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September 30, 2000

Commission Recapture Success

By Howard J. Schwartz

We have found that the success of a commission recapture program is enhanced when the broker, consultant and investment manager work together to serve their common client -the investor.

Commission recapture is institutional discount brokerage. It works by returning commission dollars directly to the investment end-user - the pension plan or fund that ultimately pays the commission. And that reduces transaction costs.

Institutional investors may be more familiar with commission subsidies or rebates in the form of soft dollars.

Soft dollars are portions of broker commissions used by investment managers to pay for research supplied by the broker, whether the research is proprietary or produced by an independent third party research provider.

Commission recapture redirects control over a fund's commissions to the beneficial owner of the pension plan or fund. Thus, simply stated, commission recapture unbundles commissions, separating the implicit research charge - the soft dollar component of the commission - from the execution charge. That charge is then returned directly to the investor that paid it in the first place.

In a typical commission recapture program, a fund directs its investment managers to execute a portion of its trading on behalf of that fund through a specific recapture brokerage firm.

The managers pay their standard negotiated commission rates. The broker then rebates an agreed upon part of the commission back to the fund. The rebate to the fund can be in cash or in payment for the fund's administrative expenses, which may include actuarial fees, accounting expenses or consulting fees. This simplicity of implementation is one reason commission recapture is becoming so popular.

Commission recapture assumes that the recapture broker is competitive in execution and price. As noted, recapture programs are typically based on investment managers' standard negotiated commission rates. Quality of execution can be measured by independent transaction cost monitoring agencies.

For instance, recent reviews by leading agencies like Plexus Group, Abel/Noser and Elkins McSherry rated Instinet first or second in (low) execution cost, not only among peers but compared to full-service brokers as well. A major attraction of commission recapture is that it is consistent with fiduciary obligation. In 1986, the U.S. Department of Labor, which administers ERISA, noted that commissions are assets of a pension plan, and plan sponsors have a fiduciary responsibility to monitor and control them.

The Labor Department reinforced this view in a 1997 study, when an advisory committee noted that "a properly structured commission recapture program can assist investment managers, reduce plan costs and help plan sponsors [trustees] fulfill their fiduciary responsibilities."

The Association for Investment Management and Research has addressed the issue from the investment manager's point of view. It noted in a 1997 report that "because brokerage is an asset of the client, not the investment manager, the practice of client-directed brokerage does not per se violate any investment manager duty."

Consultants should carefully examine competing recapture brokers to determine that they meet the highest standards.

* They should provide best execution on a global scale.

* They should be able to recapture in fixed income as well as equity markets.

* They should provide superior reporting and reconciliation services to spare the client administrative burdens.

* They should offer recapture and discount brokerage services in portfolio transitions as well as in ongoing trading.

Investment managers need to be sensitive to their clients' recapture preferences and their directed brokerage instructions. They should work closely with the broker to establish the recapture program and determine how trades for recapture credit will be identified and accounted for. The broker and investment manager will frequently need to exchange information to determine that the client's recapture targets are met.

Howard J. Schwartz is chairman and chief executive officer of New York-based Lynch, Jones & Ryan, Inc., a wholly-owned subsidiary of Instinet Corporation.