Ronald Reagan was fond of employing this Russian proverb meaning “trust but verify” in discussing relations with the Soviet Union in the 1980’s. At Commonfund we follow this same principal as a central tenet of our risk management and due diligence processes.
Recent news articles alleging foreign exchange “gouging” by certain large custody banks, including State Street Corporation, the custodian for Commonfund’s funds, have put a spotlight on the importance of independent verification, not only of foreign exchange rates, but of the pricing and execution of all securities transactions. The specific claims against State Street and others (which have been vigorously denied by them) assert in part that the banks profited by charging client accounts based on unfavorable exchange rates (often the highest or lowest currency rates for buys and sells of currencies respectively) that differed from the actual trading costs incurred by the banks, and pocketing the difference.
The objective of this article is to highlight the controls Commonfund uses to monitor best execution of trades within our funds, including currency trading, and the reasons we are confident that our processes would uncover trends of overcharging on the part of our custodian bank. Our process includes the independent sub-advisors contracted by our funds, internal teams responsible for monitoring fund trades and third party service providers that provide an independent analysis of trading activity in our investment programs.
Due diligence is a continuous process and Commonfund Asset Management Company uses a multi-disciplinary approach in its execution. Representatives of the Investment, Operations, Legal, Compliance and Risk Management teams all participate in the review of prospective sub-advisors and must unanimously approve a sub-advisor before that manager is approved to manage client assets in our marketable and marketable alternative Funds. As part of this approach Commonfund performs detailed reviews of sub-advisor policies and procedures, including broker selection, trading process, trade allocation and monitoring trade execution. This first step is to assure that sub-advisor processes and controls are appropriate for their mandate and in keeping with their fiduciary responsibilities as advisors to our funds. In addition to the initial due diligence on prospective sub-advisors, we use an ongoing due diligence process to oversee sub-advisor trade execution.
Under investment management agreements with our funds, our sub-advisors are required to obtain best execution from brokers utilized for executing trades in our funds’ portfolios. This means they have a duty to seek the best terms available given the particular circumstances of trades, including foreign exchange. Sub-advisors must select brokers and monitor trade execution to ensure favorable trading costs and reliable execution. Investment management agreements with sub-advisors provide Commonfund with veto power over individual brokers. Sub-advisors are also required to notify Commonfund immediately if they identify specific instances of trade execution that do not meet the fiduciary standards laid out in management agreements.
Commonfund’s Trade Management Oversight Committee (TMOC) is comprised of members of the Investment, Compliance, Risk Management, Legal and Operations teams and is responsible for monitoring trade execution in our funds. Commonfund utilizes Global Trading Analytics (GTA) to aggregate trade data and provide metrics that compare trading costs to peer universe benchmarks. The team meets on a quarterly basis to review results by fund, sub-advisor and broker. Any outliers are addressed with the applicable sub-advisors as needed.
The TMOC review includes a detailed analysis of foreign currency trading. This entails comparison of actual currency trading costs to reported daily ranges of currency rates for the period and various measures of variance from mean/average peer universe costs. The bulk of the foreign currency trading in our funds is executed through State Street, either through the Boston office or the London desk. We receive foreign exchange data that allows us to identify trends related to where currency trade costs fall within daily trading ranges.
In our review of this data, we have been able to confirm that for the periods examined our currency costs have been within reported market ranges and variances from market averages are within an acceptable range. Of note, we have uncovered no trends indicating a pattern of mispricing. However, this process is ongoing, and consistent with our client commitment, we continue to monitor foreign currency trading to make sure that our funds receive the best execution of all underlying transactions.