Appropriate use of client's brokerage commissions

CFA Level II
#1

Hi All - I didn’t understand these questions in level I but the answers were easy to memorize. So for example they ask,

Which statement about a manager’s use of client brokerage commissions violates the Code and Standards?

The answer is that client brokerage commissions must be used for the benefit of the client.

My confusion is this… I’m on a trade desk and we have two types of clients, advisory clients (non-discretionary) and brokerage clients. We charge advisory clients an advisory fee and the broker/dealer we use charges commission on trades and keeps those commissions (which are not spent to benefit our clients at all). Brokerage clients are charged a brokerage fee (which we split with the broker/dealer) and that is the only way we make money from those clients.

So… if running a brokerage only business, and therefore you are collecting brokerage commissions from clients placing their own discretionary trades, how are you supposed to make money if those commissions go for client benefits?

Or, if an individual investor uses an online platform like Scottrade - those broker commissions dont go to benefit the client.

Clearly “broker commissions” mean something else here. Can anyone explain?

#2

Anyone? I’ve been thinking about this and I think that perhaps managers who have non-discretionary advisory accounts can ELECT to charge brokerage commissions to cover services that benefit the client? Is that right? I mean, the use of brokerage commissions solely for the clients would not apply to a CFA that was on a trade desk taking orders from brokerage clients and only collecting the brokerage commissions?

#3

p.s. I am a level II candidate, not level I - need to change that.

#4

politely bumping this thread

#5

nevermind - i understand it.

The brokerage is never retained by the manager, it is retained by the broker. The broker could provide services other than execution in return for their commission, some of which are allowable.

So it would never be the case that the manager would “use brokerage” to buy his lunch everyday but it could be the case that the broker provides the manager with lunch as part of the services covered by brokerage, which would be against the standards.

I got thrown off by the phrasing but I think I get it now.

#6

A good broker is supposed to use client commissions on hookers and blow.

#Jordan Belfort

#7

Hardly helpful, Jordan.

#8

Hi,

I’m going to tell you how I understand this and you figure out what you got wrong.

If I run a discretionary account for Mr. Smith, as I am his investment manager, I should use what he pays me to :

1-buy research that benefits him

2- pay for brokerage for his account. but the brokerage I should choose for him must have 2 conditions: 1- Best price for 2- Best execution

Now suppose Mr. Smith is an equity only investor.

Also suppose that my firm buys research from XYZ firm because it produces the best research in the market especially for fixed income instruments. And this is the only reason my firm chooses their research. And because they give us this research, we also do our brokerage (for our clients) through them (through XYZ). But…XYZ charges higher than other brokerage firms on trades despite that it is one of three best execution choices we have. These other 2 firms charge cheaper for trades.

This means that:

1- I’m making Smith pay (partly) for research that he is not benefiting from. Because he is paying higher for brokerage trading than he would have, had we NOT used XYZ for his trades!

2- The reason we’re using XYZ is not for Smith’s benefit, becasue he is AN EQUITY-ONLY client.

SO if Smith pays us $1000 of commissions this month, he is only benefiting from the equity part of the XYZ research (say $500’s worth), and should pay less for brokerage as well ( say $300 rather than $500 he’s actually paying) had we chosen the best brokerage price for the best execution with a one of the other 2 best-execution brokerage firms.

This situation means that I’m ripping Smith off for an extra $200 he’s not benefiting from! Which is unethical!

Now suppose we have another client : Mr. Johns, who is not an equity only investor, but invests in all instruments.

If Johns pays the same amount of $1000 he should be notified that he could be paying less for brokerage had we not chosen to buy XYZ research for him. It should be explained to him that the extra amounts he pays for brokerage ($200) are justified by the quality of research we get from XYZ, which will eventually BENEFIT HIM.

I hope this helps