It’s a given that fund management firms should pay for research — aka the ideas and analysis — that helps them make decisions on whether or not to buy or sell a particular stock or bond and when.
Yet the European Commission now wants to put their spending on research under the regulatory microscope. A new version of the Markets in Financial Instruments Directive (MiFID), when implemented, would force fund managers who use client funds to pay for research to justify how much they will spend on research each year and what value they receive in return. Currently fund managers have no legal obligation to understand or even explain to each underlying asset owner — such as a pension plan, endowment, or foundation — why it spent a certain amount of its commission dollars on research.
As if the compliance challenge weren’t hard enough, the operational may be worse. As the new MiFID regime is envisioned, monies budgeted for research must be deposited in separate new research payment accounts – one for each asset owner such as a pension plan, endowment, insurance company or other firm. The allocation for research payment may need to be set up in advance and disclosed to clients; although, it remains unclear as to whether clients agreement to the amount will be required before it is spent. With the final rules for how unbundling of research from commission spending yet to be published by the European super-regulatory giant European Securities and Markets Association, asset managers have little time to prepare. The new version of MIFID is set to be implemented by early 2017.
One obvious way out of the legal and operational quagmire for asset managers: pay for the research out of their own operating budget. In fact, a recent survey conducted by agency brokerage ITG showed that 51 percent of the 40 hedge fund managers questioned already pay for some of their research using their funds’ management fees, and not fees generated through trading commissions. However, that option is typically reserved for the biggest players. The small to mid-sized ones might just opt to buy less research, or be forced to deal with the new requirements for passing along the cost to ultimate end clients.
So what’s the fuss all about? Although asset managers are meticulous when it comes to picking apart their trade execution costs, they don’t have the same expertise when it comes to research. Based on comments by panelists and attendees at a recent evening gathering hosted by the New York Society of Security Analysts (NYSSA), it appears that any type of mathematical analysis of research value won’t be easy to accomplish. The reason: there are no standard methodologies to directly correlate expenditures on research to investment returns, and it is not even certain whether returns alone are the best metric. There are other factors, such as the perks gained by having a long-term relationships with research providers.
Defining Value
“Asset managers will now need to define exactly what the terms value and research mean to their firms before they can even begin to establish the type and format of research to buy from which provider,” says Rebecca Healey, a research consultant with TABB Group in London. “While the ultimate goal of research is to influence investment decisions, it can take different forms ranging from data to a call with an analyst or an actual written report on a particular stock or industry sector.”
Under the current system of commission sharing agreements (CSAs), asset managers charge each fund they oversee a bundled or combined fee for both trade execution and research. The fund manager then works out how much of that money goes towards paying for trade execution and how much for trade research with each service provider and only then tells the underlying investment fund client. By some estimates, as much as 70 percent of CSA funds go to research.
European regulators are concerned that asset owners don’t understand what they are paying for and whether they are getting value for their money. By linking research payments to trade execution commissions, the amount of monies used research may have less to do with its value than with the volume or number of trades executed, they argue. Naturally, asset managers and broker-dealers dispute that stance.
Not even the bulge-bracket brokerages — Wall Street’s largest investment banks which execute orders and provide research on the stocks and bonds traded through their shops– break out the cost of research subscriptions from commission charges. Independent research providers — those not affiliated with a broker-dealer — do explain their offerings and charges in more detail, yet historically the bulk of research dollars has gone to bulge-bracket firms because of the added-value products.
Unlike independent research providers, bulge-bracket brokerages can also offer fund management shops access to their analysts, a corporation’s management and potential initial public offerings. Naturally, the largest most-active asset managers find these services can be worth their weight in gold. The more money an asset manager spends on research with a bulge-bracket firm the more likely it is to be allowed entrance into “preferred” client club where it will have carte blanche access to all the extra goodies.
Granted there are commission management systems which enable fund management firms to cast “broker-votes” on which broker-dealers will receive research dollars based on votes cast by members of the fund management firm such as the chief investment officer, portfolio manager and investment analyst. The “vote” does not equate to a specific monetary amount but a percentage of the CSA funds, explains Neil Scarth, principal of London-based Frost Consulting, a commission management and research management advisory firm for fund managers. “A broker could provide the same research in two periods and receive the same number of votes, but be paid a different amount simply because trading volume had varied,” he says. “The broker-vote is also a relative ruling and does not track the research a fund manager has actually received and consumed in the way brokers assess client profitability.”
Strategies for Pricing
Given the extra new regulatory responsibility what should asset managers do? For most, the place to begin will be an analysis of what was paid the previous year. Brokerages will naturally want to at least retain the same amount, if not ensure it is increased. Because fund managers will have to break out just how much they are spending to their underlying asset owners and explain their rationale, managers will want to get the same amount of research for less or even reduce the number of research providers they use.
For asset managers, figuring out what the “true” cost of research is could end up being a multi-step process. Relying strictly on the previous year’s figure is the easiest approach, but not necessarily the best one for the asset owner. If the fund manager can’t prove it has done the necessary due diligence in evaluating the price-benefit of the research, it might well be overspending or even underspending. “A far better approach for fund managers is to think of research as a service,” explains Scarth. “They can then incorporate a comparable analysis of how much it would cost them to generate the research in-house and how much it would cost them to purchase reports from independent providers into their thought process.”
The next step: “Rather than strictly thinking only about the number of research reports to be received, asset managers also need to consider access to analysts, corporate management, initial public offerings and the like,” says Michael Mayhew, chairman of Integrity Research, a New York firm specializing in analyzing research providers. “If asset managers think they need the extra services, they have to take them into consideration in their decision-making process in just how much money they are willing to spend on the research. If they don’t and just want plain vanilla research reports, they might find that an independent research provider would be just as good, if not better.”
What about asking bulge-bracket brokerages to come up with a price for only the research reports they use? Surely, asset managers don’t read — or even need– every report they buy from a bulge-bracket firm, so why not insist on a la carte prices? It sounds like a great idea, except for the fact that bulge bracket broker-dealers will likely refuse such a request. They count on fund managers to buy either all or none of their research reports and for good reason. “Bulge-bracket broker-dealers need all of the revenues generated from research to pay for all of the research so that research on the hottest stock picks can subsidize research on the laggards,” explains Mayhew.
Although fund managers may not be able to negotiate with broker-dealers on just how much research they are willing to pay for, they might be able to negotiate the ultimate price they will pay. “If they don’t need all of the research provided because they find only some of it useful, they won’t want to pay the full price,” says Healey.
If the leap from bundled to unbundled commission is large for equities, the transition for fixed-income and other securities is gigantic. No one at the NYSSA event could determine just how that could materialize. Even the most sophisticated broker-vote systems can only handle equities. “Paying for research is an entirely new concept for fixed-income securities,” explains Healey. “Trades are largely principal-based with the bank taking on the risk for managing the deal which is factored into the spread, which pays for the trade.”
Slippery Boundaries
Although MiFID is a European regulation, its impact may extend far beyond the Eurozone. No matter where fund managers are headquartered, if they have an operation in a European Union country, they have to play by the rules. They might even decide to play by the rules if they are US headquartered, but a European asset owner wants them to. What happens to the rest of the customers? That’s a multi-million dollar question. “We don’t know whether we must ring-fence US customers and Asian clients from European clients when it comes to following the European directive,” one compliance director at a US asset management firm tells FinOps. “It could become a compliance nightmare if we do.”
The road to hell is paved with good intentions. Regulators wanted to solve what they thought was an injustice to asset owners — paying too much for research — but they created a far larger practical problem instead, say some brokerage research specialists. Potential impact on the market: research in small and medium-cap companies could decline, some smaller asset managers could decide to relocate their operations outside Europe, and passive investments such as exchange-traded funds could benefit at the expense of actively-managed investment funds.
US-headquartered global asset managers have been lobbying the US Securities and Exchange Commission to help their cause and win a reprieve from following the new rules, or at the very least persuade the EC to allow them to implement them using a special version of CSAs. Attendees at the NYYSA say they are ready to sign a “Declaration of Independence” outlining their beefs, yet at this late stage they concede that it is unlikely the EC will budge.
“No one at the European Commission or Parliament cares what the US thinks,” says one panelist. “After all, we’re the ones who came up with FATCA and swaps transaction reporting rules.”
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