These FAQs are part of a series of frequently asked questions that address four primary areas of interest to investment advisers:

  1. Compliance Program Components;
  2. Daily Operations;
  3. Client Protection; and
  4. Registration and Disclosure

Q1:      What is “best execution”?

 A1:      As a fiduciary, an adviser has an obligation to obtain “best execution” of clients’ transactions. In meeting this obligation, an adviser must execute securities transactions for clients in such a manner that the clients’ total cost or proceeds in each transaction is the most favorable under the circumstances. In assessing whether this standard is met, an adviser should consider the full range and quality of a broker’s services when placing brokerage.

Q2:      Is “best execution” defined in the Investment Advisers Act?

A2:      Best execution is not specifically defined in the securities laws. The CFA Institute’s Trade Management Task Force, an industry leader in setting global standards and policies, defines “best execution” as follows:

Best Execution refers to a trading process firms apply that seeks to maximize the value of a client’s portfolio given each client’s stated investment objectives and constraints. This definition recognizes that best execution:

  • Is intrinsically tied to portfolio-decision value and cannot be evaluated independently;
  • Is a prospective, statistical, and qualitative concept that cannot be known with certainty ex ante;
  • Has aspects that may be measured and analyzed over time on an ex post basis, even though such measurement on a trade-by-trade basis may not be meaningful in isolation; and
  • Is interwoven into complicated, repetitive, and continuing practices and relationships.

Q3:      What are some of the factors that reflect on the quality of execution?

A4:      Among the specific factors that may be relevant to an investment adviser’s best execution determination are the following:

  • Confidentiality provided by broker-dealer
  • Competitiveness of commission rates and spreads
  • Evaluations of execution quality by consultants
  • Amount of business with each broker-dealer
  • Promptness of execution
  • Past history of execution of orders
  • Clearance and settlement capabilities
  • Ability to prospect for and provide liquidity
  • Quality of confirmations and account statements
  • Broker-dealer’s financial wherewithal
  • Broker-dealer’s reputation and integrity
  • Difficulty of trade and security’s trading characteristics
  • Size of the order
  • Availability of accurate information regarding the market for the security in question
  • Liquidity of the market for the security in question
  • Broker-dealer’s access to markets
  • Ability to accommodate third party research arrangements
  • Geographic location of broker-dealer’s offices
  • Trading style and strategy
  • Block trading and arbitrage capabilities
  • Sophistication of broker’s trading facilities
  • Specialized expertise (i.e., for smaller brokers)
  • Access to new issues of securities for client accounts
  • Number of trade errors/ability and willingness to correct
  • Overall responsiveness to manager’s needs/willingness to work with manager
  • Broker-dealer’s distribution network
  • Broker-dealer’s ability and willingness to commit capital

Q4:      What types of conflicts of interest can affect or relate to best execution?

A4:      There are a variety of potential conflicts, including:

  • Soft dollar arrangements
  • IPO allocations
  • Client referrals
  • Sales of shares of mutual funds advised by the manager
  • Payment for order flow
  • Equity interests in market makers or market centers
  • How does directed brokerage affect an investment adviser’s best execution responsibility?
  • In a directed brokerage arrangement, the client directs the adviser to execute a portion of the trades for the client’s account through a particular broker-dealer. The general consensus is that client directed brokerage relieves an adviser of their best execution responsibility. Advisers, however, are required to disclose to clients and potential clients that by directing brokerage, the adviser may be unable to achieve most favorable execution of client transactions.

Q5:      Is there any guidance on best execution for fixed-income securities?

A5:      Yes. The Securities Industry and Financial Markets Associations (SIFMA) released a White Paper on best execution guidelines for fixed-income securities. SIFMA defined best execution in the context of fixed-income securities as an “asset manger’s duty to determine and evaluate the circumstances under which the overall value of investment decisions for its clients with respect to those securities will be maximized.” The White Paper states that essential elements for an adviser to meet its fixed-income best execution responsibilities include:

  • Identifying the key components of favorable and efficient fixed-income executions;
  • Identifying significant factors and information to be considered in selecting fixed-income trading counterparties;
  • Determining and documenting trade execution policies and procedures;
  • Developing a defined system of controls and risk management regarding fixed-income executions;
  • Providing regular supervision and rigorous review of the fixed-income best execution process; and
  • Testing and monitoring compliance with fixed-income policies and procedures.

Q6:      What issues should an investment adviser consider when developing or evaluating their fixed-income best execution policies and procedures?

A6:      According to the SIFMA White Paper, an investment adviser should consider the following:

Guideline 1 – Policies and Procedures: A firm should develop best execution policies and procedures tailored to its operations and the types of fixed-income securities in which it trades.

Guideline 2 – Establishment of a Best Execution Committee or Similar Structure: A best execution committee may help in establishing and evaluating periodically the process a firm will follow.

Guideline 3 – Review of Quantitative and Qualitative Information: A firm should evaluate and determine, in light of its access to reliable market data for the types of fixed-income securities in which it will primarily invest on behalf of clients, the extent to which its best execution policy should include pre-trade evaluation of data and execution decisions and/or post-trade analysis of transactions.

Guideline 4 – Counterparty Selection: A firm should identify specific quantitative and qualitative criteria for selecting counterparties and such counterparties should be evaluated periodically against these criteria.

Guideline 5 – Utilizing Technology: A firm should consider and incorporate available technological recourses when developing its best execution process.

Guideline 6 – Dealing with Conflicts of Interest: Regardless of whether a firm’s emphasis is pre- or post-trade, the firm’s policies and procedures and internal monitoring systems need to address potential conflicts of interest that could impair the firm’s ability to obtain best execution.

Guideline 7 – Transaction Reports: Transaction reports, particularly when viewed on an aggregate basis and over time, can provide a valuable tool when gauging and evaluation the success of a firm’s best execution efforts.

Guideline 8 – Use of Market Data to Evaluate Best Execution: When readily available, post-trade market data can help to ensure an effective best execution process. Post-trade information, may, however, have limitations, particularly with respect to fixed-income securities traded in less transparent markets, and firms should evaluate carefully the usefulness of such data when developing their best execution process.

Q7:      What about best execution and derivatives?

A7:      Similar to the challenges that arise in the context of trading in fixed income securities, trading in derivatives presents some unique best-execution considerations not present in the context of equities, including fungibility. This consideration relates to the fact that equities can generally be purchased on one exchange and sold on another; typically, however, derivatives can be sold only on the exchange on which they are listed or in the over-the-counter market. Thus, the duty of best execution may at the same time in this context be simpler (in the case where the derivative is traded on only one exchange) and more complicated (in the over-the-counter market, where a nearly infinite number of counterparties may offer “better execution” than the next) to fulfill.

Q8:      How can an investment adviser fulfill their duty of best execution?

A8:      An adviser fulfills its duty of best execution not by obtaining the best price or the lowest commission rate, as is often assumed to be the case, but rather, by establishing and maintaining a process through which the investment adviser assures that it is giving due attention to each of the many factors affecting the quality of execution of client trades.

Q9:      What are the components of the best execution process?

A9:      The best execution process should include:

Periodic and Systematic Evaluation. Investment advisers must periodically and systematically evaluate the execution performance of broker-dealers executing their transactions, and should have in place policies and procedures for reviewing the execution of client transactions.

Comparison against Alternatives. The SEC staff has noted that the periodic review should entail a review of the quality of execution that the adviser is receiving against the quality likely to be received from alternative venues. A best execution review requires that an investment adviser periodically assess the quality of competing markets to ensure that its order flow is directed to markets providing the most advantageous terms for the customer’s order.

Approach to the Evaluation. The SEC staff has suggested that, in evaluating best execution, investment advisers ask two basic questions:

  • Is the current line-up of broker-dealers the best available?
  • Are there alternatives that would give clients a better deal?

Policies and Procedures. Investment advisers can adopt a number of different policies and procedures in order to adequately review best execution. The SEC staff has noted that adequate policies and procedures for testing best execution are viewed by the SEC’s Office of Compliance Inspections and Examinations as one of the key indicators of a culture of compliance. The SEC examination staff, in accordance with its risk-based approach to examinations, focuses a great deal of its attention upon the processes and mechanisms an adviser uses in testing best execution.

Q10:    Should an investment adviser document its review of best execution?

A10:    Absolutely. Investment advisers should ensure that its review of best execution is thoroughly documented, including the steps taken in the review as well as the considerations addressed in making the best execution determination. Thorough documentation will assist an adviser in ensuring that its reviews are systematic and its procedures for review are consistently applied, and will also provide evidence to the SEC’s examination staff of the methodical attention the firm gives to the analysis of best execution.

Q11:    What other reviews should I conduct?

A11:    In reviewing its trading practices to evaluate best execution, an investment adviser should check to ensure that its practices correspond to those disclosed to clients. An adviser’s best execution policies are required to be disclosed on its Form ADV, and certain provisions of the adviser’s investment management and other agreements likely provide for certain brokerage practices. Best execution practices which conflict with disclosures made to clients may constitute a violation of the anti-fraud provisions of the federal securities laws.

Q12:    What best execution related documents does the SEC typically request during an examination?

A12:    The Staff of the SEC may request some or all of the following documents and information pertaining to best execution:

  • Any written best execution policies and procedures.
  • Any documents created in the evaluation of brokerage arrangement and best execution.
  • A copy of the compliance reports used to monitor best execution.
  • A list of any third-party vendors who monitor best execution and a copy of their most recent report.
  • Brokerage commission allocation reports for the examination period with aggregate totals (specify by broker-dealer the aggregate amount of agency commission paid to each such firm and principal values or imputed compensation for principal transactions).
  • A list of approved broker-dealers currently in use by your firm’s trading staff.
  • A list of all trades where your firm had the executing broker “step-out” all or a portion of the entire transaction to another broker for settlement and confirmation (include the trade date, security, executing broker and confirming broker identities, the total number of shares filled by the executing broker, and the number of shares stepped-out by the broker).
  • A written description of all step-out arrangements utilized by your firm and the purpose of such arrangements.
  • A list of all broker-dealers, including ECNs, affiliated or unaffiliated, that, to your firm’s knowledge, received order flow payments or rebates related to executing transactions for client portfolios.
  • A copy of any commission schedules that were in effect during the examination period.
  • A list of all clients or investors that have requested that your firm or its related persons direct brokerage to a particular broker-dealer and the name of the broker-dealer.
  • A list of commission-sharing arrangements including the name of the broker-dealer and total dollars allocated to each arrangement during the preceding 12 months.
  • A list of any seminars, conferences or other programs attended by your firm’s employees, officers or agents that were conducted, offered or paid for, directly or indirectly, by research providers or broker-dealers during the examination period.