Securities analysts shine light into the murk of corporate finances for investors’ benefit — but the arithmetic of their own business is far from transparent.
Equity researchers collect some undisclosed portion of the fees their brokerage firms collect from asset managers. Fixed-income analysts make their living still more opaquely, out of the bid-ask spread their broker employers earn on bond transactions. In an age when clicks are counted on any news story or search-term advertisement, analysts still send their material scattershot to clients, with no hard feedback on who is reading which reports, or consigning them to the electronic trash. All that may soon change, at least in Europe, with potentially wrenching consequences for the research industry and its core users among active asset managers. The transformation agent is the Markets in Financial Instruments Directive II, which takes effect January 3, 2018. Among other voluminous requirements aimed at market clarity and efficiency, MiFID II demands that asset managers break out the costs of research from their own management fees and pay for them separately. Buy-side managers are expected to press the same requirement on their sell-side providers to clarify just what they are paying for, with the result that less research is spewed.
“When investment banks want to drum up trade, they often sell research along with it,” says Mick McAteer, a former board member of the U.K. Financial Conduct Authority (FCA) and now co-director of the Financial Inclusion Centre in London. “But a lot of what is sold is not really worth paying for.”
MiFID II has been developing in the corridors of the European Union since 2010 (the original MiFID went on the books in 2007) and gained European Commission approval in April of this year. However, it took consultation papers released in September by the FCA and French counterpart Autorité des Marchés Financiers (AMF) to start focusing market minds on its daunting requirements.
Most practitioners read the FCA paper as a signal that the U.K. will enforce MiFID — despite its looming departure from the EU, not least because authorities see regulatory uniformity as one key to the hoped-for passporting of U.K. financial services to its soon-to-be-former union partners.
“The FCA is very concerned,” says Leonard Ng, co-head of the EU Financial Services Regulatory group at law firm Sidley Austin’s London office. “The time has come for the total unbundling of research from broker’s commission.”
That principle is far easier to dictate than put into practice, however. To start with, no one knows what share of current commissions research represents — or, if they do, they are not telling. Estimates in the market vary between 25 and 50 percent. “Is there any rule of thumb going in? The answer is no,” says Jack Pollina, global head of commission management for New York–based broker ITG.
The research component may be lower for funds that deal in familiar securities close to home and higher for emerging markets or small-cap investments. Much of the value added by research departments can come from arranging access to company managements, an intangible element devilishly hard to quantify, Pollina points out. Regulators look to be divided on whether technical market analysis counts as research: A hawkish FCA indicates that it does, while a milder AMF indicates little. And that is in the equity sphere, where managers and brokers were already edging toward pricing research and opening it to third parties through so-called commission-sharing agreements (CSAs). The cost of bond-market analysis is a thorough black hole.
While sell-side banks and brokerages hold the secrets on research costs, the burden of compliance with MiFID II falls squarely on buy-side asset managers. The directive essentially offers these firms two choices. The first is to establish a research payment account (RPA) for every client, with the amount set in advance annually. This RPA is subject to rigorous — some might say onerous — documentation and audit requirements aimed at presenting investors with an itemized, phone bill-style accounting of exactly where their research euros or pounds went. The client would have to approve any overruns.
“Under the current system, if you budget $1 million for research and go to $1.5 million, it’s no big deal because it’s mixed in with so many other costs and charges,” Pollina says. The French interpretation would allow managers to maintain their current CSAs, but subject to RPA-esque reporting and oversight.
Option two for asset managers is to forget all the new paperwork and pay for research themselves in so-called hard dollars. The biggest U.K. asset manager, Legal & General Investment Management, which controls £853 billion ($1.06 trillion), has announced it will do just that, raising fees on most of its funds by 10 to 15 basis points to compensate. Edinburgh-based Baillie Gifford, with £148 billion under management, has also started absorbing research costs, without disclosure on any fee hikes.
A recent report from CRISIL, a Mumbai-based subsidiary of Standard & Poor’s, predicts other European fund managers will largely follow suit into hard-dollar research payments, at considerable cost. It predicts a 17 percent slide in operating profits for active managers, even assuming they can cut research costs by 20 percent. Others dispute that outlook, such as Elizabeth Corley, vice chair of Munich-based Allianz Global Investors, which manages €469 billion ($518 billion).
“What we would not want [is to begin paying for research ourselves], and then find that our trading costs across the market have inflated by a magical factor,” she told the Financial Times in May. “We would be very upset about that.”
A recent survey by consultants EY found that more than three-quarters of European asset managers have yet to decide how to cope with research unbundling. “It’s early days yet,” advocate McAteer says.
One point inspiring wide agreement is that the current research regime is wasteful and outmoded. Sell-side analysts duplicate effort, choking clients’ inboxes with PDFs that may or may not address their needs. “Unbundling research is an opportunity to explore some new alternatives,” says one fund manager. “If I were starting with a clean sheet of paper, I wouldn’t start with the sell side.” His firm will look to cut back on brokers’ input, reaching out instead to academics and industry experts in burgeoning fields like technology and health care. One group trying to drag securities research into a 21st-century, Amazon.com-style format is RSRCHXchange, a London–based online marketplace launched a year ago. While mainstream investment banks have been slow to get on board, the exchange currently posts research from more than 140 providers, says Vicky Sanders, a former Goldman Sachs equity saleswoman who is a co-founder. Fund managers can see ratings before they buy and track their own consumption in detail to satisfy the MiFID II requirements. The anticipated result is less research used much more effectively.
“This is the equivalent of converting a library into a bookstore,” Sanders says. “It doesn’t make much sense to have books in a store that nobody wants to buy.”
Perhaps the biggest question hanging over Europe’s drive to unbundle research is whether it stops in Europe or will spread in time to the world’s biggest financial market: the U.S. America’s regulatory structure raises a significant obstacle to wholesale adoption of MiFID II mechanisms. The Securities and Exchange Commission allows only registered investment advisers to take direct payment for research, and bigger sell-side firms are reluctant to gain RIA status because that would preclude much of their trading activity.
Yet market logic indicates that unbundling will migrate across the Atlantic in ad hoc fashion, market players say, especially if it works as intended to lower investors’ costs and increase their sense of control over their own money. U.S.-based asset management giants will have to become MiFID II-compliant for European operations, and U.S. investment banks MiFID II-friendly to service the European buy side. Those standards could quickly be implemented globally if the ultimate clients in the investor community start to demand it.
Says ITG’s Pollina: “Global asset managers are going to implement one global policy as investors say, ‘The other guys are doing it, why don’t you?’”