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The Real Value of Commissions. The Measurability of Execution, Full Service Research and Soft Dollars
Ned Phillips, Hoenig Far East Ltd

May 2003

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 and simple.

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.

Contact Details
Ned Phillips, Hoenig Far East Ltd
Hong Kong
+852 2846 3518


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