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February 1, 2002

Her Majesty's Soft Dollars: Guest writer Wayne Wagner challenges a controversial proposal on fund m

By Wayne Wagner

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  • Her Majesty's Soft Dollars: Guest writer Wayne Wagner challenges a controversial proposal on fund m
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Investment managers - and not, as is customary, the clients of institutional investors - should eat the research costs generated by transactions in managed accounts.

It is a brave new world, but that is the conclusion of a controversial report on the U.K. pension industry, inked by a former chief executive of Gartmore Investment Advisers.

"Clients' interests would be better served if they required fund managers to absorb the cost of any commissions paid, treating those commissions as a cost of the business of fund management, as they surely are," declares Paul Myners, in the report commissioned by the U.K. government.

The conclusion is not surprising because there is a wide-spread perception that these costs, associated with soft-dollar practices, are prone to corruption. It has been an issue in the U.S. since the 1975 birth of negotiated commissions. An Act of Congress was needed back then to permit commission payments for research services. Indeed, the majority of plan sponsors instruct investment managers to trade through a selected broker. The broker agrees to rebate part of the commissions to the pension plan. That reduces commission pools available to the manager.

Still, eliminating soft-dollars risks serious market damage. It risks taking soft' expenditures out of commissions and putting them with the principal price.

In most scenarios, the clients of institutional investors, including pension plans, mutual fund shareholders, 401(k) participants, will not end up winners. Since 1975, the cost of processing an ordinary transaction has plummeted to around a penny or two per share. Yet, at the same time, average full-service commission rates remain about six cents a share. In other words, the charges have not come down in line with the cost of providing the basic service.

Sure, six cents a share may be justified for handling difficult transactions. Brokers earn this level of commission when they handle a large and delicate order. Still, no matter how simple the trade, the going rate for non-automated trading is still near six cents. No market force, buyside, sellside, nor even plan sponsors, seems to want to bring the price down. The reason: Sheltered under this six cents umbrella' is a host of institutional research and tools accepted as essential to asset management.

Vital Services

Most managers carefully budget their soft-dollar services. Many have administrators who see that soft-dollar standards are followed. Yet the heart of the Myners report notes that the services acquired are not adequately scrutinized to determine whether they are indeed vital.

Here's an example: In today's environment, a large manager is likely to receive a dozen or more research recommendations as brokers strive to display their competence. This sounds excessive, but the value of information is not as evident as suggested by Monday morning quarterbacks. Perhaps most of the important research is redundant, but who wants to disregard research by Ms. X under this arrangement? She might stumble across something important that is ignored by other analysts.

Suppose - under the Myners scheme - investment managers picked up the costs generated by commissions: How would pension management be affected? How would it affect trading?