Let's face it: Asset management is a commodity. Just look at the hundreds, even thousands, of mutual funds that you have the ability to put clients in. So, just how, exactly, does your firm choose which funds or managed account managers to put on its “preferred vendor” lists?
It's been an open secret among advisors, but not something that clients have generally been aware of: Choosing a manager for a brokerage's preferred list is as much about peripheral business (read: monetary) arrangements as it is a given manager's skill in running money. “It's a business decision as much as an alpha decision,” says one executive of a large money management group.
This is not to suggest that any asset manager — fund or separates — can buy his way onto a preferred list. You have to be an outperformer. But to be on a short list with continuing analyst coverage, you have to know that you will be expected to pay tens of thousands of hard dollars for broker/dealer conferences and other “training” programs. In addition, most broker/dealers will require that asset managers pay for that privilege by paying fees via directed trades (worth somewhere around four basis points of assets under the management, according to one fund family executive). Strategic partners, as those managers are sometimes called, are then welcomed, even expected, to send an army of wholesalers through the branches, educating advisors, helping them close deals and offering any other support they can, including meeting with retail clients.
Such revenue sharing is standard practice and is typically disclosed in the “statement of additional information” area of prospectuses. But now the SEC wants to bring such disclosures out of the fine print and, perhaps, onto a new mutual fund client “confirmation” statement, said the SEC's director of the investment management division, Paul Roye, to a December mutual fund industry gathering. The idea is to make it easier for clients to understand how advisors and the people who provide them with products are paid.
But the trend to stop “directed brokerage” has already begun. Morgan Stanley, in settling with the SEC and NASD for pushing proprietary funds over third-party funds, said it would “no longer accept direct brokerage (soft dollar) payments for retail distribution of mutual funds.” Some mutual funds, notably Putnam and MFS, said they would quit directing trades for broker/dealers' selling of their funds.
Is It Really a Problem?
This activity raises some important questions, including: Do the arrangements described above materially compromise broker/dealer due diligence in the choosing of managers? And Do clients even care?
The managers interviewed for this story, none of whom would talk on the record, see little wrong with the current arrangements. From an asset manager's perspective, the process of gaining access to a network of financial advisors costs money. From their perspective, paying in soft dollars, revenue sharing and directed trades is preferable to paying hard dollars.
“As long as there is equal access, we're okay with it,” says an executive of a large fund family.
The reason the process passes muster is that the soft-dollar arrangements are arranged once the manager has passed the selection process. Before placing a fund on a preferred list, broker/dealers put managers through the due-diligence grinder, with quant-oriented gearheads testing for “value added,” or alpha. The goal is to determine whether the manager rewards investors for the risk taken.
After a manager passes the due diligence process, he is sent to a board of executives, which determines if the manager has what it takes to make it in the program. It's here that the “business issues” can come into play. The executives will ask questions like: Is there demand for this manager in our system? Will the manager help the firm and its brokers raise assets? Does the manager have a team of wholesalers who will fan out across the branch network, not just to flog their own products, but to teach and service clients in general?
Is this way of doing business bad? “No,” says one asset manager executive, “it's healthy for the system.” He asks, rhetorically, “Can you imagine the scenario, ‘Yeah, I'm a really good manager, strong long-term performance but we're not marketing’? Is that really healthy for the system?”
Says another fund executive: “Pay to play: I don't have a problem with it. Everyone pays at some level. I just mind if b/ds make it easier to do business [for preferred vendors] and make it harder for everybody else.”
“It's retail,” adds one Morgan rep. “You'd do the same thing at a grocery store — if you want Folger's coffee on the third shelf, you're going to pay for it.”
“If you don't want that kind of stuff,” he adds, “change the system.”
That last little bit sounds like a dare, but don't be too surprised if the regulators take him up on the challenge.
Top 10 Separate-Account Investment Managers
|Asset Management (PPG)|
|2 Merrill Lynch||30.6|
|Investment Management Ltd.|
|5 Lord Abbett||15|
|& Co. LLC|
|Investment Partners Ltd.|
|Capital Management LP|
|Managers Group Inc.|
|Source: Cerulli Associates, as of Sept. 30|