Hans-Olov Bornemann believes there needs to be a debate about how broker-dealers serve fund managers. The issues go beyond unbundling, though, and into the opaque world of how traders use confidential client information. By Nick Fitzpatrick
Do asset managers trust their external broker-dealers? Sometimes the relationship can be tricky. Transparency is the crux of the matter and raises questions about the quality of service that asset managers receive from some of the biggest names in finance.
But few buyside portfolio managers or traders are willing to stick their necks out about the subject – the upside of potentially upsetting some of the large investment banks, who are powerful and well-connected, is too great.
Hans-Olov Bornemann, senior portfolio manager and head of the global quant team at SEB Asset Management, the Swedish investment manager, is not so timid. Bornemann, who runs $4bn (e2.85) in global equities funds and absolute return portfolios, has put himself in the firing line with a presentation called ’10 Ways of Getting Fooled by a Trader’. In the presentation he highlights ten trading methods that, although harmless in themselves, could be employed by bad traders to make money at their clients’ expense by harming the ability to produce alpha.
The full list of tricks, as defined by Bornemann, is:
- Spread arbitrage
- Limit orders
- Afternoon close
- Guaranteed open
- Implementation shortfall
- Guaranteed VWAP
- Structured products
- Program risk trades
- Transition trades
- Big Flows (frontrunning aggregated flows)
Bornemann, who stresses that his views are personal and not those of SEB, doesn’t imply that these methods are in themselves corrupt, but he believes “bad traders” – those who put their own books before those of their clients and are prepared to flaunt best practices and regulations in the process – could utilise these methods to their own ends.
Bornemann admits it would be very hard to prove mis-conduct as the area is so opaque, and he isn’t accusing any dealers.
But he began to think about the issue after receiving poor executions from one bank several years ago.
“There is quite a wide spread in execution quality between the best and the worst brokers. One investment bank gave us extremely poor executions, so we decided to discontinue trading with them. We had enough underlying trades, which were measured over 13 months, to say that either they had been totally incompetent, or they had been taking advantage of our order flow. This broker’s execution results were way out of line with the rest of our execution brokers.
“We spoke to the bank about it and they claimed to have had bad luck in a number of trades. Unfortunately, when such an excuse comes from an investment bank that employs very competent people and is making a killing on proprietary trading, the explanation doesn’t sound very credible.”
Lack of trading transparency
Proving malpractices, he says, is too difficult owing to the lack of transparency in trading. “But,” he tells Funds Europe, “having worked for more than ten years on the sell-side and having measured trading performance in detail since I became a fund manager a few years ago, I can say that some dealers are not giving us as good a quality of execution as others. The question is, why? Are they just being less successful, or are they trading with their own agenda?”
He adds: “In my opinion, the global investment banks are probably the most conflicted companies in the world. Tones of articles have been written about that and I am sure that more will follow, but if we just focus on the trading area, one can say the following: On the one hand, the investment banks are serving their clients with agency execution; on the other hand, they are employing proprietary traders who are trying to make as much money for the bank as possible.
“Both the guy servicing the client, the guy trading with the bank’s own money and even the poor compliance officer who has the impossible task of trying to make sure nothing illegal is taking place, are all getting paid – directly or indirectly – in relation to the bank’s total profitability. An interesting set-up, wouldn’t you agree?”
More specifically, Bornemann says he is concerned about how the banks treat the information they extract from the aggregated order flow of clients. Do they see this as private or public information? Regulators would hopefully regard this as private information, and therefore as inside information. But Bornemann asks whether brokers regard this in the same way.
“I bet that a number of them are not acting on the basis that this is private or inside information.”
In fact, he argues, all the brokers that sent out letters declaring that they will continue to do so-called ‘pre-trade hedging’ – when you, as a client, ask for a risk price on a programme trade – “have basically declared that they...regard the detailed information from your planned trade as public information”, claims Bornemann. “What happened to the insider trading laws?”
This is a controversial statement and brokers would argue that pre-hedging, which is not illegal, can be a valid form of securing prices for a client.
Another feature worth considering, says Bornemann, is why some of the investment banks focus more on getting huge order volumes rather than commission revenues from their clients.
“Clearly, the more accurate a picture you can get of the order flow in the market, the easier it is to tell whether individual stocks, sectors and/or the whole market will be going up or down that day.” This information could be tempting, he claims, to a trader with a proprietary order book who is prepared to frontrun clients.
“To me, it is a mystery how loose-handedly regulators have chosen to accept this conflict-of-interest situation. Have they not noticed that an increasing share of profits at the large investment banks is coming from proprietary trading?
“It would be very interesting to learn where regulators draw the line for insider trading.”
Bornemann believes that asset managers who share his concerns are increasingly looking to the service of non-conflicted brokers.
“I would argue that you can see that the shift has started to take place. Unconflicted broker dealers, as well as crossing networks, have been able to establish a presence in the market and they have been gaining market share ever since they were established.
“However, there are a couple of reasons why this is not happening even more quickly. One problem is that a number of fund managers are still blinded by the impressive marketing pursued by investment banks. Almost all brokers I have come across have been able to find some statistics ‘proving’ that they are the best execution firm around. Thus, it is hard for clients to get a fair and accurate picture of reality.
“The second obstacle becomes apparent when you start to gather your own data and measure the execution quality yourself. Due to the presence of randomness in share price movements, you need to execute a decent amount of trades with all the brokers in order to get a good picture of their respective average execution quality.
“The third obstacle is that it takes time and effort to implement full debundling of commission payments. You want to execute with the brokers providing the best execution quality, but you also want to get research and sales service from the banks that are best in that part of the business.
“Since you pay for all these services through commission, you face a dilemma when your favoured research and sales providers have colleagues on the trading side running a different agenda than truly helping the client. To solve such problems of inefficiency, you need to have your legal department establish commission sharing agreements (CSAs) with the respective brokers. That way, you can execute with the best execution brokers and still pay the best research and sales providers.”
A number of fund managers are still not measuring the execution quality of their brokers in any scientific way, Bornemann says, and quite a few are yet to establish CSAs. A lot of fund managers are not even aware of the alleged pitfalls in trading.
SEB Asset Management has developed a proprietary formula for measuring the execution quality of its brokers. Benchmarks are explained to brokers so that they are themselves able to follow up how well they are doing.
“Having measured execution quality of about 20 of the largest brokers in the world since 2004, we have learned how important this is to generating alpha, or at least, to avoid losing the alpha you had identified in your stock picks. “This year, we will have a total turnover in our global equities and absolute return products of some $20bn. In other words, we have a pretty good database of trades to draw our conclusions from. In fact, if it weren’t for our focus on execution quality, we would not have been able to achieve information ratios of one and above in our products.”
As neither the brokers’ internal compliance officers nor regulators will have the time, resources or trading expertise to monitor the activities of all proprietary traders, says Bornemann, a fund management firm can only protect itself by measuring execution performance and reallocating order flow to the better execution houses. If a firm is good at executing its own orders, direct market access (DMA) may be a good solution, too.
“What we have done is basically the following: on the basis of the execution performance of the different brokers since 2004, we have gradually shrunk the number of executing brokers. Today we have six executing brokers at any time. These top six execution brokers get 100% of my team’s trades, ie, 100% of the $20bn that we are executing in global equities every year.
Trust your numbers
“If any of the top six brokers start to slip in their average execution quality, they are replaced by one of the brokers waiting on the sideline to get a new chance. Through the commission sharing agreements, there are another ten brokers who receive commission for their research and sales services.
“Again, I am not saying that all brokers are doing a bad job. There are some unconflicted agency-only brokers who are doing a great job and there are a couple of traditional investment banks who are doing a good job as well. However, you need to find out who is in what camp. You should ignore all the marketing talk and just trust your numbers. Don’t be surprised if you find a negative correlation between brand and execution performance. In this area, things aren’t quite as good as they seem to be at first glance.”
Bornemann is supportive of the the requirement under Mifid to deliver best execution. He also acknowledges that some brokers have taken action to prevent information about client orders being shared by brokers and proprietary traders. Bornemann says good brokers need to be concerned about the issue in order that they don’t see their market share fall and make less money than they deserve.
Bornemann says he recommends that fund managers spend more time on this crucial part of their investment process.
He adds: “Brokers, both conflicted and unconflicted, may want to participate in this debate as well. It is definitely an area where some seem to be making more money than they should and others are making less money than they deserve.
“Down the road, maybe even some concrete actions will follow from the debate.”
© fe October 2007
Background: Being a Bad Trader
Golden Rules (of Bad Traders)
- Own book comes first, Client’s interest comes second.
- If you do break laws, regulations or good business practice, make sure you don’t get caught.
- Ask somebody else to keep the Client happy.
- Information on Client flows = Gold. - Get it and use it.
Source: "10 Ways of Getting Fooled by a Trader", a presentation given by Hans-Olov Bornemann, portfolio manager and head of global quant team, SEB Asset Management.What do you think? E-mail the editor, Nick Fitzpatrick ([email protected]).