So, let’s say your robo-adviser firm has created a brand new strategy that you think would be attractive to investors.  You’ve registered your firm, licensed your personnel, built and tested the algorithm, and now you’re ready to bring your strategy to market.  Now, all you need to do is find a broker who can help buy and sell the securities your algorithm recommends.  Does it matter who you pick?  You bet it does.

All investment advisers owe a fiduciary duty to clients to seek “best execution” of their securities transactions.  The SEC has described this requirement generally as a duty to execute securities transactions so that a client’s total costs or proceeds in each transaction are the most favorable under the circumstances.  To fulfill this duty, an adviser should consider the full range and quality of a broker-dealer’s services in placing trades. Critically, the SEC has explained that best execution is not determined by the lowest possible commission costs, but by the best qualitative execution.  Otherwise stated, you needn’t necessarily pick the cheapest firm – instead, you’re looking for the best value.

So what does this mean practically?  It means that before you pick a broker to execute client trades, you will need to determine (and document) how that broker will fulfill your best execution obligation.  You should consider a number of quantitative and qualitative factors in selecting a broker, such as execution capability, commission rates, financial responsibility, confidentiality, frequency and correction of trading errors, expertise in specific securities, credit quality, the value of research provided, and responsiveness to your firm.

Moreover, best execution is not a once-and-done thing.  The SEC expects advisers to periodically and systematically evaluate the performance of brokers executing client transactions.  As a result, over time, you may have to consider whether a change in broker is warranted.

Worried about how to get this all done and documented?  Just create and implement best execution policies and procedures and train your personnel on how they work.  Such policies and procedures should contain guidelines and factors used to select brokers, formalize the frequency and process for ongoing evaluations, appoint specific individuals or teams responsible for action items, and require documentation of steps taken.

However, that’s not the end of the story when it comes to brokerage practices.  Part and parcel of the best execution obligation is understanding and addressing conflicts created when a broker provides your firm with research products and services under what is commonly known as a “soft dollar” arrangement.  We hope you’ll return for our next post, when Josh will explain how such arrangements work and how to use them effectively.