How can a hedge
fund measure the value of commission? Well, if the old adage
is that if you put 100 economists in a room and ask them a question
you get 101 answers, then the same may be true of this. Theoretically
when a hedge fund pays commission they can receive a mixture
of execution, full service research, and soft dollars in return.
In practice, there are many other factors that are involved
but we will just look into these three. One is clearly quantifiable;
one is measurable in a variety of ways, depending on your yardstick;
and one has proven over time to have no agreeable way to quantify
its value. The validity of doing an exercise such as this is
particularly important for hedge funds. In these volatile times,
the ability to measure the cost of running the business is vital,
especially for smaller organizations.
So which of these three cannot be measured at all? That award
has to go to full service research. This is not to say that
full service research does not serve a purpose; it does, and
has proven over time to be a very profitable part of many
large investment banks. The issue is that as it is coupled
together with execution, as one service, it has proven very
hard to attach a direct value to it. With the new directives
on Wall Street being handed out, and shortly to be enforced
by the SEC, such bundling is being challenged and this will
only serve to further highlight the pricing issue it faces.
If investment banks have to price their research on a commercial
basis it may be out of the reach of all but the largest funds.
Execution can be measured in a variety of ways depending
on your attention to detail and your budget. Transaction cost
measurement is critical to controlling trading costs and has
become a focus of the international trading community. Disciplined
analysis can assess the costs of different trading styles
and reveal cost patterns. Execution results can also be compared
against benchmarks and execution quality amongst brokers,
traders, portfolio managers, and trade destinations. Armed
with this information, you can adjust your trading strategies
to optimize your trade execution and overall performance,
and keep an accurate record of your transaction costs. With
management fees related to performance, of which trading is
a key part with hedge funds, optimising trading efficiency
has obvious impacts.
This leaves us with soft dollars, which is clearly quantifiable
as it separates the transaction cost from the research cost.
At present, unbundling is very much a key word in the finance
world and it is the crux of soft dollars. By apportioning
a certain set amount of commission from each trade to soft
dollars you have an exact figure to hand. The fact that these
soft dollars then go to purchase independent research means
you are able to put a price on this type of research and buy
them in discrete amounts determined by the manager. With this
valuable tool, it sets benchmarks by which full service research
can be measured
So why should hedge funds care about the pricing of these
three services? Mainly because their clients are increasingly
demanding for accountability in every cent of the fees charged.
And hedge funds need to have an answer for them that are clear
As the whole fund management industry moves towards absolute
returns, lead by hedge funds, there will have to be greater
transparency of commission payments and a greater emphasis
on cost control. This in turn has to lead to a time where
every service has to be individually priced, so a fund can
clearly show the transaction costs it incurs and the price
it pays for third party research. The debate that will ensue
is what is the best measure for execution and research, and
this debate will surely come to a point where best will mean
'most easily understood by the end investors'.
Soft dollars offer the clearest path to pricing research.
With soft dollars being used to purchase research, an exact
price is established for each piece of research together with
accurate record keeping that can be shown to the end client.
Full service brokerages are slowly realising the truth of
this matter and are moving more and more into soft dollars
as their research departments suffer under the new regulations.
Their only issue is that cohabiting soft and traditional broking
under the one roof can be contradictory. The key to soft is
the rise of independent research, which is difficult for full
service houses to promote, as this goes against the grain
of their variable pricing model for research. This means that
the provision of soft dollars comes best from specialist agency-only
firms who do not have in-house research or any other conflicting
business lines, such as proprietary trading.
The measurement of transaction costs can be done in a variety
of ways but the key point is the relevance of the method to
the investment style of the fund. Clearly, there is a different
need for transaction analysis for a long-term traditional
fund as opposed to a merger arbitrage fund. Transaction cost
analysis can be used in various ways. For example open orders
can be evaluated each day to determine the cost to trade them,
and can be modified to execute the balance in an effort to
reduce costs. Or in cases where there are large volumes of
data, we can look into a search for long-term trends in trading
costs, and make appropriate adjustments to reduce them. Either
way, or with other techniques, the cost of trading can be
analyzed, accounted for and managed.
People only buy things they can understand. Brokers need
to offer services that are clearly priced, unbundled and measurable
in terms of value. This will enable managers to show their
end investors a breakdown of how their commission dollars
are spent. This can only be a beneficial thing for investors
in funds, which in turn will bring more money into the industry.
Ned Phillips, Hoenig Far East Ltd
+852 2846 3518