Architects of Financial Prosperity

Investment Management Consultants

Emerging Brokerage Firms in the United States

Presented to The Board of Trustees

Los Angeles City Employees Retirement System

October 6, 2005

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About the Study: Objectives

– Gain sound understanding of emerging brokerage landscape– Identify emerging brokerage firms– Support the LACERS Board in

determining constructive and informed policy decisions Moving ahead to provide access and opportunity to firms in the marketplace

Basis for the Study– Commissions as Trust Assets– There is ‘alpha’ at the point of trade

Backdrop– Fiduciary responsibility– The Concept of Best Execution

Content– In-depth review and analysis of the current landscape– Quality database

Detailed profiles of each firm– Review of other emerging brokerage programs

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The Concept of Best Execution– Brokerage commissions are an asset of the Fund– Trustees can direct managers to employ certain brokerage firms

as long as trustees honor fiduciary responsibility and managers obtain best execution.

– Best execution: SEC: “a duty to seek the most favorable execution terms reasonably

available given the specific circumstances.” AIMR: “the trading process firms apply that seeks to maximize the

value of a client’s portfolio within the client’s stated investment objectives and constraints.”

– Why put a name to the concept? SEC: to ensure that brokers and managers trade in the client’s “best

interest”. Trading costs are not limited to commissions on trades. Effective trading = cost containment plus value-added.

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Best Execution Components

– Explicit Commissions: price change associated with executing a trade:

– Cents per share - Mark up/Mark down– Basis points on total value

– Implicit Market Impact or Liquidity Charge: caused by a trade entering the

marketplace Timing: price change due to information leakage or momentum Opportunity Cost: cost of incomplete orders

Examples of Methodologies for Measurement– Volume weighted Average Price (VWAP)– Implementation Shortfall

Who measures?– Plexus - Quantitative Service Group– ITG - Others

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Best Execution Why measure?

– Can affect performance– Can impair ability to generate “alpha”– Can be one of the largest erosions in investment value and a

barrier to superior performance A Pro-active Stance…

– Acknowledges and establishes best execution standards– Monitors transaction costs of both managers and brokerage

firms.

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The Investment Manager’s Perspective

Stated Methods for Brokerage Selection

1. Traders and portfolio managers decide

2. Trading Oversight Committee

3. “Tiers” system– Tier I: Bulge bracket firms - Tier III: Client Mandated– Tier II: New firms, niche players

4. Separate category for sources of “street” research Getting on the “Approved” List: Some Stated Criteria

1. Quality & quantity of proprietary research

2. Ability to execute different types of trades, like directed or programmed.

3. Legal & compliance profile 4. Financial Strength

4. Financial strength 5. Credit Risk

6. Regulatory violations

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In Search of Emerging Brokerage Firms Definition:

– “Emerging Brokerage Firm” is typically used to refer to relatively “new” companies with a newly developing revenue model.

– A firm is usually considered “emerging” based on its years of experience and its volume of business.

– Such firms are usually established by seasoned professionals with an interest in developing certain working teams and strategies, and with a knack for or interest in executing specific trading strategies.

– These firms seek to compete on equal terms with larger, traditional brokerage firms.

– The term “emerging” is also used in reference to firms whose owners are women, ethnic minorities and/or the physically challenged.

Definition employees:– 51% ownership African American, Hispanic, Asian, Woman and/or Disabled

Veterans – Members of the National Association of Securities Dealers

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Preparing the list:– Conversations with LACERS– Conversations with LACERS investment managers (10)– Firms known to Consultiva– National Association of Securities Professionals– New America Alliance

Reaching out– In-depth, comprehensive RFI based on

– Brokerage criteria and trading qualifications provided by managers– Existing programs across the US– Covers:

1. Organization and Firm Overview 6. General Trading Capabilities2. Legal & compliance Issues 7. Equity Brokerage3. Company Personnel 8. Fixed Income Brokerage 4. Research Capabilities 9. Emerging Brokerage Experience5. Sales

– 57 firms contacted, 31 responded.– Subsequent tele-conferences with each.– Profiles developed for each.

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The Universe

Observation Minimum Maximum Average

Years since Founding

3 34 12

Number of Employees

2 136 26

A Seasoned Group:1. At least 21 (72%) firms are more than 10 years old.2. All founders with over 15 years experience.3. Most have over 20 years experience

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The Universe

Location Number

New York 8

California 7

Illinois 5

Texas 3

Washington DC 2

Other 4

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Male Female Total African American 12 3 15 Hispanic 6 1 7 Asian 3 0 3 Disabled Veteran 2 0 2 Caucasian 0 2 2 Total 23 6 29

•52% African American•24% Hispanic•10% Asian•7% Disabled Veteran•7% Woman-owned Caucasian

The Universe

Type of Services # Firms Wealth Management 2 Institutional Brokerage 28 Retail Brokerage 8 Banking/Underwriting 16 Research 16 Asset Management 4

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Stated Trading Capabilities– Most have average trading experience of over 15 years.– All have electronic trading capability.– Nearly 40% provide either equity or fixed income liquidity.– Nearly 30% have proprietary trading desks, either equity or fixed

income.– 75% have Transition Management capability, either through an

alliance, or through their correspondent.– 13 firms execute trades for soft-dollar credit.– Commission rates are $0.01-$0.06.

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Existing Emerging and Minority Brokerage Initiatives– Gathered information on 46 initiatives across 16 states– A three level progression

Programs List of “Approved Broker/Dealers” 34 Goals or percentages of allocations of business 1 Predefined goals, milestones,

accountability and monitoring 11

– States with most comprehensive programs: Illinois and Ohio

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Findings1. Policies without goals, tracking or monitoring are tantamount

to no policy at all.

2. Active communication between plan sponsors, broker/dealers and managers is essential.

3. Strategies should be developed to address the use of small firms versus larger ones.

4. Approved brokerage lists rest on will of managers.

5. “Caps” are counterproductive.

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Recommendations Create a formal Emerging Brokerage Program with a clear

Statement of Purpose– “Support the development of new and innovative initiatives in

securities brokerage that will enlarge the landscape of providers, while providing increased opportunities for new firms.”

– “Support and promote competition among brokerage firms” A clear description of Eligibility Criteria

– the qualifications, registrations and certifications Specific Implementation Suggestions: Some Best Practices

– Develop and staff¹ a tracking or trade monitoring system;– Establish standards for scoring or grading, gradually awarding more

business to best performing firms;– Standards for volume of trades by asset class, to be executed by the

firms included in the program ;

¹ “Staff” refers to internal or external human resources

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Statement and Process of Intent to Implement– Staffed mechanism to track:

Investment managers ongoing reporting on – volume of business executed with each emerging firm – verification of the manager’s attempts to trade

Actions and guidelines for investment managers who do not meet policy goals or failure to adequately document reporting requirements.

– Incorporate emerging brokerage policy and guidelines into the investment manager mandates

Support with Governance– Staff the initiative! Assign accountability for success.– Sponsor communication forums between brokers and managers– Engage managers in developing fair trading structures for

allocations, while mindful of managers regulatory circumstances

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Protect the Integrity of your Intent– Ensure best execution capabilities: Conduct a study on trading

costs and best execution Implicit trading costs contribute more than commissions

– Market Impact– Timing– Opportunity costs

Next Steps– Review best practices for LACERS program options– Develop program recommendations for Board consideration.– Conduct a study on trading practices and best execution.– Follow up with firms to set up formal communication and

introduction with LACERS Managers.

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Conclusions– A more level playing field today: technological advances

– Today, best execution is indifferent to firm size and ownership structure

– LACERS Database of Emerging Brokers encompasses firms with sound institutional capabilities to service the needs of investment managers.

– Challenges for the emerging firms: Concentrated skill: domestic equity Concentrated source of flow: Directed Brokerage Access to the business: Not being acknowledged by managers

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Addendum

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Consultiva Internacional, Inc.– Independent, employee-owned, investment management and

research firm– “Boutique”, specialized in financial architecture, serving the

small-middle market. – Based in San Juan, Puerto Rico and New York, New York– Over 20 years of experience with pension assets– Our job:

To determine appropriate asset allocation and investment strategy,

To advocate on behalf of clients with product designers, vendors and asset managers.

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Whom we serve: Fund-specific methodologies in place, delivered

in a multi-cultural environment...

Pension Funds

Savings Plans

Corporate Reserves

Endowments & Foundations

Taft Hartley Plans

Insurance Companies

Individuals & Families

The only Hispanic investment consulting firm in the United States.

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Client

Capital Markets Research

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Investment Management

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“Best of Breed” Business Model

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