Chief Investment Officer Summary
The following report presents the fiscal status of the CalSTRS Directed Brokerage Program for the calendar year ending December 31, 2013. Included in the annual report is the background on the program, a glossary of terms and an educational piece on the world of directed brokerage and soft dollars.
Brokerage credits used by CalSTRS are called “directed brokerage.” Credits used by money managers are considered “soft dollars.” The usage of the credits by CalSTRS is dictated by fiduciary law since they are considered plan assets. This annual report provides details on how many credits were generated for CalSTRS and how they were used.
The use of directed brokerage credits lies in a middle ground between two federal regulators. The Department of Labor has determined that they are “plan assets.” Therefore, they must be managed and used for the benefit of the plan sponsor trust. The Securities and Exchange Commission has promulgated safe harbor rules for the use of soft dollars by external investment managers. Directed brokerage/soft dollars have existed in this middle zone for over two decades. While many have predicted their demise, they continue to exist particularly among minority brokerage firms as a way to entice trading activity.
In trying to describe directed brokerage credits, people have used an analogy of “frequent flyer miles.” In the case of directed brokerage, these credits are generated by trading securities, either stocks or bonds, with certain brokers. How much is created and who uses the credits is up to the plan sponsor to dictate. The use of these credits is blended between the underlying investment manager and the plan sponsor. At CalSTRS, the credits are used primarily by the Teachers’ Retirement Fund; however, we do allow some of our external managers to use some of the credits generated from their trading activity with our assets to purchase research needed for their investment process.
Directed brokerage/soft dollars remain an oddity of the highly-competitive financial marketplace. They make auditors and regulators uneasy because they don’t feel like real dollars yet they do have a monetary value. After a discussion by the Teachers’ Retirement Board in 2007, the use of directed brokerage was shifted to other budget sources. Staff will continue that plan so that any credits created in 2014 will be rebated back to the fund rather than used to offset the budget.
Over the past decade, the use of directed brokerage credits has offered both a budget offset and financial flexibility. Having the use of this system has provided the Investments Branch the ability to be nimble in procuring the highest quality research services. By discontinuing the use of credits, this flexibility has been eliminated. This annual report details credits generated and the credits spent for the past year. Additional pages outline the income statement for the calendar year and the process of how the credits flow. Lastly, we include a glossary of the terms used in this program.
Chief Investment Officer
December 31, 2013