March 28, 2011 – Investors in externally managed and sub-advised accounts could save about $1 billion a year in commissions paid to brokerage firms by their fund managers.
So says UAT, a Denver-based technology firm specializing in the externally managed and subadvised industry. Launched last year, the firm started off providing pre-trade compliance and commission saving software to sub-advisors but in late February launched a new Web-based system called iPerX that it said can potentially triple the rate of commissions recaptured. Where existing service providers recapture 25 percent of commission paid out to brokers, UAT says its system recaptures 75 percent.
Case in point: if a fund manager spends $1,000 with a broker-dealer on commissions, UAT can save the fund manager about $750 while other commission recapture firms can win back about $250 of that amount.
Externally or sub-advised accounts are pools of assets managed by a firm other than the one holding the assets. About 13 percent of mutual fund assets are externally managed while 42 percent of variable annuity assets are, according to Financial Research Corp, a Boston-based research firm specializing in investment and asset management.
“Money managers overseeing these assets can increase the efficiency of their trading desk as they gain an automated algorithm that saves their institutional clients millions annually for the benefit if the underlying individuals in these products,” claims Tom Warren, president of UAT, which has won five patents from the U.S. Patent Office for its technology and business methodology.
Here is how IPerX works. At its core is an algorithm that allows money managers to categorize their orders using a real-time rules based process as either high-touch or low-touch based on their potential market impact. The big savings are in putting “low touch” orders into low-cost venues. That’s because the low-touch, low impact orders can account for 75 percent of an account’s order flow. That flow, which can be largely automated, gets routed to designated low-cost agency brokers to maximize commission savings.
The money manager’s trading desk then “works” the high-touch orders to provide value-added services to orders which significant market impact. iPerx is customizable down to the individual identification number of the security involved. The fund manager or sub-advisor controls the rules of the algorithm while the sub-advised fund can have real-time access to how the trade is being divided and which broker-dealer is executing the order. This is achieved through the web portal.
Warren says that it is because of iPerx’s ability to separate low-touch from high-touch orders that money managers are able so save so much on commissions. UAT has agreements with several agency broker-dealers that can execute those orders cheaply – for as little as 0.8 cents a share. Because it is not a registered broker-dealer, UAT makes fees based on a percentage – it won’t disclose what that is – of the total value of the assets in the sub-advised account.
What do incumbent commission capture firms think? “If it sounds too good to be true it usually is,” says David Choate, senior vice president at Capital Institutional Services, an agency brokerage and commission management specialist in Dallas.
For one, Choate says, commission recapture is a misnomer when it comes to iPerX. “UAT is attempting to make it s program sound familiar to prospective clients but its really not commission recapture but trade recapture,” asserts Choate. The phrase typically refers to the practice of fund managers “recapturing” a percentage of the commissions paid to broker-dealers after they are paid.
Semantics aside, Choate disputes UAT’s premise that the cost savings can be achieved by UAT’s broker-dealer partners executing part of the block-order. UAT, for instance, believes that any order that represents 4 percent or less of the average daily volume of a trade can be and should be handled in an automated or “low-touch” way.
Four percent seems “very high” given the fact that a trade involving 20 percent of the average daily volume of a stock can take the entire day to process, Choate says. He suggests a cap of 1 percent. “A four percent order can easily be a two-hour execution process and I don’t know many traders who would put an order in a box for two hours and walk away,” Choate says.
His other two concerns: information leakage and potential competition. Investment managers of sub-advised accounts are very concerned about others knowing what they are trading. Given the fact that UAT may decide to execute the order through one of its trading partners, money managers of the sub-advised accounts would face immediate competition. Presumably the money manager would send the UAT related portion of the block trade at the same time the remaining block is sent to the subadviser’s trading desk for execution. Should UAT elect to execute its piece, two firms would be competing for the available shares and the situation becomes even worse if the sub-adviser has more than one fund using UAT’s technology.
End result: Trades sent to UAT will most likely be segregated from the block and sent by the money manager to UAT after completion of the block trade. The process is often referred to as sequencing an order. Should the smaller order arrive in the marketplace after the block order has been completed it is likely to receive an inferior price because of the block order’s market impact. Such a “sequencing” scenario also defeats UAT’s claim that the execution quality of smaller orders is improved because they have a low market impact, says Choate.
Given all the potential flaws in the premise of UAT’s strategy what makes UAT think it can succeed? Chaote claims that UAT is targeting its technology to independent directors of subadvised mutual fund complexes. “Many are not familiar with the intricacies of institutional trading practices and may be enticed by the cost savings argument,” he says.
Warren counters that if his technology sounds “too good to be true” it’s because the firm’s goal was to make it simple to understand and use. “It has taken five years of work to receive five patents as well as establish the business relationships on our end to make this seamless to implement and bullet proof to our clients,” he says.
Warren also insists that large agency brokers agree with his analysis that a four percent ADV is a guidepost for dividing high and low touch orders. If the money manager doesn’t agree it can always change the parameters.
Warren dismisses any concern that money managers of subadvised accounts could end up competing with brokers executing orders sent to UAT. “IPerX routes orders to execution venues in milliseconds while block orders are executed in multiple minutes, hours or even days,” he says. “The differences in time scale, order size and venues are orders of magnitude so it’s like saying that filling up a tank of gas will change the global price of gasoline.”
This story originally appeared on Securities Technology Monitor.
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