Speech by SEC Commissioner:
"Lifting The Veil - Investment Industry Trading Practices And Best Execution Workshop"
Mutual Fund Directors Forum
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
June 7, 2006
Good afternoon. I appreciate the opportunity to address the Workshop on Trading Practices and Best Execution hosted by the Mutual Fund Directors Forum. I would especially like to thank David Ruder and Allan Mostoff for their efforts to bring me here to speak to you.
As you know, while you were all grappling with some significant issues in the mutual fund arena over the past few years, I was comfortably ensconced in the more placid world of market regulation. I now welcome the opportunity as a Commissioner to immerse myself in all of the issues the Commission covers, including your issues as directors of mutual funds.
The Mutual Fund Directors Forum has worked hard to provide a medium for independent directors to discuss difficult and important issues, and I appreciate that. I also appreciate that as independent directors you face many challenges and have significant responsibilities and duties. My remarks today are intended to assist you by presenting issues to consider in fulfilling your oversight responsibilities and duties relating to best execution. I also will relate to you some issues specific to soft dollars and fees and expenses. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
Mutual funds have been the investment of choice for over 90 million Americans. They are the primary investment vehicle of most retail investors who are saving for retirement, planning for educational expenses, or seeking to invest in the securities markets. They provide investors with the opportunity to achieve a variety of investment objectives while diversifying risk and obtaining professional investment management, all in the context of an affordable and redeemable security. While the last several years have tested investor trust in our securities markets generally, and in mutual funds in particular, I believe that our actions, both at the Commission and on the part of independent directors, are helping the mutual fund industry restore its firm foundations and regain investors' trust and confidence.
Although you may have heard this once or twice before, I believe that it is worth repeating: mutual fund directors, and particularly independent directors, play a critical role in protecting the interests of mutual fund shareholders. They are indeed the investors' "watchdogs" charged with vigilantly protecting the interests of fund shareholders. Independent directors must actively participate in fund oversight, challenge fund management where appropriate, and critically review compliance policies and procedures.
By law, directors generally are responsible for the oversight of the operations of a mutual fund. In addition, under the Investment Company Act, directors are assigned key responsibilities, such as negotiating and evaluating the reasonableness of advisory and other fees, selecting the fund's independent accountants, valuing certain securities held by the fund, and managing certain operational conflicts. Because mutual funds are usually operated by external money-management firms, conflicts of interest and incentives for abuse exist. For example, fund advisers may be inclined to maximize their profits through high fees, or minimize their own costs through soft dollar arrangements where the adviser, rather than the fund shareholders, receives a benefit. Thus, directors must be particularly vigilant to protect shareholder assets, so that their use is truly for the benefit of the fund shareholders and not the management firm.
As part of their oversight function, fund directors must also review and inquire into the trading practices of the fund's investment adviser and, in particular, how the adviser is fulfilling its obligation to seek best execution for portfolio transactions.
II. Best Execution and Soft Dollars
An adviser has a fundamental obligation under the Investment Advisers Act of 1940 and state law, to act in the best interests of his or her client. Fiduciary principles also prohibit a money manager from using client assets for its own benefit. As a fiduciary, a money manager has an obligation to seek best execution of clients' transactions under the circumstances of the particular transaction. The manager must seek to execute securities transactions for clients in such a manner that the client's total cost or net proceeds in each transaction is most favorable under the circumstances. The determinative factor is not necessarily the lowest commission cost, but whether the transaction represents the best qualitative execution for the managed account. In this connection, a money manager may consider the full range and quality of a broker's services in placing brokerage including, among other things, the security's trading characteristics and the relative difficulty of execution, the broker's access to markets or expertise, price, confidentiality, speed of execution, the value of research provided, commission rate, financial responsibility, and responsiveness to the money manager.
As you already know, fund managers should periodically and systematically evaluate the execution performance of broker-dealers executing their transactions. Directors, in turn, should review the manager's selection of executing brokers and ask for data sufficient to evaluate their relative performance.
It would be unfair of me to suggest that directors of mutual funds need to be experts on the markets. But I think it might assist you in better understanding the landscape if I touched on a few of the changes that have been taking place in the markets, and their potential impact on mutual fund performance. As you may know, last year the Commission adopted Regulation NMS, which modernized the regulatory framework governing our equity markets. Since its adoption, we have witnessed changes in the New York Stock Exchange's (NYSE's) auction market that were previously unimaginable. Competition between Nasdaq and the listed markets has intensified. In fact, right now almost every exchange and trading venue is in the midst of revamping its operations to improve speed and reliability and is reconsidering its business model and trading rules in the hopes of reaping some competitive advantage once Regulation NMS is implemented. For instance, regional exchanges and options markets have crafted proposals designed to provide trading venue alternatives to the two dominant equity markets and major firms are making significant equity investments in regional exchanges to ensure a competitive alternative. New ECNs have been formed and some existing markets are expanding into new products not currently traded on their exchanges. As a result of this business innovation, the competitive landscape among equity trading venues is changing.
I believe Regulation NMS will have implications for mutual funds that are both significant and positive. For example, exchanges are enhancing their automated trading systems to take advantage of Regulation NMS' order protection rule, which provides protection against the execution of trades at prices outside the best quoted prices that are immediately and automatically accessible. These enhancements may make the systems even more efficient for executing algorithmic trades placed by fund advisers. Regulation NMS may also result in better execution of large-sized blocks. It provides for an intermarket sweep order that permits all the better priced orders be executed in one "sweep" before the remainder of the block is executed at an inferior price.
As the markets continue to change, the advantages of the various trading applications and trading venues will likewise evolve. While it is unlikely most of you will become technical experts, you can certainly ask probing questions of your fund managers, and they in turn with their executing brokers, about the reasons for selecting certain trading opportunities and the advantages of one or another market for types of securities. You may also see and get an explanation of the broker's execution quality statistics as well as the execution quality statistics for the markets where your broker directs your orders. When reviewing these statistics you should be mindful of and inquire into broker's policies and practices to seek price improvement opportunities. Some markets routinely offer opportunities to execute an order at a price better than the quoted price. Broker-dealers should take this opportunity for price betterment into account when choosing where to direct your orders.
Finally, a vigilant director should consider how potential conflicts of interest, such as receipt of soft dollars and other compensation arrangements, influence a manager's selection of executing brokers. Use of client commissions to pay for research and brokerage services, that is, using so-called soft dollars, presents advisers with significant conflicts of interest. It may give incentives for advisers both to disregard their best execution obligations when directing orders to obtain research and brokerage services and to trade portfolio securities inappropriately in order to earn credits for such services.
Recognizing the value of research in managing client accounts, however, Congress enacted Section 28(e) of the Exchange Act. This section permits a money manager to pay more than the lowest commission rate in order to obtain research and brokerage services provided the adviser makes a good faith determination that the commission was reasonable in light of the value of the products or services received. This section establishes a safe harbor that allows money managers to use client funds to purchase "brokerage and research services" for their managed accounts under certain circumstances without breaching their fiduciary duties to clients.
Last year, the Commission issued a proposed interpretive release on soft dollars that, I believe, clarifies the scope of the safe harbor. Specifically, the release addresses what research and brokerage services may be obtained under the safe harbor. Based on examinations, we had become concerned about the appropriateness of products and services that were being treated as "research," the allocations of "mixed-use" items, the general disclosure by advisers about their client commission arrangements, and the lack of documentation. The proposed interpretive release directly addresses the abusive practices that had developed over time and updates the interpretation in light of new technologies and practices. The interpretation also serves as a reminder to the industry that the safe harbor does not give a money manager a reprieve from its duty of best execution. We have received many thoughtful comments, including some from the Forum, and our staff is currently considering them and should be making a recommendation to the Commission shortly.
I note that the Commission's proposed interpretation is generally consistent with rules recently adopted by the U.K. regulatory authority, the FSA, which should mitigate the cost of compliance for firms operating under multiple regulatory regimes. The discrete areas where the two regulations may differ in scope result from the differences in our governing laws and rules. For example, the U.K. does not have a statutory provision similar to Exchange Act Section 28(e) that governs their activities.
I believe the SEC's proposed interpretation of the safe harbor is an important first step to guide the industry in satisfying the safe harbor's conditions, particularly with respect to assessing the eligibility of services and performing the good faith analysis. I recognize, however, that the SEC's interpretive release does not address all questions relating to soft dollars and best execution. For example, documentation of the brokerage and research services an adviser receives with soft dollars, particularly from full-service brokers, is scant. This means, in turn, that an adviser's discussion of its soft dollar practices to the fund board may not be able to be adequately scrutinized by reviewing documents about these arrangements.
Generally, I believe fund boards could better assess the appropriateness of soft dollar arrangements if the Commission mandated better disclosure of the research and brokerage services provided to the adviser for the bundled commission rate charged. When directors review the fund adviser's brokerage practices, I think it would be useful for directors also to review the brokers' execution-only commission rate as a means to compare the costs the fund would have been charged without such additional research and brokerage services. Fund directors could then make more meaningful inquiries into the value of such additional services for the fund shareholders whose interests they represent.
Last year, the U.K. recommended disclosure of soft-dollar practices by advisers to fund boards, which the industry is currently implementing. I understand, anecdotally, that the disclosure has informed managers and spurred discussion between investment advisers and broker-dealers about the quality of execution and research services received for commissions spent. There appears to be a trend emerging where broker-dealers are "pricing" their proprietary research separate from execution, similar to the way third-party research is currently offered. I am encouraged by such news of improved transparency and accountability in this area.
Therefore, going forward, the Commission must address whether and how to improve disclosure to the fund board of the adviser's use of soft dollars and improve the adviser's accountability by requiring more robust recordkeeping as to products and services obtained with soft dollars and the basis for allocations of mixed use products.
In the meantime, I encourage you to request greater disclosure and recordkeeping from your fund advisers regarding their soft dollar practices. You, as independent directors, should inquire about the portfolio execution process, and should be asking about and receiving full explanations of the adviser's broker selection process. Both to understand the adviser's fulfillment of its best execution obligations and to comprehend transaction costs, you might request and review regularly reports from the adviser on execution of portfolio transactions and an analysis of execution quality.
You are already armed with some tools to assist you in this endeavor. For instance, the Commission now requires investment companies and investment advisers to have written compliance policies and procedures. A fund board could also consider independently requiring the fund adviser to develop written policies on the execution of portfolio transactions that address, among other things, the adviser's determinations about routing orders and allocating trades and how the adviser seeks best execution on all brokerage transactions. If research or the receipt of another benefit, such as a rebate, is considered when routing orders, the policies and procedures should squarely address this. Also, the policies and procedures should describe how the adviser monitors execution quality, including use of analytical tools, conducts periodic assessments of broker execution quality, and provides reports to the board.
The board should also assess the adviser's policies and practices at least annually. To do this, the directors should request and review on a regular basis reports on the execution of portfolio transactions and information about execution quality. Because best execution is the result of many factors, some of which are readily measured, such as commissions and spreads, and others less so, such as market impact and opportunity costs, boards of directors should engage the adviser and other experts, if necessary, to better understand the various methods for measuring and evaluating execution quality and transaction costs.
As part of its review of portfolio executions, directors should consider the impact of commission rates on best execution. Directors should consider requesting from their advisers reports summarizing commission rates paid to brokers; seek explanations for the commission rates that exceed the customary rate paid; and examine, particularly for liquid securities, the adviser's relative use of alternative execution strategies such as program trading, direct access, and ECNs that can achieve quality executions at reduced cost. With respect to trades executed by an affiliate of the adviser, directors both should require that the adviser obtain the most favorable commission rate that the affiliated broker-dealer gives comparable clients, and that such affiliate provides the best execution reasonably available under the circumstances to the fund. I would note that many of the actions that I have highlighted today are also addressed by the Forum's "Best Practices and Practical Guidance for Mutual Fund Directors."
There are other areas where directors can seek greater disclosure from advisers. One of the most important is fees and expenses.
III. Fees and Expenses
To my way of thinking, the biggest "bottom-line" contribution that independent directors can make, and perhaps the most important improvement they can make to the status quo, is in the area of fees and expenses. Obviously, one of the biggest fee issues that impact investor returns on their investment is advisory fees.
Section 15(c) of the Investment Company Act requires fund boards to consider whether to approve the terms of the advisory contract, including the amount of the advisory fee. Fund directors have a fiduciary duty to act in the best interest of the fund when approving an advisory contract and the advisory fee. Fund directors should carefully scrutinize the contract and the fees, using a broad range of information that advisers are required to provide. They should also demand detailed disclosure of information concerning the fund adviser's conflicts of interest.
Some academic studies have shown that over the last decade, the growth of retail investment in mutual funds and the proliferation of fund products have been associated with an apparent rise in fund fees in the absence of a commensurate rise in operating costs or fund performance. I find this particularly puzzling. It would appear that some funds may not compete on the basis of price, or fees, for the delivery of professional management advice. Further, advisers may not be passing on to investors cost savings resulting from economies of scale. One then must consider why? More vigilant assessment of fund fees by boards of directors may help address these concerns.
To be sure, the structure of fund complexes and advisers to these complexes is one source of tension. External management of funds is nearly universal in the industry and means that while such management companies seek high returns for fund investors, they at the same time also seek a return for themselves. Also, external managers typically control all facets of fund life from inception through selection of the initial board, and such control continues over time.
Thus the importance of independent directors.
Independent directors must focus on the critical task of monitoring fund fees and negotiating appropriate fee rates on behalf of investors. Independent directors should understand and be prepared to explain to shareholders the basis upon which they determined that fee levels were reasonable and appropriate. Fund boards should dig beneath the adviser's representations to the board and request relevant records and reports of actual expenses from the adviser.
As you know, many of the fees and practices of mutual fund advisers are not entirely transparent and may involve the use of fund assets. A few obvious ones include Rule 12b-1 fees, which permit mutual fund shareholder assets be used to pay for activities to facilitate the sale of fund shares and other services for shareholders; soft dollar arrangements, which permit fund managers to receive research and brokerage services by paying higher brokerage commissions; and revenue sharing, whereby advisers pay from their pockets for broker-dealers to distribute fund shares.
Investors simply do not understand the amount and impact of mutual fund fees and expenses. While transactional fees, such as front- and back-end sales loads, are relatively obvious, portfolio transaction costs, management fees, and distribution fees are less evident because they are deducted directly from fund assets. Also, practices such as soft dollar arrangements where the adviser obtains research and services it would otherwise have to pay for itself and then recoup in a management fee, reduces the adviser's actual management costs and the related advisory fees that a fund is explicitly charged. Revenue sharing practices are not currently disclosed in detail because they are paid from the adviser's resources, and as a result obscure for the fund board and for the investor the true costs of distributing fund shares. A fund investor trying to understand more about the revenue sharing would be hard-pressed to find a full and comprehensible discussion of this in the fund's disclosure documents.
With respect to management's practices in these areas, it is critical that fund boards of directors, especially independent directors, assess whether the manager is fulfilling its fiduciary duties and is doing its best to provide value to fund shareholders. Greater transparency of the costs and the services provided is fundamental for the board directors to meaningfully assess overall fund performance. As I noted earlier, with transparency, a board may be able to compare the costs of securities trades, analyze the fund's operating expenses and evaluate the adviser's revenues and expenses in managing the fund. Without transparency, it is difficult for a board of directors to carry out its duties effectively since the costs of portfolio securities transactions and the value of the advisers' arrangements and value added is opaque. Moreover, a lack of transparency regarding costs and benefits received by advisers makes an adviser's evaluation of best execution, and its related disclosure to the board about execution quality, less than robust.
Yet many money managers' fees and arrangements obscure critical information on fund costs which complicates any analysis the board may undertake concerning fund and manager performance. Moreover, managers are faced with many conflicts of interest when routing portfolio orders to broker-dealers and then allocating portfolio transactions. Fund directors play a critical role in overseeing and monitoring the manager's conflicts. Without a clear understanding of portfolio transaction costs, both explicit and implicit costs, and the adviser's routing and allocation decisions, the fund board is hamstrung.
I would also encourage fund directors to drill down on other arrangements, such as revenue sharing, and fees, particularly Rule 12b-1 fees, and request fund managers to detail what services are obtained for the fund. As you know, Rule 12b-1 permits mutual fund shareholder assets to be used to pay for activities that facilitate the sale of fund shares, such as advertising and marketing, and are also used to pay for some services to fund shareholders. Over time the use of Rule 12b-1 fees seems to have migrated beyond its original purpose. In truth, Rule 12b-1 fees have become a substitute for a sales load.
I must note that I believe the Commission should do its part to review Rule 12b-1. I know that you are struggling with these fees and appreciate the difficult issues that they present. I would ask that you continue to ask thoughtful questions about the use of Rule 12b-1 fees, however, and to seek an accounting of how they are spent. Also, seek to understand whether shareholders are benefiting from the sales fees paid and the services provided.
Directors should also ensure that fees and arrangements make sense in the context of the particular fund's structure and investment objectives. For example, when a fund is passively-managed, such as an index-tracking fund, the costs of providing advice should be significantly less than for an actively-managed fund, since there is little stock picking involved. Rather, these funds try to minimize the tracking differences with the index, and because this is mostly a mechanical exercise, administrative and personnel costs are low. You should inquire, then, why the manager may be obtaining soft dollar credits to obtain research for transactions in such index-tracking funds.
Related to the appropriateness of a fund's fees is the performance of the fund, particularly whether the fund is fulfilling its investment objectives and ultimately delivering value to fund investors. You should ask probing questions of management in this area as well. For instance, you should understand the factors contributing to the fund's current performance and inquire how to improve performance. You should understand the expertise of the management team and be sure it aligns with the fund's objectives.
I truly appreciate the significant responsibilities that you have and believe that your role in protecting fund shareholders is critical. By highlighting current market changes and select practices, I hope that my comments today might assist you in fulfilling your responsibilities and in making thoughtful inquiries into fund managers' practices, particularly in the areas of best execution, soft dollars, and fund fees and expenses. If, during the course of your review and inquiry, the data or responses from management do not make sense, I encourage you to ask again, dig further, and, if necessary, retain independent consultants or legal counsel to provide an independent perspective on the practice or policy in question.
Ultimately, investors are depending on you to obtain satisfactory answers, to require accountability, to ensure fairness and integrity in the conduct of the funds' business, and to maximize the value of their investment. This is an important responsibility, but I am confident that you are up to the challenge.