutes best execution and that it is not solely based on price anymore. MiFID has therefore provided us with a clear definition of what is best execution and regulation has required that the market conforms.”
In the past a lack of consensus and the different opinions on what constitutes best execution has meant that clients could be represented inconsistently, says Tanner. “A regulated standard best execution definition forces managers to comply with MiFID and provide a standard approach to dealing and consistently achieve a common standard of best execution.”
Article 21 has shown that best execution is now a process and not simply a number; however, this brings its own complications. When best execution referred solely to the cost of trading on one exchange, life was simple, even if it was inaccurate and inefficient. Now that fund managers have to define their own execution policy based on their specific trading strategy and motives, brokers will face a more arduous task in conforming to the potentially wide variety in their clients’ policies.
“For sophisticated institutional investors there could be many definitions of what they perceive to be best execution within the parameters of their investment strategies, and here the definition of best execution and the approach to the problem has to be dealt with almost on a case-by-case basis to make sure the investor’s specific requirements are met as closely as possible,” says Jerry Lees, head of alternative execution services at France-based broker CA Cheuvreux.
According to Lees, the concept of consensus on best execution may have some relevance for the retail market where it is important to send clear messages to relatively unsophisticated investors confirming that they are getting looked after correctly and a consolidated price feed could confirm best price has been achieved. But for the professional investors it is more important to have their specific requirements met rather than building consensus around generalised solutions.
“Fund managers should be able to design an execution policy that suits their trading strategy and is based on bilateral discussions and negotiations with their brokers,” says Octavio Marenzi, founder and CEO of France-based consultant Celent. For example, what are the reasons for trading, how should the order be treated and what are the relevant benchmarks for best execution?
These discussions are taking place, says Marenzi, particularly among the more sophisticated fund managers who have always been interested in ensuring execution quality but, thanks to MiFID, have been involved in more intense negotiations. But is execution quality now becoming important enough for fund managers to decide what brokers to use based on execution quality?
“Absolutely,” says Tanner at Morley. “Asset management dealing desks must now only deal with a broker who can provide best execution.” This obligation has been made easier by the advent of unbundling, meaning that fund managers can look at execution as a separate service and, for example, are no longer forced to achieve a certain level of trading with a broker in order to receive their research services.
But this distinction surrounding execution comes with an expense for both brokers and fund managers. Those managers with dealing strategies based on looking at the primary exchanges will have to start basing their execution expectations on a wider range of liquidity sources and this means an initial investment on smart-order routing, the technology used to trawl venues in search of liquidity.
Inevitably these changes and the attached effort and expense will not be universally welcomed. “The market does not always like change, even if it does mean that the end client will be getting better results,” says Alasdair Haynes, chief executive of agency broker ITG in Europe. “Of course a broker could simply say that it is going to stick to one exchange as part of its execution service, which is not against the regulations, as long as it states what its policy is. But it may lose clients as a result.”
The majority of brokers are, however, mindful of their ability to source liquidity, minimise market impact and achieve lowest cost execution and are spending to ensure they stay ahead of the game. “We have had to invest heavily in technology in sophisticated crossing engines, multiple light and dark pool access, optimised smart-order routers and faster market access,” says Lees, of CA Cheuvreux.
Of course, the new vigilance around best execution will be redundant without reliable measurement. Fund managers can leave their brokers to measure their own execution performance, many of whom are now investing heavily in producing more detailed and transparent execution reports. But Marenzi feels this is not the way to go and more fund managers should be doing this measurement themselves, through transaction cost analysis (TCA) tools.
Haynes also believes that TCA will play a big part in the measuring of best execution. “If you can measure the cost of transactions, then you can also control the costs and this will become increasingly important for fund mangers because consultants are going to start ranking them by their net returns and that could determine how much business they get.”
As with the definition of best execution, there is no single answer in terms of measuring best execution but, says Haynes, there is more of a consensus developing on the methodology that should be used. “Managers are looking to use implementation shortfall as a way to analyse their brokers and there is more recognition of TCA in general.”
And for those fund managers that do not want to invest in TCA tools of their own and do not implicitly trust their brokers’ own execution reports, there is a third option – getting another firm to do it for you. For example, the alternative trading platform Equiduct Trading, through its Partner Ex product, offers its participants guaranteed best execution on an order-by-order basis. “We try to identify clients who think this kind of service is important and will be willing to pay a reasonable price for that,” says Artur Fischer, joint CEO of Equiduct Trading.
It is essentially an outsourcing of the best execution process, says Fischer. By working directly with the market makers and brokers on behalf of the fund managers, Fischer believes that he is providing the benefits of smart-order routing without some of the problems.
“Best execution is a complex issue and we can make it simple for fund managers. For example, we are talking to managers that have established a neutral trading desk that executes trades for the portfolio managers, but that desk is costing a lot of money. Instead they can replace that desk by using us.”
It is still too early to tell how much of an issue best execution has become for fund managers and how much of a consideration it is when considering where to trade and which third party to use. MiFID’s stipulations are less than a year old and many of the alternative execution venues needed to make the pursuit of
best execution worthwhile are only just launching.
Nevertheless, the educational effect of article 21 and the fact that so many more participants in the industry are aware that they have these rights as regards execution quality should keep trading desks and brokers alert. Certainly there should be no one still thinking that best execution refers to the least traumatic way to be sacked.
© 2008 funds europe