Andrew “Buddy” Donahue is the director in charge of the Securities and Exchange Commission’s Division of Investment Management. He spoke recently at the Securities Industry & Financial Markets Association’s Institutional Brokerage Conference on buyside trading issues.
On trading in general
Recent trading developments have been positive, but also present a number of challenges.
On best execution
An investment adviser has an obligation to seek best execution for its clients’ securities transactions. To seek the most favorable terms reasonably available under the circumstances or those that represent the best qualitative execution for the account. The way investment advisers fulfill best execution obligations is more complicated and challenging than ever before.
On trading costs
In considering best execution, advisers should consider not only the commission or spread cost of each trade, but also the implicit cost such as price impact, information leakage and opportunity cost. To minimize these types of costs, advisers should formulate and adopt policies and procedures designed to determine the appropriate trading venue for each transaction. Although best execution is becoming increasingly complicated, investment advisers’ trading decisions are critical for their clients. The amount of transaction costs, both explicit and implicit, incurred during a typical year can be substantial. For example, one study estimates that the average annual trading cost for a sample of 1,700 U.S. equity funds between 1995 and 2005 was 144 basis points per year. The average expense ratio was 121 basis points. So, trading costs exceeded all the other costs for a fund.
The increased use of electronic methods to order, track and analyze securities trading has increased transparency of the costs associated with trade execution. This development is allowing advisers to determine and fund boards to oversee with greater certainty the expense of research funded by client assets and virtually unbundled research and execution services.
On commission-sharing arrangements (CSAs)
The use of CSAs may enable a clearer determination of the actual amount of commission dollars used to pay for research and those used to pay for execution.
On fund boards
My division is developing a recommendation to the commission as to how fund directors should oversee the trading practices of investment advisers to funds, including the use of soft dollars. We are seeking to ensure that our guidance reflects actual market practices and is based on actual industry experience. Accordingly, we are taking into consideration the fact that regulatory guidance needs to be flexible enough to accommodate rapidly evolving market conditions and practices in the area of soft dollars.
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