The future of wrap

David Sher, managing director at ESP Technologies, examines the difficulties facing asset managers in achieving best execution for wrap accounts and how settlement aggregation tools can help fulfill their fiduciary obligations.
Over the past several years one of the bright spots in the asset management business has been the dramatic increase in wrap and separately managed accounts (SMAs). These separately managed brokerage accounts, as opposed to mutual funds, are offered by large banks and brokerage firms (sponsor). Their popularity with high net worth investors is due to the transparent nature of the product, and the beneficial tax treatment, as compared to mutual funds. Customers generally pay a single fee based on total assets under management in exchange for a service providing, among other things, asset management, trading commissions and custodial services. The sponsor bank or brokerage firm shares the fees with an affiliated or third-party asset manager. 

While the wrap and SMA market continues to grow, many asset managers have not been able to fully participate due to the difficulty in efficiently processing transactions and allocations. As distinct from a typical institutional offering, a wrap programme may have thousands of small accounts, introducing a great deal of complexity into the management and maintenance of a large programme.

Historically, asset managers have simplified this process by transmitting most orders for execution to the sponsor, or by rotating execution among sponsors. Recent market structure changes have prompted asset managers to reassess their best execution obligations and trading strategies in light of increased fragmentation and lower transaction costs. A new breed of innovative technology has recently been introduced to address these problems through the settlement aggregation of dispersed order flow and automation of the end-of-day allocation process for wrap managers.

Navigating the conflicts
In the current environment, asset managers must choose between operational efficiency and best execution, creating a position that no asset manager wants. The asset manager must consider the following trade-offs when executing orders on behalf of multiple sponsors as well as mutual funds: 

•Having the sponsor agree to a rotation in which each sponsor serves as the sole executing broker for all shares effected on a given trading day. When reconciling the transactions end-of-day, that sponsor steps out of the respective positions to the other sponsors. At the opening of the next trading day, the responsibility rotates to a new sponsor.

By executing through one sponsor on a given day, the asset manager may significantly limit its ability to obtain better prices for the sponsor’s customers due to the variance in execution capabilities among the sponsors, which includes their ability to access dark pools, agency brokers and other liquidity pools.

•Under the second approach, the asset manager executes a block of stock during a specific time period that is defined by the number of sponsors. For example, the asset manager will execute a block over a four-day period if there are four sponsors. Each sponsor will execute its portion of the block order on its designated day. The advantage of using this approach is that step outs are not required; however, despite the fact that the investment strategy across sponsors is the same, the sponsor’s customers may receive different execution prices.

•A third approach is for the asset manager to route orders based upon a pro rata distribution of trades to each sponsor in the rotation. This option may cause performance variance (i.e., different execution prices) for the asset manager across the different sponsors. The back-office process becomes complicated due to an increased number of instructions and trade tickets impacting end-of-day settlement, step out and allocation processes.

Settlement aggregation
New settlement aggregation technology provides asset managers with the tools to fulfill their fiduciary obligations, while achieving superior operational efficiency in the settlement process. Settlement aggregation enables asset managers to trade wherever they want to achieve best execution while simplifying the settlement process. Through technology, the asset manager can instruct its sponsors to receive trades ‘done away’ in an automated manner, as well as consolidating trades on behalf of wrap accounts with institutional order flow. Benefits of the approach include the ability to:

•Execute an entire block of a security traded for both wrap and institutional accounts during a single trading day.

•Aggregate executions from all executing brokers and venues into a single, average-priced block trade and allocate fairly across all accounts.

By aggregating the settlement process, the asset man-ager can dramatically simplify workflow by eliminating the need for single sponsor execution or sponsor rotation. Best execution can be achieved by using multiple execution venues to source liquidity. As a result of these two steps, the man-ager can show consistent performance across all wrap and institutional accounts as they receive the same aver-age execution price.

The use of settlement aggregation may simplify back-office operations, while lowering the potential for trade breaks or fails, as all instructions are centralised though a single provider rather than the traditional many-to-many approach of the past. Indeed, perhaps there is some hope that settlement aggregation can remove many of the obstacles to the continued growth of the wrap business.