Unbundling research – the transition

The way that asset managers procure and consume investment research is changing rapidly. Regulatory change is set to accelerate this in the coming years. As things stand, there are concerns that the new regime could cause widespread upheaval and a slew of unintended consequences.

 

It all comes down to a handful of MEPs in Brussels who will determine whether research unbundling proceeds with clarity, and whether a variety of payment mechanisms are allowed – or not. Having spoken to Markus Ferber MEP, one of the key voices involved in MiFID II, it is clear he is aware of the risks of unintended consequences.

Reform has been a long time coming. The Myners report back in 2001 put in play a movement towards increasing transparency over the cost, price and value of investment research. The subsequent 14 years have seen a quiet evolution in the provision of investment research, especially in its relationship with volume of equity trades being executed.

The introduction of Commission Sharing Agreements (CSAs) in 2006 went some way to alleviating regulatory concerns, primarily over the conflicts of interest between execution and research provision. One of the key achievements of the CSA system, is that asset managers now have much greater diversity and independence in the research providers they use. Meanwhile, the link between research provision and execution of trades – which has been such a concern to regulators – seems to be in decline.

The complete unbundling of commissions and research payments contained within Mifid 2 is set to accelerate this evolution and clear any remaining conflicts of interest that still exist in the discretionary funds management space.

“It’s no bad thing that a light is being shone on the issue,” says Roland Spurr, business manager for equities at Alliance Bernstein. “As is the case with trading costs and best execution principles, the place of external sell side research in the investment process is a perfectly valid debate, where clients should be aware of what they’re paying for and what they’re not paying for.’’

Many of the proposed regulatory requirements are unlikely to be met with much resistance from asset managers. That’s partly due to the fact that the industry has already started to implement more robust procedures in the way it procures research. Under the proposed new rules, fund managers will need to set pre-agreed budgets for research payments, provide detailed audit trails of payments made to research providers, and also disclose transparent methodologies as to how they select and pay for research.

In the new, unbundled world, pre-agreed budgeting will provide the backbone of the new regime by severing the one-for-one link between the quantity of research investors receive and the amount of trading that they do. At the same time, a process of price discovery will need to take place, and it could take some time before an equilibrium price level is found. Moreover, finding a relative value across a range of providers is likely to be even more problematic.

‘’You can’t value sell side research (in an uniform way) because it depends on who is doing the buying,’’ says Robert Alster, who is head of research at Close Brothers, a London-based private wealth manager. ‘’You don’t quite know what research you’re after, and where you’re going to find the best ideas.’’

The initial price discovery will likely be a combination of individual firm value assessment, benchmarking to independent research providers and internal research resourcing. As the market transitions and settles in its new regime, asset managers will look for solutions to validate the prices paid for research.

Many large asset managers have already gone to great lengths to make their own assessment of value by building extensive data capture systems that record every interaction with sell side research providers. These include everything from the amount of research received and then consumed, to telephone calls, meetings and emails shared with analysts.

‘’In the future these physical data inputs be will ascribed values from which budgets will be set, which will then determine the hard dollar amounts we pay,’’ says Alster.

How do we pay?

Without clarification on how RPAs can be funded it seems that many asset managers will move to pay for third-party research out of their own P&L. Many fund managers conclude that it may be difficult to pass these costs onto their clients, and as such, there will be a significant drop in spending on research.

“Not many asset managers have pricing power in this environment and therefore they may struggle to pass on the costs,” says Alliance Bernstein’s Spurr.

“Regulators seem to be comfortable with capacity being taken out of the industry, both on the sell side and the buy side, and that’s fine,” adds Spurr. “But we’re not entirely convinced they know where the capacity will be taken out, and more importantly which end clients will benefit, which ones will be detrimentally affected.”

For instance, if the end result is a strengthening of the position of investment banks at the expense of smaller competitors, then it may not serve the retail client well, adds Spurr.

In a report released in March, TABB Group surveyed 50 global heads of trading of major buy side firms and found that 86% of respondents expected research payments to decline due to regulations. Just how that translates into a reduction in revenues, investors and research providers who spoke to Substantive Research in recent weeks suggest that it could fall between 30% and 50%.

The independent sector will be particularly hit, as it typically operates on lower margins and without the benefit of support from a trading business, meaning it is less equipped to absorb this sharp adjustment in revenues.

“If you’ve got a situation where all of the investment banks suddenly take a hit in relation to what they’re being paid, there’s a degree of cross subsidization that can absorb that in the transition period,” says Peter Allen, chairman of the Euro IRP, the trade body for European independent research providers. “If all of the independents take same hit, some of these guys will go out of business.”

This is not an argument for no change, but a suggestion that regulators should make a risk assessment of the potential ramifications of a sudden reduction in the capacity of investment research in the market.

Are regulators listening?

It seems that the door hasn’t yet completely closed on any reasonable arguments. MEP Markus Ferber told Substantive Research that a solution could be found that might limit the detrimental impact of a reduction in equity research coverage, in particular, when it comes to covering small cap stocks.

Speaking to us earlier this month Ferber made it clear that research costs provided a method of circumventing the ban on inducements, however, ‘’I do understand that there is some need to do something about the research issue, but it will be key to strike the balance right in order not to be in the way of SMEs. On the other hand, this problem confirms my point that a general ban on inducements is not the answer to the problems we are facing,’’ he said.

Kay Swinburne, another prominent member of the European Parliament and a member of the influential Economic and Monetary Affairs Committee, also appeared to offer a more conciliatory tone when she told Financial News this week, saying that the “political intent [was] never intended to prevent the bundling of the product”. She added: “It was only ever decided that we would force transparency on the market, as opposed to prevent it from happening.’’

Perhaps most tellingly she seemed to indicate that a slower transition might be the preferred option. “The parliament feels quite strongly that we shouldn’t be completely changing the model. If it happens over time because the market chooses to go in that direction, all well and good. But we are not there to force the model to change overnight.”

Why discard CSAs

If the slow-burn growth of CSAs are any example to go by the adoption of RPAs may take some time, and some fund managers fear that if they are forced to adopt a product that is not yet fully understood, they may just opt out and adopt a pure ‘hard-dollar’ policy. This could have dire consequences on research spend.

“Many of our members feel that to create and prepare the industry for RPAs with a January 2017 deadline is unrealistic,’’ says Guy Sears, of the Investment Managers Association, a trade group for asset managers. “I would imagine some firms will realise that they’re getting so close to the wire…the option between paying P&L and using RPA swings towards paying P&L.’’

The reasons for discarding CSAs seems a moot point. In a report published in March, Alistair Haig and Professor Bill Rees, from the University of Edinburgh, indicated that the introduction of CSAs had allowed fund managers to obtain a higher degree of independence in the advice they purchase, a wider choice of inputs and better value for money. And if breaking the link between execution and research payments is the ultimate outcome, findings of Haig and Rees suggest this seems to be happening by natural attrition anyway.

70% of the fund managers surveyed by the University of Edinburgh suggested research commissions to executing brokers declined in the period between 2010 and 2015, while there was a growing trend towards asset managers not charging their clients for the purchase of research, with 44% of those surveyed, affirming this trend.

Smoothing the transition

The industry now awaits clarification from the European Commission as to what the final rules will be, but those involved in lobbying regulators and politicians suggest some minor tweaks in the language could have a significant impact in limiting the disruption to the research market.

Some parties involved in the negotiations with regulators have proposed language that stipulates that payments on the RPA can be collected by the use of fees and client commissions, but those commissions would be called ‘’research commissions’’ as against trading volume-based execution commissions.

This would still break the link between the scale of those payments and the actual level of the trading that is taking place, while the use of commissions would be capped by the ‘ex-ante’ budgets.

Another option being debated is whether it is theoretically possible to create a quarterly charge based on daily accruals as to the research purchased but still use commissions to fund the RPA, according to a report published by the Tabb Group this month.

‘’At the moment it’s not clear how RPAs will be funded and how they might work, and given the short transition time, one should consider the existing CSA infrastructure that could do the same job, while still breaking the link with execution,’’ says another large UK fund manager.

And that seems to be the consensus industry view too. A recent survey of buy side professionals by Westminster Research Associates found that 88% of European-based respondents thought that regulations regarding CSAs should remain the same. In the same survey more than two-thirds of the investors said they would use less research if they were forced to pay cash.

Come June and the release of the delegated acts CSAs may become a thing of the past, yet it’s hard to see how CSAs couldn’t be part of the transparent, value-oriented market that the FCA and the European Commission envisage.