June 3, 2013

The AdvisorAssist CCO Series: Best Execution

The duty to seek best execution centers around your firm’s obligation to seek the best available total cost for trades that you execute on behalf of your clients. While admittedly an amorphous concept, it is an important element of the fiduciary duty owed to clients since the costs of trading have a meaningful impact on portfolio performance.

Best Execution In a Nutshell

Regulations state that, as fiduciaries, registered investment advisors owe their clients a duty to seek to obtain “best execution” on securities transactions, under the circumstances of the particular transaction.

It is important to note, that this does not necessarily mean “lowest commission” or “most favorable execution price” but rather, the best qualitative execution quality that is available to the advisor at that time.

While commission rates are certainly a component of determining best execution, the explicit “cost to trade” is just one of several factors to consider. Advisors may also consider the full range and quality of a broker’s services, including:
  • Value of research
  • Execution capability (e.g. minimizing market impact)
  • Financial responsibility (e.g financial strength of broker-dealer)
  • Responsiveness of the broker-dealer
Below we describe some specific guidelines you should follow based on your firm’s specific circumstances.

Discretion to Select Brokers vs. Recommend Brokers

If your firm has brokerage discretion (see Item 8.C.3 on your Form ADV Part 1) this means that, on a trade by trade basis, your clients have given you the ability to determine which broker-dealer will execute each transaction. In this case, you will be expected to demonstrate the rationale behind broker selection for each trade.

If your firm does not have brokerage discretion, but rather you recommend brokers to your clients, (See Item 8.D on Form ADV Part 1), then essentially your client is selecting the broker-dealer to be used for their trades. They are doing so based on your recommendation, usually because your firm has a preexisting relationship with a custodian that executes and clears your client trades.

In this case, your obligation is to monitor and assess this broker-dealer/custodial relationship on a periodic basis. (see below)

Single vs. Multiple Brokerage (custodial) Relationships?

Regardless of whether your firm uses one or multiple broker-dealers, you are required to “periodically and systematically” evaluate the quality of execution services received from each.

In either case, you are expected to monitor (and review formally, at least annually) the arrangement(s) in place with your broker-dealer(s) to confirm that the total transaction costs paid continue to be competitive when compared to other alternatives available to your firm.

A common misperception is that if you utilize just one broker-dealer (and your firm simply recommends that broker-dealer) then there is no evaluation or due diligence requirements. However, this is not the case.

Through the Regulator's Eyes

Since the concept (and determination) of best execution is, in many ways, a qualitative one, it may be helpful to view it more as a process. Regulators need to determine that your firm has a process whereby you continuously assess the total costs borne by your clients for trade execution, after considering the facts and circumstances that prevail.

A common document request from regulators would be: a copy of trade blotters for a specific period of time that identifies the executing broker, as well as any documents created in the evaluation of brokerage arrangements and best execution.

The latter can be satisfied by providing the regulator with a copy of your Annual CCO report, which should include a section on vendor due diligence.

At the end of the day, regulators expect your firm to be able to answer questions like:
  1. Is our current line-up of broker-dealers the best available?
  2. Are there alternatives to this line-up that could provide our clients with a better deal?

CCO Best Practices for Best Execution

  • Review the “Brokerage Practices” section of your compliance manual to confirm that the policies and procedures laid out here are being followed.
  • Review the brokerage-related disclosures in your ADV Part 1 and 2A for consistency with your compliance manual and current brokerage activities.
  • Review performance of brokers on an ongoing basis, paying particular attention to commission rates paid and quality of execution and settlement (i.e quality execution prices, low error rate on order management and trade settlement).
  • If you use one broker/custodian for trade execution, perform a review of your relationship (at least annually) to assess the full range and quality of the services your firm receives (i.e. value of research, execution quality, commission rates, financial responsibility and responsiveness).
  • Document your broker/custodian review process in your Annual CCO Report. (Click here for our white paper that explains annual CCO reports.)
  • If you use multiple brokers, perform due diligence on each new broker relationship prior to placing trades with them and establish controls to ensure that your firm is only utilizing approved brokers.
  • If you have brokerage discretion, implement a process of periodically reviewing your trade blotter to monitor broker usage at the firm- and client-level, as well as by security type.
  • Review your investment advisory agreements to confirm that they are consistent with your brokerage discretion disclosures and brokerage practices.

The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program.  Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.

Brian Lauzon


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