The Investment Management Front Offi ce 101 is, that the trade itself will cause the price to change signifi cantly. For example, if the fund wants to sell 12,000 shares of a stock that normally trades only 15,000 to 20,000 shares per day, other players will lower the level of their bids as soon as they see the large sell order. The mutual fund trader could decide to work the order over several days, but that leaves the fund open to having the price change in an unfavorable direction. Brokers help funds avoid such mar- ket effects either by completing the order in smaller parts, or by acting as the counterparty for all or part of the order themselves (block trading).
The fund pays the broker for handling a trade either by an explicit com- mission, or via the spread. Buy-side fi rms such as mutual funds may also receive research services (broadly defi ned to include not only information, but also computer hardware and software that supports research) from the broker in return for some part of the commissions generated by the fund’s trading business. The term “soft dollars” refers to the cost of the research services provided in such an arrangement. Federal securities laws explicitly allow investment managers, including mutual fund investment advisors, to direct brokerage transactions to particular brokerage fi rms in return for soft dollar–funded research. The advisor must be able to show that the overall amount paid to the broker is reasonable as compared to the overall value of the services—trade execution plus research—the broker provides.
A fund trader can contribute signifi cantly to the performance of the fund through the skill with which he or she gets trades executed. Funds often place big orders, orders that could easily induce a market effect. The fund trader must decide how to complete an order to get as close as possible to the market price prevailing at the time the order was placed. This may mean breaking it up into smaller trades that go out anonymously over ECNs, dealing with a brokerage fi rm for a block trade, or attempting to cross the trade directly with another institution.
fee for the fund of 96 basis points) for its portfolio management services.23 Stra- tegic Insight reported that the average asset-weighted advisory, administration, and operational fee amounts for all open-end funds was 60 basis points.24 This fee pays for the compensation for the analysts, portfolio managers, and traders;
the information systems and other tools they use; the support infrastructure they need (space, secretaries, etc.); and, in most cases, some profi t for the fi rm that employs them.
The fi rst part of the active-versus-passive argument focuses on these advisory fees. A passively managed fund, which does not utilize research, analysis, or much portfolio decision making, pays very little in advisory fees.
An actively managed fund usually pays a signifi cant amount for them. If one believes that making effective securities selection decisions is not possible, then paying for all this decision support and decision making is futile. Thus the proponents of passive management argue that shareholders in active funds pay a premium for a service that is worthless.
The second part of the argument turns on trading costs. Most active funds trade more than passive funds, because the active portfolio manager often trades in the attempt to improve fund performance. The passive man- ager trades only when he or she is forced to as a result of cash fl ow needs or changes in the benchmark.
Thus the actively managed fund incurs greater transaction costs involved in trading—money spent on brokerage commissions or the spreads. As dis- cussed in Chapter 3, portfolio trading costs are not always possible to deter- mine, but they can be signifi cant. For actively managed equity funds, they can easily reach 60 to 80 basis points on the average value of the portfolio.
Active funds are also more likely than passive funds to order trades that result in unfavorable market impacts. A passively managed fund usually buys or sells relatively small amounts of the various securities that make up its benchmark (basket trades), amounts too small to have any impact on prevail- ing prices. Once an active fund manager has decided that a particular security is unattractive, he or she wants to dispose of it, no matter how large the fund’s holding. Sometimes it is impossible to divest a large block of a security with- out a price effect no matter how carefully it is worked. Those who believe that improving performance is an unattainable goal view both the transaction and the market impact costs incurred due to pursuit of performance as a waste of money.
Clearly, whether or not the cost of portfolio decision making and trad- ing involved in active fund management is excessive depends on whether one believes in active management. (Another part of the active-versus-passive argument revolves around shareholder taxes, covered in Chapter 7.)
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The Investment Management Front Offi ce 103 Table 5.1 Summary of Results of CFA Institute/Russell Reynolds Compensation Survey for Respondents from Mutual Fund Management Companies.
2003 Median Compensation ($)
Position
2003 Salary
2003 Bonus
2002 Non-
cash 1 Total
90th Percentile2
Chief Investment Offi cer 150,000 34,690 20,000 220,000 1,035,000
Head of Equities 178,000 75,000 18,500 255,955 1,055,015
Head of Fixed Income 144,025 50,000 15,000 200,000 807,000
Portfolio Manager—Domestic Equities 110,000 27,000 10,000 142,210 405,000 Portfolio Manager—Domestic Fixed
Income
118,000 50,000 10,000 165,000 514,000
Portfolio Manager—Global/International Equities
114,150 42,350 10,000 160,000 465,000
Portfolio Manager—Global Fixed Income
115,000 60,000 8,470 176,105 455,120
Securities Analyst—Domestic Equities 90,000 35,000 4,895 124,990 400,000 Securities Analyst—Domestic Fixed
Income
95,000 40,000 5,000 130,000 335,000
Securities Analyst—Global/International Equities
95,000 35,000 5,000 124,990 400,000
Securities Analyst—Global Fixed Income
97,385 40,000 5,000 127,980 70,000
Trader 85,000 60,000 5,705 140,000 500,000
Source: Investment Management Survey, CFA Institute and Russell Reynolds Associates, 2004.
1 Value of non-cash compensation received during the year (usually stock options).
2 The 90th percentile value for median total compensation, except where there are fewer than 10 respondents, in which case the value given represents the highest value reported.
The spectacular amounts earned by a few portfolio managers have made portfolio manager compensation a particularly visible part of what funds pay their investment advisors. However, few portfolio managers make the mil- lions per year attributed to such fi gures as Jeff Vinik ($5 million per year when he was managing Fidelity’s Magellan Fund)25 or Mario Gabelli ($15.8 million for serving as portfolio manager to several mutual funds).26 Surveys suggest that the median annual compensation for mutual fund portfolio managers is about $148,000. A 2003 survey conducted by the CFA Institute found that compensation varied according to factors such as the size of the fi rm, the type of fund managed and experience. For example, the median for U.S. domestic fi xed-income fund managers was $165,000, while for domestic equity fund managers it was $142,000.27 Half of this total compensation typically rep-
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resents incentive compensation based on investment performance. Table 5.1 summarizes the results of the 2003 CFA Institute compensation survey for various investment positions in mutual fund management companies.