By Carl Weir
Carl Weir, HSBC, provides a snapshot on the MFDV’s space, the market size, why it is interesting and the business possibilities in this market.
In the US, over the last few years, a small yet growing group of broker dealers has been stealing a march on the larger institutions for a share of the pension fund space. This group is known as Minority Female Disabled and Veteran (MFDV ) Broker Dealers. It is important to remember for the purpose of this article that MFDVs are known by such names as Qualified Minority Broker Dealers, MBE Broker Dealers, WBE Broker Dealers, Emerging Managers, Emerging Brokers, Underserved Broker Dealers and Economic Transacted Investment (ETI) Broker Dealers – to name but a few. This space requires identification for a number of reasons:
a The allocations of US state, municipal and corporate pension funds to this space are increasing year on year.
b The allocations are federal, state and municipal government mandated.
c Some MFDVs are getting allocations of funds to invest from multiple states and municipalities.
d Based on 2010 figures from Thomson Reuters, MFDVs have been outperforming larger institutions in the areas of fixed income and global equities (e.g. in 2010 MFDVs participated in 25.8% of all municipal fixed income transactions in Illinois, by volume, compared with 13.3% in New York, and 14.2% in California).
e Competitive investment performance is one of the primary factors driving demand for MFDVs among institutional investors.
f Diversification is leading to the potential for reduced risk through portfolio diversification in their investment strategies.
g Their focus is through specialization.
h They offer reduced organizational risk, and
i Reduced operational risk.
The simplest way of looking at this space, whether you are a buy-side or a sell-side institution, is to ask yourself: “Do I have a relationship, and am I obtaining order flow from a US pension fund?” If the answer is “Yes”, the assumption is that you are getting as much order flow as can be transacted with that pension fund. Then ask yourself: “Do I have a relationship, and am I obtaining order flow from a US or global investment manager of a US pension fund?”
If the answer is “Yes”, the assumption is that you are getting as much order flow as can be transacted with a US or global investment manager of a US pension fund. At this point you might see a light switch on above your head, as you ask yourself: “Hey, if the pension fund and the investment manager of the pension fund are both giving me order flow, then is the MFDV allocation of the fund not diluted between the two?” The answer is “No”.
Look at it this way… If a pension fund, for example Texas TRS (with Assets Under Management (AUM) as at 30 June 2010 of $92.3bn) dictated that 42.5% of assets are managed ‘externally’, but also states that investments through minority and women-owned businesses equals 5% of externally managed assets, then without access to MFDVs, your actual available order flow is only part of 37.5%, and so on.
Ideally, if you are an MFDV you should be looking for international organizations with global infrastructure you can leverage, that can take you to more than 100 exchange destinations across the globe. Preferably you would want an organization that has a global reach for both execution and custody, and has ‘bricks and mortar’ (people on the ground that know the local market) including those in emerging markets. Also, you probably want to engage an organization who will not compete with you in your US institutional business.
Why should you care?
Based on data compiled in 2010 from Texas TRS, Albourne Associates, Altius Associates, Credit Suisse, Ennis Knupp, Hamilton Lane and The Townsend Group, of the top 16 US state (10) and corporate (6) pension funds with $1.68 trillion AUM, the total Minority Broker Universe is currently 469 firms (compared to the MFDV Universe recorded in the landmark 2005 LACERS Consultiva report figure of 29), with a combined $AUM of 423.7bn.
The investable Universe by pension funds for MFDVs with >$1bn AUM is 82 firms, with total AUM of $347.1bn. Not taking into account the diversity, products and activity of a $347.1-$423.7bn market would be foolhardy to say the least. To break this down into further total and investable Universes with an example of real pension fund commitment (Illinois pension funds have been intentionally overlooked as they are historically used as a benchmark, Texas Teachers Retirement System [Texas TRS] has been chosen to illustrate the growth of the MFDVs space outside Illinois):
For long-oriented equity the number of firms is quoted as 155 with a combined AUM of $301.7bn with 46 > $1bn AUM, and those with AUM >$1bn equating to $281.1bn. TRS’s commitment is to two MFDVs for $1.2bn, where the $1.2bn was committed to two women-owned MFDVs.
For hedge funds the number of firms is quoted as 21 with a combined AUM of $21bn with 7 > $1bn AUM, and those with AUM > $1bn equating to $18.1bn. TRS’s commitment is to three MFDVs for $370m, where the $370m was committed to two Asian-owned MFDVs.
For real estate the number of firms is quoted as 62 with a combined AUM of $16.5bn with 7 > $1bn AUM, and those with AUM > $1bn equating to $12.6bn. TRS’s commitment is to four MFDVs for $400m, where the $400m was committed to four African American-owned MFDVs.
For private equity the number of firms is quoted as 231 with a combined AUM of $84.5bn with 22 > $1bn AUM, and those with AUM > $1bn equating to $39.4bn. TRS’s commitment is to eleven MFDVs for $121m, where the $74m was committed to six African American -owned MFDVs; $21m was committed to two Hispanic-owned MFDVs; $15m was committed to one women-owned MFDV; and $8m was committed to two Asian-owned MFDVs.
Why do MFDVs and buy/sellsides need each other?
MFDVs are increasingly pushing for international products (especially equities) and an ever increasing international market reach. Therefore the access they need sits with the sell-sides. They require this to be more effective in this space. The MFDVs are eager to take advantage of the cross-asset FIX infrastructure provided by sell-sides at a minimum covering international equities, FX and fixed income. As MFDVs are utilizing complex algorithmic trading strategies in the US domestic market, they are looking to replicate that internationally. The pension funds and investment managers expect best execution.
New product offerings are of high importance to MFDVs. These include Exchange Traded Funds (ETFs), DeltaOne products, Asian markets, energy commodities and syndicated products. Due to the rapid change in the MFDV space new, emerging and minority brokerage programs are started all the time (e.g. Detroit MURS, a 97% paid-into pension fund implemented an MFDV policy from 1 January 2011), as such MFDVs need their sell-side partners to move quickly because:
- The pension funds expect the MFDV allocations to be acted upon in both an active and passive capacity.
- By not reacting, this will diminish increased allocations to the MFDVs which would in turn affect their partners. An example is the Ohio Police & Fire pension fund, where they have not been performing and their commissions from the pension fund were zero for 2010; as such, the two MFDVs asset allocation has been unchanged for the last two years.
The MFDVs only have access to limited research and therefore require better access to more research. Pension funds are interacting with each other more and more thereby generating MFDV overlaps between funds and increasing the spotlight on the MFDV goals . Commission Sharing Agreements (CSA) and ‘step-out’ policies are slowly being disbanded in this space.
As such, sell-side partners are becoming a necessary requirement of MFDVs. An investment manager can no longer simply ‘cut-a-cheque’ to avoid utilizing MFDVs. This has been confirmed with CalPERS/CalSTRS (who state that multi-firm arrangements such as ‘step-outs’ are generally considered to be non value-added, uncompetitive business models. As such, firms that are not directly involved in the execution will not be included in the investment process).
New York under NY SEC Amendment 12A-1 (this states that directed brokerage is banned. The SEC added a new paragraph [h] to rule 12A-1 to prohibit funds from compensating a broker dealer for any promotion or sale of fund shares by directing brokerage transactions to that broker. These amendments also prohibit ‘stepout’ and similar arrangements designed to compensate selling brokers for selling fund shares). Representatives of the Chicago chapter of the NASP confirmed on 8 December 2010 that CSAs and ‘step-out’ arrangements are now outlawed in Illinois for MFDVs.
Finally, MFDV operational efficiencies are of high importance in the face of cross-asset business, and cross-border international equity flow. This covers back office, settlement, custody and clearing, and is intrinsic to the operational efficiencies of an MFDV with respect to taking advantage of the SEC rule 15a-6 for cross-border trade execution and settlement. MFDVs need to be able to reduce costs whilst ensuring a workable regulatory solution.
If MFDVs wish to expand in competitive marketplaces, they may require sell-side participation to ensure international DMA, lower operational and management costs, potentially pure agency trading, assurances of no crossing or internalization of trades, the minimization of counterparty risk (i.e. agency trades have less chance of failure); a provision for a single point of entry for all markets; anonymity for institutional investors (i.e. trading and settlement process protects clients’ identities), and a standard of matching every trade within 24-hours makes T+1.
It is important to note that the MFDV’s operations solutions are very important, as they provide the foundation for the MFDV to sell-side relationship. For the MFDV it ensures that SEC rule 15a-6, which sanctioned brokers to transact international securities on an agency basis adhered to the rules; for the ability for the sell-side to perform the MFDV’s business is proven; ensures minimized MFDV regulatory capital requirements; minimizes sell-side risk capital requirements, and for both sides assuring STP throughout the trade’s life-cycle where execution and settlement costs are minimized (i.e. $5-$15 per ticket, instead of $90-$127 per ticket) ensuring a better ‘bang-for-buck’ on both side of the transaction.
An example of the latter was identified in a statement by the North Carolina Department of State Treasurer (NCDST) who through an Ennis Krupp and Associates independent review of the North Carolina MFDV HUB programme found that at least one of their MFDVs had not only the highest traded volumes as compared to the investment managers, but also the lowest commission rates, which made an attractive average market impact cost to NCDST. This led to an increase and a positive usage of MFDVs in their HUB programme.
The latter could not have been done without both the trading and operational efficiencies in place and a global institutional broker with a large execution and custody footprint, who had strengths in the very emerging markets the pension funds wanted to invest in. Looking at the MFDV space in 2011 The potential of the MFDV space can be summed up by a quote from Ted Krum CFP, VP, Portfolio Management, and Northern Trust Global Advisors. In his article ‘Insights on … Emerging Managers Hold Their Edge vs Elephants’, he states: “We hear over and over again that institutional clients hire the largest firms because they view them as safer than emerging managers. In reality, this decision is just another over-crowded trade that may expose clients to excess volatility and nasty surprises, without adequate compensation in terms of full life-cycle performance.
Investors who limit their large cap exposure to just the large and mega-managers (AUM > $33bn) are missing out on 78% of the manager opportunities and 61% of the products on the market .” While there has been much ‘handwringing’ in the financial press concerning the funding and liability issues facing pension funds, the likelihood that these entities will disappear any time soon seems remote.
Many have strong local political support, and possible avenues of increased funding through various reform strategies. And even if their structure were to be altered from the defined benefit to the defined contribution format, it is quite likely that the mandates will survive that modification. What opportunities will you seek?