1. Introduction

The Sunday Times describes soft commissions as "backhanders ... payment in kind in return for the fund manager giving the broker his business." ^x The IMA ^x and IA ^x are "baffled and disappointed" by the paper of the FSA on bundled brokerage and soft commissions, because it says that bundled brockerage and soft commissions should not be disclosed to retail investors:

"2.8 We have considered whether it would be desirable to mandate disclosure of bundled and softed arrangements to retail investors. Our conclusion is that the benefits would be very limited and would not justify the likely cost to investment managers. .. Most retail investors have little or no knowledge of the way securities are traded or the kinds of arrangements that exist in the wholesale market, so the information would be largely meaningless to them."

The paper seems to be "jumping the gun". Before disclosure to retail investors of "bundled brokerage and soft commission arrangements" come disclosure of: a) portfolio turnover, b) stockbrokers' commission, c) stamp duty. It does not mention stamp duty and portfolio turnover only once (page 11). It says little if anything about the disclosure of total stockbrokers' commission to retail investors - which is what interests them in the first instance rather than bundled brokerage and soft commission arrangements.

It recommends "investors representatives":

"1.4 .. So we propose that an individual or body should act as a representative of retail investors by considering the new disclosures on their behalf and interacting with the manager where necessary."

Disclosure of the total amount paid to stockbrokers is discussed in my UCITS submission. ^x This total amount is highly dependent on portfolio turnover, and can be large. It is not given in the accounts of unit trusts and OIECS or the Simplified Prospectus - at least I have not seen any. (Example: x x ) Philip Augur and Paul Myners say:

"For some funds commissions can be larger than the fee paid for fund management itself." ^x

In the US (September 2004):

"Today, brokerage fees incurred by mutual funds are normally not included in the expense ratio included in the prospectus - they are reported in the Statement of Additional Information (SAI), which is available upon request, but is not provided automatically." ^x
(some additional links to the US: x x x )

The word "total" in total expense ratio (TER), seems slightly misleading, as it does not include transaction costs. There is surely a case for developing another expense ratio which includes these costs. This would help to discourage high portfolio turnover. A problem may be defining exactly what is a transaction cost, beyond stockbroker's commission and stamp duty. The Financial Planning Association in the US says:

"Although transaction costs are taken into account in computing a fund's total return, they are not taken into account in computing a fund's expense ratios. .. FPA has long been on record in support of including transaction costs and related soft dollar expenses as part of funds' expense ratios." ^x

Fitzrovia says that "a small minority of European and offshore funds" include transaction costs in their calculation of the TER.

The existence of soft commission agreements is often if not always already disclosed in the accounts of unit trusts and OEICS, and the existence of fee-sharing agreements and soft commission arrangements is a requirement for UCITS-approved funds. But this is just the existence rather than numbers such as portfolio turnover. I agree that most investors find such information confusing. But secrecy is unacceptable, and the alternative proposal of the FSA for investor representatives is unworkable. The industry is therefore caught between a rock and a hard place.

2. UCITS-approved funds

As mentioned above the Consultation Paper proposes that the FSA should not "mandate disclosure of bundled brokerage and softed arrangements". But as discussed in my response to an EC Green Paper abouts UCITS, this is a requirement for UCITS-approved funds: ^x

The Simplified Prospectus has to contain according to UCITS:

"2.2.1 (f) An indication of the existence of fee-sharing agreements and soft commissions" ^x

Which includes:

"2.2.2.1 (a) fee-sharing agreements on transaction costs between a UCITS' management company and a broker whereby the broker agrees to split with the management company the transactions fees paid by the UCITS to the broker for processing transactions for the UCITS;"

"Fee-sharing agreements" does not seem to be the same as "soft-commission arrangements" but like "commission recapture". This prompts the question whether "bundled brokerage and soft commission arrangements" should be extended to cover commission recapture?

"An indication of the existence of" in the Directive seems weaker than "mandate the disclosure of bundled and softed arrangements". Funds often do "indicate the existence of" already.

I am wondering about the extent to which UCITS-approved funds have to disclose stockbrokers' commissions. It seems not at all. In Appendix 1 of the FSA report Implementation of the Simplified Prospectus requirements in the UCITS Management Company Directive (2005, Policy Statement 05/4 ^x), the "Contents of Simplified Prospectus" (under COB 6) says that it must give:

"(14) (a) (iv) an indication of all the other costs not involved in the TER, including transaction costs".

"An indication of" seems to mean "an indication of the existence of" without quantifying how large they are. The FSA says in COB 6, Annex 2, defining transaction costs:

"2. (c) They include brokerage fees, taxes and linked charges and the market impact of the transaction taking into account the remuneration of the broker and the liquidity of the liquidity of the concerned assets." ^x

3. Portfolio turnover comes first

Investors in a fund are interested in the total dealing or transaction costs of the fund.

total transaction costs = (cost per unit transaction)
x (total number of transactions)

The cost per unit transaction is the stockbrokers' commission, stamp duty and market costs resulting from bid-offer spreads. A measure of the total number of transactions is the portfolio turnover. Stockbrokers' commissions for share dealing do not vary greatly between different stockbrokers in comparison to portfolio turnover. ^x If portfolio turnover is low, investors can be sure that total transaction costs are low. Bundled brokerage and soft commission agreements provide an incentive for high turnover. For these reasons portfolio turnover is a more useful measure of total transaction costs than stockbrokers' commission.

UCITS-approved unit trusts and OIECS have to declare portfolio turnover in a "Simplified Prospectus" because of the EU directive UCITS III. ^x The EU has a consultative Green Paper on UCITS. ^x

There is much information about the disclosure of CIS fees and commissions on the web. A publication of IOSCO gives an international perspective. ^x Also interesting is a report about The Netherlands. ^x

4. Stamp duty

The Treasury Committee says: "We believe that transparency in all aspects of the charges borne by investors should be paramount." ^x Fitzrovia says in their report Portfolio turnover of UK funds (2002 edition)

There are two kinds of stamp duty, referred to in the Treasury's CAT standards for ISAs as a) "stamp duty on transactions in fund assets" (paragraph 37) and b) "stamp duty in dealings in units" (paragraph 38). "Stamp duty reserve tax" means stamp duty on paperless transactions.

The amount of a) never seems to be given in the accounts of unit trusts. The amount of b) is sometimes given, but both a) and b) are largely stealth taxes. Is there a full discussion somewhere of the disclosure to retail investors of stamp duty and SDRT? This seems to be a further problem.

5. Soft commissions

Soft commissions pay for stockbrokers' research. The charges of stockbrokers are taken out of the capital of investors by the stockbroker, rather than out of the annual management charge of providers.

"Investment managers of retail funds ... are commonly party to bundled brokerage and soft commission arrangements." (page 4)

The FSA has a new requirement that soft commissions should be restricted to payments for "research". ^x Stockbrokers can have other charges especially for custody.

Bundled brokerage is the ordinary commission bundled with the soft commission and with any other charges.

bundled brokerage =
ordinary commission + soft commission + any other stockbroker charges

The FSA in its report UCITS: charges disclosure - presenting product charges to customers (2005) ^x does not mention stockbroker's commission, stamp duty or transaction costs.

Discussing soft commission arrangements the FSA says:

"2.1 .. The manager will be required to make timely and adequate disclosure of the arrangements to the customer."

The problem is that the customer might, for example, be a life assurance company, and then this information may not be passed on to policyholders.

"2.4 .. There is no requirement for this information to be passed on to underlying investors."

In the case of an occupational pension scheme, the customer is the trustees, so that there is not this problem with passing on information.

6. Background

This website started in March 2001 with the heading The cap con, ^x discussing charges outside the stakeholder cap on charges. The Consultation Paper of the FSA (September 2005) also relates to charges outside the cap.

Because of the size of dealing charges which the Treasury describes as "substantial", the government has been encouraging the trustees of occupational pension schemes to "have a full understanding of the transaction - related costs which they incur":

"Transaction costs are an important cost to pension funds. For trustees to fulfil their duty to act in the best interests of their beneficiaries, trustees must ensure that these costs are properly managed." ^x

"Despite a great deal of controversy over Mr Myners’ proposals on commissions, few responses to the Government’s recent consultation disagreed with his central proposition, that these costs 'which are substantial' are 'subject to insufficient scrutiny' and that 'clearer and more rigorous disciplines could be applied'. On the contrary, the clear message from the consultation responses is that the problem is, if anything, greater than Mr Myners originally suggested ... Trustees, or those to whom they have delegated the task, should have a full understanding of the transaction-related costs they incur, including commissions." ^x

The IMA and NAPF have developed a Pension Fund Disclosure Code. ^x

7. Levels of disclosure

There are various levels of disclosure to individual investors:

1. in accounts and key features documents,
2. on the web in comparative tables,
3. on request to any investor,
4. on request to an "Investor's Representative".

The Consultation argues in favour of the fourth option using some extraordinary arguments, such as full disclosure:

"poses a risk that competitive pressure on fund managers would not be uniformly exerted" (2.14)

The Consultation Paper says:

"2.8 We have considered whether it would be desirable to mandate disclosure of bundled brockerage and softed arrangements directly to retail investors. ... 2.12. ... requiring it to be sent to all investors. "

What is meant by "directly to retail investors", "sent to all investors"? It should be in the accounts of unit trusts, OEICS and investment trusts.

"2.9 Even if we were to prescribe a summarised form of disclosure, it would probably not be very enlighting".

It would, on the contrary, be very useful. The total stockbroker's commission could be specified, and the amount caused by soft commission.

The Consultation Paper says:

2.10 Furthermore, disclosure as a tool is only valuable to the recipient if it can be used it to challenge the behaviour of the provider if necessary."

This is referring to disclosure after a sale. But what about beforehand?

"The FSA recognises that the majority of retail investors will have little interest in receiving this detailed information as it would be largely meaningless to them or they have limited means of influencing the investment manager's behaviour if they are unhappy with it." ^x

"Little interest in receiving" implies that the FSA is proposing to send the information to investors, rather just being available if they want to see it in accounts. As mentioned above, it will be useful information when considering a purchase.

The FSA is saying either most investors will not be able to understand the information or, even if they do understand it, they will not be able to act on it. And this is at the same time as the government is promoting "informed choice."

8. "Investors' representatives"

The FSA suggests that retail investors in a particular fund should have an "investors' representative" who has responsibility for overseeing dealing costs. FSA makes suggestions in the Consultation Paper about who these representatives should be. It suggests depositaries, the trustees for unit trusts, the actuaries for life assurance companies. But they are appointed by the provider and are therefore not independent, like the trustees of pension schemes:

"5. The trustees are independent of the investment manager and have fiduciary duties towards investors or beneficiaries."

Furthermore the representatives suggested are from the financial industry, and therefore do not represent investors. This problem of finding suitable representatives seems insupperable. The proposal to have such representatives although unworkable, is at least a recognition and ackowledgement that dealing costs are problem.

9. Conclusion

There are six quantities, outside the TER in addition to details of fee-sharing arrangements and soft commissions, that need to be put in a) accounts, b) key features documents:

1. portfolio turnover,
2. stockbrokers' commission for dealing,
3. stockbrokers' soft commission for research,
4. any other stockbroker charges,
5. stamp duty,
6. SDRT.

The Contents of the Simplified Prospectus ^x (14)(a)(4) says that it must give "an indication of all the other costs not involved in the TER, including transaction costs". "An indication" seems vague.

The Pension Fund Disclosure Code ^x mentions further helpful information such as the use of crossing networks. These avoid the cost of buy-sell spreads by enabling buyers and sellers to trade with each other directly, rather than through the market.

The Investors' Representative proposal 4 is unworkable. The other proposals 1 - 3 should be adopted.

I like the idea of "Investor Representatives", meaning trustees, rather than as proposed in the Consultation Paper. In my opinion long-term saving in unitised funds should not take place without trustees. This is a reason for introducing new institutions as advocated on this website. The disclosure of commission payments is described as a "market-based solution" by Philip Augur and Paul Myners:

"This approach is a big test for market-based solutions that often appear to work better for financial services practitioners than for their customers. The chain that links the ordinary citizen's pension and mutual fund contributions to the end product is long, complex and difficult for end investors to unravel." ^x

Rather than: "The end product is long, complex and difficult for end investors to unravel.", another way of expressing this is: "The end product is inherently incomprehensible." ^x

This problem will not be solved by education. Ned Cazalet said to the Treasury Committee:

"All this talk about consumer education, we will never catch up with financial inventions and have no chance of doing so." ^x

Nor will it be solved by product "simplification". For example in the case of stakeholder products all of the above six quantities are hidden. "Industry-fabricated fees" ^x are so numerous that long-term savings "products" are in practice incomprehensible.