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Portfolio Trading

Directors have a duty to oversee fund trading practices and the use of brokerage commissions, including the manner in which the fund’s adviser fulfills its obligation to seek “best execution” when trading portfolio securities. Nevertheless, directors are not required or expected to monitor each trade the fund makes. Over the years, a number of regulatory developments and technological innovations in trading and market structure have resulted in board oversight of fund trades becoming a potentially complex task.

Brokerage Commissions

Boards oversee the adviser’s use of fund brokerage commissions and the overall transaction costs that the fund incurs when the fund buys or sells portfolio securities. This is an important function of boards for two reasons. First, transaction costs have an impact on a fund’s net performance (because the costs are reflected in the fund’s total expenses). Second, fund advisers are subject to a number of potential conflicts of interest in conducting portfolio transactions on behalf of clients, including funds. Fund brokerage commissions, which are paid out of fund assets, may, for example, be used to obtain brokerage and research services that might otherwise be paid for directly by the fund’s investment adviser. This practice is known as using “soft dollars.” In addition, an adviser may use a commission recapture arrangement, whereby the fund receives a portion, or rebate, of the brokerage commission (or spread) charged by the broker-dealer handling the trade. Additionally, an investment adviser may use fund brokerage to pay certain providers for services utilized by the fund through an expense reimbursement arrangement with a broker-dealer and/or its affiliates.

Best Execution

A fund adviser generally must seek to execute securities transactions for its clients in the most favorable manner under the circumstances. In seeking to achieve best execution, the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the account. Accordingly, an adviser may take into account the full range and quality of a broker’s services in selecting broker-dealers including, among other things, the value of research provided as well as execution capability, commission rate, market impact, financial responsibility, and responsiveness to the adviser. It is common for boards to receive periodic certifications from the fund’s adviser confirming that the adviser has executed all portfolio transactions pursuant to its obligation to seek best execution.

Soft Dollars

Some fund advisers may use brokerage commissions generated by the fund’s securities transactions to obtain research and related services from broker-dealers. This practice, known as using “soft dollars,” is regularly reviewed by directors. Also, because soft-dollar services benefit the adviser as well as the fund, directors may review the adviser’s soft-dollar practices to evaluate whether they result in a “fall-out benefit” to the adviser under its contract with the fund. Soft-dollar reports provided to the board by the adviser typically identify the top broker-dealers that are providing soft-dollar services and the average commissions per share that those brokers are charging on soft-dollar-generating trades. While boards, as overseers, won’t usually second-guess an adviser’s selection of broker-dealers, it is important for boards to be comfortable with the process used by advisers for selecting broker-dealers and to satisfy themselves that any potential conflicts of interest are addressed by that process.

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