Mifid II looks certain to shake up the way investment managers buy external research.
With implementation of Mifid just months away, some fund managers have shown their hand, but there remains considerable uncertainty as to how the rules will affect the quantity and type of research used by fund managers, and how much they will be willing to pay for it.
In the meantime, investment banks are in a holding pattern, waiting to see how demand for their services will pan out. The rules are clear – sell-side firms must not induce clients to trade by bundling research with their execution services.
The quid-pro-quo of providing stock trading ideas in exchange for doing deals can no longer happen. In theory, this is fine. Investment banks merely have to unbundle the cost of trading and research, and make sure that investment managers pay the appropriate fee for each.
However, the concern is that investment managers will become overly discerning in the research they use if there is a pounds and pence cost attached to it that either they must pay themselves or pass onto clients.
For the buy side, firms must make explicit payments for research and show that this research contributes to better investment decisions.
This is designed to ensure that investors don’t suffer from poor investment decisions enacted because the investment manager has a clubby relationship with an investment banker.
However, it is not easy to prove. The definition of a good investment decision is wide open to debate, particularly as the success of investment decisions may not become clear for some years.
This is also likely to impose increased reporting requirements on fund management groups using research.
A recent survey cast doubt on asset managers’ readiness for the new rules. A recent survey by RSRSCXchange found 85% of asset managers were expecting to become compliant by Q4 2017 or later, pushing up against the January 2018 deadline.
This makes it tough for investment banks to judge how to adjust their business to meet asset managers’ requirements. The UK FCA has recently laid out its interpretation of the rules. It has softened the rules in a number of areas.
For example, research firms will now be able to offer trial periods of up to three months. They will also be able to offer connected research for primary market capital raising.
However, this does not change the general direction of travel. In assessing the response of the buy side, the situation is easier for equities than bonds.
Unbundling charges for equities is relatively easy; commission-share agreements (CSAs) are already in place in many cases, and the separate costs are clear. For bonds, the cost of research is embedded in the spread.
The other problem area is for US broker-dealers, where unbundled costs are not permitted without it being considered investment advice.
WHO PAYS THE PRICE?
For buy-side, the question of who ultimately pays seems relatively far advanced. A poll for EY last year suggested that around a quarter of asset managers would absorb the costs themselves.
This includes companies such as M&G, Aberdeen Asset Management, Woodford Investments and Jupiter, which have all stated publicly that they will pay for research themselves before the new rules are in place.
Other asset managers, including Amundi, Janus Henderson and Schroders, plan to continue to pass the cost on to their clients.
The willingness and ability to pass on these costs depend on existing fee levels, the strength of products and whether clients appear likely to pay.
It should be noted that investment management fees are already under pressure from the march of passive competition, and clients may not tolerate fee rises.
However, the costs are, in many cases, not significant. Richard Pease, manager of the Crux Asset Management’s European Fund, estimates that research accounts for around 4 basis points of cost, in a 0.8% management fee.
Clearly, the impact will also depend on the amount of research used. Many larger firms have deep internal research teams and only use external research selectively.
An Aberdeen spokesperson says: “In our view regulators’ intention is to stop managers using client commissions to pay for third-party research and we are well progressed in putting this in place over the course of 2017.
“Our investment process will be unaffected, grounded in internal research generated by our investment teams supplemented by third-party research, but payment for third-party research will no longer be made via client commissions but instead be borne by Aberdeen Asset Management.
“Given our focus on managing client commission costs, research payments having been trending lower for several years now and will continue to do through 2017 and cease completely by 2018.”
Buy-side firms have two options when paying for investment research. They can make it directly from their own account, or via a research payment account (RPA), supported by a commission sharing agreement (CSA), which outlines how execution costs are split between trading costs and research.
Some are still deciding on their approach. For example, a JP Morgan Asset Management spokesperson says that the group’s policy currently remains under review.
A third of asset management firms have yet to decide how they will pay for broker research once Mifid II rules come into force in January next year, according to the RSRCHXchange survey. Nevertheless, this should not be taken as a sign that asset managers aren’t working to put a strategy in place.
One group anonymously commented in the survey: “The industry is not asleep at the wheel. There is huge awareness of the implications for intermediaries and investors.” What is less clear is the amount of research the buy side will use after Mifid and this is unlikely to become clear until after implementation.
Jeremy Davies, co-founder of research aggregator platform RSRCHXchange, says they have not picked up any clear patterns in the way the buy side uses the research on its platform.
“Some pieces have sold a lot and some have never sold, but we would need more data,” he says. “It is likely to be a couple of years into Mifid implementation before these trends are seen. Discerning consumption hasn’t kicked in yet because most asset managers are still getting research for free.”
Pease says that there is some research they find invaluable and they will pay to keep access to the strongest analysts; there are other areas where they just pay to keep their name on the research distribution list.
“We have done some research to try to figure out the implications. We have concluded that nothing is going to change very much. There won’t be an impact on the business or the way we do research. Some research we pay for out of our budget. Very few were pushed onto the ongoing charge figure, simply because we don’t want to see it go up,” he says.
“The key thing is that it will create extra work. We will need to detail how we use research and what is valuable. That’s tricky because often you often don’t know until years later whether it has been valuable or not.”
He believes there will be a process of working out how much fund managers should be paying investment banks for research, but this won’t necessarily become clear until later.
Corporate access is another issue. Some companies have forced asset managers to pay for access to senior executives. Few asset managers will admit to doing it because most like to sell themselves on their prowess in corporate access.
Certainly, fund managers with enough assets and a strong reputation are unlikely to be affected by the change. As Pease says: “We have done it out of convenience, but in general we’ve got the CFO’s phone number.”
For the sell-side, there is an element of wait-and- see. No-one yet knows what the buy side will want in a post-Mifid world.
Many have suggested that it will lead to the slow death of the equity analyst. Consultancy McKinsey said it would be “an end to equity research as we know it”.
A poll from RSRCHXchange shows that 74% of respondents foresee a decline in investment bank research.
INVESTMENT BANK SUPPLY
Investment banks themselves are less willing to talk about the change. A spokesman for the Bank of America Merrill Lynch, for example, said its head of equity research did not want to discuss what it meant for their business.
There are signs of consolidation in research departments already. For example, Union Asset Management, Germany’s third-largest asset management company, recently said it will cut more than 100 external research providers.
Amundi said it has halved the number of external providers it used in the process. There are concerns that fund managers have left it too late to negotiate all the agreements by the deadline, which will naturally leave some research groups off the list.
A number of providers have set up electronic platforms for research, including RSRCHXchange and the Electronic Research Interchange (ERIC).
RSRCHXchange now has 200 research providers signed up, with 421,031 reports. They believe this will help the buy side and sell side get round the huge administrative hurdle of forging individual agreements with hundreds of different research providers.
If the buy side goes to a platform, they only need to sign one document. Asset managers can also request that the platforms bring on certain research providers.
Davies says that the group’s early interest came from the large long-only asset management groups that realised they couldn’t negotiate the agreements in time.
However, this has since broadened to smaller funds, fund of hedge funds and funds from outside Europe. This may prove to be a necessary solution to the problems faced by asset managers in the run-up to Mifid.
Either way, the real impact may not be seen until implementation, when investment banks finally understand the type of research that the buy side is willing to pay for.