Best execution isn’t just about numbers: Why broker ranking matters

This article was written by Lisa Roitman for Bloomberg Markets magazine. It appeared first on the Bloomberg Terminal.

Investment advisers have a duty to seek “best execution” for their clients. That doesn’t mean they have to obtain the absolute lowest price for their customers in securities transactions. But it does require that advisers seek the most favorable terms—considering all relevant circumstances.

For U.S. investment advisers, best-execution issues generally arise in connection with selecting broker-dealers. The Securities and Exchange Commission, in Release No. 34-23170, says the duty of best execution requires an investment adviser to “execute securities transactions for clients in such a manner that the client’s total cost or proceeds in each transaction is the most favorable under the circumstances.”

Just what do those circumstances include? They cover the “full range and quality of a broker’s services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the money manager,” according to the SEC. Because of that guidance, many compliance officers rely on their analysts and traders to stack rank brokers, allocating the largest commissions to the brokers who come out on top.

You can’t just set and forget such rankings. Michael Butowsky, a member of Jones Day’s financial institutions litigation & regulation group, says the SEC has held that advisers have a duty to “periodically and systematically” review trades to determine whether they’re obtaining best execution. “Ideally, for investment advisers with trading discretion, this means having policies in place to ensure that those reviews actually occur—and keeping records to prove to the SEC staff that they did,” Butowsky says. A failure to take appropriate steps to build such policies and procedures can lead to enforcement actions and fines.

It’s important, then, that trading staff understand they need to speak up when circumstances change. Whether companies use best-execution committees or detailed questionnaires to help compliance professionals develop broker-performance metrics, trading staff need to feel comfortable—and motivated—to provide feedback on an ongoing basis. For example, if an adviser has chosen responsiveness as one of its ranking factors, and the broker-dealer sitting at the top of the company’s ranking is no longer responsive, traders need to have a mechanism to get that information into the company’s best-execution committee’s consideration.

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The SEC expects an investment adviser to disclose to clients the factors it takes into account when choosing brokers, including soft-dollar arrangements. These disclosures are typically made in the Form ADV and in the offering documentation relating to investment products. “On SEC exams, one should expect that the SEC staff will compare those disclosures against the minutes of the investment adviser’s best-execution committee meetings and other records to determine if the investment adviser did, in fact, take the disclosed factors into account when selecting brokers,” Butowsky says.

Bloomberg provides a number of tools that can help traders and compliance officers meet best-execution regulatory requirements. One is KYC Entity Exchange, a secure, web-based platform that enables investment advisers and brokers to exchange the data and documents necessary to meet regulatory obligations. Sensitive information is permissioned in an encrypted environment, with auto-match and auto-population of forms and questionnaires. A full audit trail and version control enables compliance officers to evaluate the operational efficiency of brokers in support of a broker ranking analysis. For more information, go to {KYC <GO>}.

Running {BTCA <GO>} for the Transaction Cost Analysis function lets you quantify broker performance across multiple asset classes and regions and compare relative performance against pretrade estimates and that of peers.

Finally, for information about Bloomberg Vault’s supervision and surveillance tools, investigative functionality, reporting, and record keeping, go to {BVLT <GO>}.

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