The great City fees scandal

Published on Sunday 10 June 2001 01:00

IN THE review of institutional investment that the Chancellor of the Exchequer asked me to carry out, I proposed that pension and other institutional funds should require their fund managers to absorb the cost of commissions paid on securities transactions, rather than - as at present - leaving these to be paid by the client.

This is clearly a significant change. It is, therefore, not surprising that a series of arguments has been made against it. But I find none convincing. In fact, if anything, they have tended to strengthen my belief that it was correct to challenge a practice that appears poorly aligned with the best interests of the client.

Most of those who have commented agree that there is an important issue here that is not currently being addressed: namely, the fact that the very significant sums paid in commission are not properly scrutinised or managed by the fund manager’s client.

Some critics have attempted to argue that since fund managers compete intensely on investment returns and since commissions affect investment returns, there are already strong incentives for fund managers to manage commissions effectively. But the existence of soft-commission and commission-recapture demonstrates that this cannot be the case.

Broking houses are clearly willing to make substantial payments out of their commission income - either to fund managers in the form of soft-commission, whereby the fund manager receives goods and services free of charge, or whereby pension funds and other clients secure substantial rebates through commission-recapture programmes.

If commission costs were really being managed effectively, these arrangements would not exist. The reality of the situation is that competition for investment returns is largely relative to that of other managers. Provided the commission payments incurred by a manager are broadly in line with the industry norm, competitive pressure to scrutinise commission payments need be only limited.

The predominant debate over my proposal has centred on arguments over its effect, rather than whether there is a problem in the first place.

The most frequent objection has been that if these different fee arrangements lead to fund managers cutting their commission payments, broking businesses will simply widen their bid and offer dealing spreads to compensate, leaving customers no better off.

But surely this should be prevented by competitive pressures in broking and market-making, and by fund managers’ fiduciary duties? An arbitrary but pervasive widening of dealing spreads in response to this change would suggest the existence of quite profound competition issues. Remember, the commission is a reward to an agent for executing a transaction. How can a change in the source of the agency payment, from the clients to its funds manager, justify an improvement in the market-maker or principal’s margin?

On a related issue, it has been argued that if commissions were to fall and spreads to widen, this would represent a significant reduction in transparency for clients, as commissions are separately visible whereas spread is not. This evidence is at best confused thinking.

Currently, institutions use a variety of transaction methods. In some the client pays through commission, in others through spread. In some of these, the cost reflects only the costs of transaction. On others, the client is paying for their fund managers to receive a whole host of services quite unrelated to the transaction in question, such as access to corporate management, flotations and securities research.

In such a situation, whether the proportion of commissions decreases or not has no material impact on transparency. The situation as it stands now is entirely untransparent. Pension funds and other clients of fund managers have effectively no idea what price they are paying or what services their fund managers are receiving in return.

I see little merit in the argument brought forward by others that my proposal will lead to an increase in "net trading" - where the fund manager contracts directly with the market-maker on behalf of his client rather than using a broker - and that this in some way is fraught with risk for the client.

Clients should remember two things. First, fund managers over the past 15 years have conducted an increasing proportion of their business on a net basis, including in leading UK equities. Second, a net bargain still exists behind an agency transaction. It is not a question of "either/or": agency commissions come on top of a net transaction.

Some have argued that the issue of transaction costs could be addressed through greater transparency to the end client. While transparency is undoubtedly a good and useful thing, it is not sufficient in this case. Commissions are the results of day-to-day investment decisions requiring a detailed understanding of specialised and technical financial markets issues.

Pension-fund trustees, even with the greater degree of professionalism that I propose in my report, can realistically have only a limited impact on such decisions. Fund managers will struggle to provide clear and compelling explanations of the services received and the price paid.

Pension funds are in no position to judge whether they are paying too much or too little in commission. Only the fund manager who has the day-to-day contact with the market can know this. My proposal puts the fund manager in the driving seat.

Some fund managers have argued that this is impracticable because it will require them to estimate the likely level of trades over the next year when agreeing a fee with their client. But the process of estimating likely future costs when agreeing prices today is something that businesses do every day. Expecting customers to carry that risk is the exception, not the rule. This argument also assumes that payments to brokers must all be transaction related.

This is not necessarily the case at all. They are at the moment because that enables them to be passed on to the client. That is a distortion. Under the protocol I propose, fund managers are more likely to break the link between access to external research and the generation of a transaction.

This would appear to be a benefit in itself if it reduces the pressure to trade and instead fosters the development of longer-term relationships between institutional fund managers and the companies in whose shares they invest their client portfolios. My expectation is that my proposal will see fund managers develop more in-house proprietary research, backed up by commissioned research from independent houses, which would not necessarily need to promote a transaction in order to be rewarded.

Some critics claim that the proposal I have made would damage the City as a financial centre in various forms, or would penalise small fund managers, or small brokers, or small company research.

These are the same arguments that were used at the time of Big Bang in an attempt to defend fixed commissions. The dire consequences predicted then did not come to pass and they will not come to pass this time. Small companies always have some disadvantages in competing with large ones. But they also have advantages. Those with a good niche proposition have succeeded and will continue to succeed. They do not need special arrangements for raising extra money from clients through roundabout routes to remain viable. Cross-subsidisation is generally associated with sub-optimal behaviours. This is no exception.

We have continued too long with a protocol for allocating securities transaction costs that are poorly understood and insufficiently scrutinised. It is time that this situation changed.

Paul Myners is chairman of Gartmore Investment Management, but these are personal views, not necessarily the views of Gartmore