This Time It’s Structural

Paul Squires, Head of Trading AXA Investment Managers systematically analyses the consequences of structural market change and sell-side head count reduction across the street.
Amid the current market and trading environment the expression “A Perfect Storm” springs to mind because, clearly, the entire industry has seen decreasing margins and volumes since 2008. At the same time, there has been an arms race to invest in technology just to maintain position. Those two things aren’t exactly the best backdrop for cash equity. Furthermore, even if the cash equity business is seen as a loss-leader for other more profitable asset classes, Basel 3 and global banking reforms seem to be impinging upon those commercial realities as well. 2012 was a very tough year for banks and brokers, and I think we’re finally seeing a little bit of fallout from that in terms of strategic reorganisation. It’s not just a seasonal thing now; many in the industry had sustained hope that it was just a tough period, that we would come out of it and that volumes would return to 2008 levels; however, I believe people are realising it’s much more structural.
Splitting Hairs
Commission Sharing Agreements (CSAs) are increasingly an essential facility for the buy-side. CSAs were really the avenue to enable CP176 (FSA consultation paper on unbundling). They reduce the extent to which trade execution might be constrained to where fund managers are getting their advice and service. In other words, the buyside executes with the broker where they have a CSA (provided they can give good execution), paying both an execution and an advisory component at the same time thus building the advisory pot, which can then be used to pay for independent research (or gives the fund managers the freedom to pay for advisory services from a broker whose execution service is not as strong).
More recently, the FSA has said that fund managers weren’t embracing the opportunity to split the different commission components as much as they had hoped, and the FSA is pushing again for that to happen. This is entirely appropriate from a client’s perspective, in my view. It’s the client’s money that’s being used every time the buy-side trades; if you’re paying a bundled commission, that’s effectively the client paying for the execution service and the advisory service and they should expect the best decision for both elements of that.
There are a couple of areas of focus within the current consolidation of advisory services and execution services. On the execution side, we’ve seen most impact from a more strategic ‘top-down’ view of sales trading. In the past, electronic sales trading was seen as supplementary to the traditional cash equity sales trading. There’s been a hard push to set up the provision of algorithms, and that has created a duplicated set of execution services. Now, my desk has taken a decision to focus our contact with our primary cash equity sales traders, but enabling them to see our algorithmic flow. This means that if we’re trading a significant volume of a stock and the cash sales trader can see what we’re doing, we’re optimising all our execution avenues. There is electronic access to multiple venues, but there is also the traditional broker distribution channel.
As part of our regular trading reviews, we explained to our brokers that our cash sales trader is the one who knows our account and our style of trading. We’ve had the historic relationship with them and they are best placed to disseminate the most relevant market information to us very quickly. For example, if we self-direct an algorithmic order, they could see that we were looking to buy a chunk of a French small cap; if they happen to see flow in that stock from another source internally, then they would be able to pick up the phone and say, “I know you’re working an algorithm, but if you’re interested, we’ve got the natural seller.” This is the level of service we want, but it’s taking the market quite a long time to get to that point. Based on our conversations, we’ve discovered that we are in the minority in wanting the sales trader to see the algorithmic flow. In contrast to our view, we believe many in the buy-side see anonymity as the key benefit of an algorithm.
A lot of the buy-side use algorithms almost primarily for the anonymity, which means they end up with a duplicated set of coverage with electronic coverage and cash sales trading. Clearly, that’s an expensive way to organise coverage for a typical asset manager whose volumes have declined substantially in the past couple of years. Therefore, I think we will continue to see brokers moving their electronic teams much closer to the program team or the cash sales traders.
Sell-Side Headcount Changes
The impact on the buy-side isn’t just caused by the fact that the headcount of sales trading has shrunk, it is that the number of clients has expanded. There are now so many small hedge funds and boutique asset managers. In many instances, the sales trader is doing his best to pick up the phone and put the orders into the system but, in our view, he often no longer has time to closely scrutinise the markets and stocks in the way that we used to benefit from.
At AXA Investment Managers, we trade with approximately one hundred brokers a year. But within that, it’s a very concentrated focus with our top 20 or so brokers being absolutely key. In addition, there’s a significant tail of brokers that we need access to less frequently for very specific orders.
There will likely always be two or three brokers, who, while market consensus suggests a certain direction, may feel that it’s worth their while taking a different view and who see an opportunity to gain market share by going against the trend.
Does a buy-side firm these days need more than two or three execution-only brokers who are the traditional sort of agency guys who are very driven to get your flow? They do a lot of work to be close to the market; talk to a lot of people; give you a lot of market colour. I think what this means is that the emphasis has shifted from the buy-side trader picking up the phone to someone on the sell-side who then directs how to execute your order, to the buy-side trader now having all the relevant tools. This concept of “best selection” as a process for us is one of the main aspects of “best execution”; in other words, the due diligence before we decide exactly how we are going to trade the order. Do we pick up the phone because, in fact, we just want a risk price; we want instant liquidity and the immediacy of execution? Do we want to park it passively in a couple of dark pools, and know a particular algorithm that is going to do that for us? Do we want to just pick up a phone to the sales trader and say, “Just keep it to yourself for a while, but I’m looking to buy a chunk of this particular stock in case you see anything in it”? Maybe we want to have a look around the shareholder list, see who might have been active in it and see if we’ve got any opportunities to do cross a block naturally? There are so many different ways to execute now and hence this concept of ‘total liquidity management’.
Do we really have a sense of whether the advisory services of one firm are better than those of anyone else, and how do we ascertain the value of that? I think both the brokers and buy-side have been reluctant to dig into that granularity.
Maybe the buy-side hasn’t been very good at being able to articulate what it wants and really focus on why they’re using certain brokers or execution channels to accomplish their objectives. I think because of the ongoing consolidation in the industry, the buy-side has to be much smarter about that. The result, I believe, is a polarisation in that the bulge-bracket firms are going to give you some very good algorithms, including access to their own internal flow, on one hand, while on the other, there are driven agency brokers who do a little bit more of the old-fashioned broking and may be a better channel for small caps. Where I think the outlook is less clear is where you have a broker which is quite good at several things but not outstanding at anything. This is a trend the market has been discussing over the past few years, but we finally are seeing that come to fruition.
Vendor Impact
From the vendors’ point of view, they have been relatively untarnished by the pain felt in the broader industry, because another consequence of this shift from the sell-side to the buy-side is that the buy-side has had to invest a lot of money in technology. In the old days, it was bundled into the broker service and paid for with the commission that was given to brokers. We would rely on the brokers for all sorts of things. To some extent, for example on the governance of algorithms and different venues, the sell-side is still much better positioned to provide that insight than the buy-side itself. We on the buy-side haven’t got the time or capacity to fully analyse our venue data. I’ve got it because we spent money on it, and I’ve got a great team here that’s enabled that, but to build regression testing to see what might have happened if I had placed that order on different venues; it’s very difficult to do that properly. We are dependent on brokers who not only see our flow but will see the flow of hundreds of different clients. In our case, we’ve now got an Execution Management System (EMS), which has enabled us to take things a step further in terms of functionality and real-time transaction cost analysis with much better visibility of the algorithms and venues. This has all played into the hands of the vendors. Where I think the brokers now feel the pinch is the Order Management System (OMS) or EMS providers’ ability to manage the connectivity infrastructure of the buy-side. If our EMS provider is also a connectivity hub for us, we ask brokers to connect into the EMS providers’ hub so we can send orders via FIX, which is a prerequisite for us, with some very small exceptions. Every time they do that, the connectivity provider can go to 50 brokers and say “It’s going to cost you thousand pounds a year to do that”. Now, imagine what the broker is thinking: on one hand, he may think “Well, if we don’t connect, they’re not going to give us any flow, so we almost have to”, but at the same time, the broker may feel that “if it’s going to cost £50,000 a year to connect and if we are only getting £60,000 a year commission, is it an investment worth making?”. However this type of calculation is only starting to be reviewed now.
The situation previously was “Of course, we’re going to connect to them because they’re an important client. We need to see the flow.” So they did. What we are seeing much more now is brokers ringing us up and saying, “Can we just go through this because, according to our figures, you’ve got this many traders and, therefore, the network is charging us this amount of money and it looks like we’re paying this amount of commission; is there a cheaper way for us to do this?” So I think the vendors will start to feel the pinch on connectivity charges because they’ll either have to review their own charging structures or they will see a drop off in the number of brokers plugging into them.
Regulatory Push
The momentum has definitely been in this area. Late 2012 the FSA pushed out a review of a number of visits to asset managers that they conducted over a 10-month period. They followed up with a Dear CEO letter to a hundred different asset managers with the results of their visits. They said that there was a good focus by asset managers generally on some issues, but they’ve observed, probably because of falling volumes, a drift away from those principles recently and, therefore, they listed the good and poor behaviours that they had observed.
What’s clearly in their minds, I believe, is the perspective of the client and if, for example, one of those asset managers was only paid execution when they trade (i.e. they pay for all of the research from their own bottom line) that is therefore what the regulators think should become the template for all asset managers.
That represents a shock for many asset managers, to suddenly start paying large advisory bills from their own bottom lines, but it’s certainly the direction in which the regulators would like to push. The FSA is trying to shift the current mindset, and when you start looking it’s hard to disagree with the general objectives.
The FSA has made it pretty clear that it does not feel that client commission should be used to pay for corporate access, or at least not to a broker if all that broker has done is arrange for you to go and see the company. Conferences and one on ones can make up a very significant part of most asset managers’ advisory spend if the investment philosophy is fundamental stock picking, meeting the management of companies and based on those close interactions, making the investment decisions. As an example, I was at an Investment Management Association (IMA) meeting a few weeks ago and I’ve never seen the IMA so full. The meeting was arranged to discuss some of the principles that the FSA has reported. There’s a high level of uncertainty and focus on some of these principles, but that’s not to say that it isn’t appropriate, in my view.
A Focus on Specialisation
Focusing on ones areas of expertise is a trend that we’ve not obviously seen across the industry in the past but one that is now really being driven home. The timing of this is due to the realisation that there is a structural change taking place, not just a seasonal change. It’s a natural evolution to focus on the areas where you’re strong and make sure they are protected when it’s quite apparent that cash equity is over brokered and M&A activity is lower.
The reality is that market volumes were down (again) in 2012, and the payment of most service in this business is geared towards turnover, which is completely unknown in advance and to some extent should be unknown. I don’t think fund managers should start the year with a target of doing a certain amount of business. If their portfolio is in the right position then they shouldn’t be generating too much turnover. As markets turn and they choose to move positions around then that’s completely normal. Of course, there is a sort of a range of turnover that we would expect, and we do make projections, then budget and plan as we would with any other monetary considerations. This gives us an indication of our likely advisory spend, and I think that’s what the FSA is pushing for – closer scrutiny as to what client commissions are paying for and how best to optimise value from them.
Looking ahead, I believe a lot of the media comment in 2013 will be on regulatory reform, but actually most of our focus will be on the same core issues as always. The key areas for us are going to be are we retaining assets or are we increasing assets under management? Where are we growing assets? Is it in Asia, is it in the US, or is it in European equities or high-yield fixed income for example? Are we executing at good prices? Are we still able to give our fund managers good market commentary? Our focus is really much more on day-to-day business issues.