Investment Research: Broker-Dealers Have Their Own Unbundling to Do

Fund managers may not be the only ones forced to unbundle payment for trade execution from research when the new incarnation of the European Markets in Financial Instruments Directive (MiFID) takes effect.

Broker-dealers will be facing a similar challenge and they could be just as unprepared. Ordinarily classifying the research they provide fund managers as “value add” to their execution services, broker-dealers will have to deal with new requirements that fund managers must procure transaction services separately from most research products. In addition, as “manufacturers” or “distributors” of research, they will be expected to identify the target market for their offerings.

The result could be a new marketing requirement to match what they offer to what asset managers want and can justify in value to their investors, says a new research report released by Woodbine Associates in Stamford, Conn.

Published at a time when fund managers are struggling to figure out how they will comply with MiFID II, Woodbine Associates’ report offers some inkling of what research providers may have to do to stay competitive in an unbundled environment. MiFID II will be requiring their client fund managers to manage research and its costs in a a new way that either eliminates the investor charges altogether by absorbing the expense into management overhead or alternatively working from research funds provided by investor money. In the latter case, the proposed changes require the investors be informed of the price and value of the research they are funding — which would put the onus on broker-dealers to some degree to provide not only pricing, but also supporting information.

Further clarification on the technical standards as well as the draft regulation to be presented to the European Parliament are expected later this year. Preliminary documents indicate that some basic equities research may be exempt from the unbundling requirement, but other types of research and research services are likely to be viewed as a perk that could influence a fund manager’s choice of execution services provider — and thus will have to be separately offered and priced.

Scheduled for implementation as early as January 2017, the new legislation supposedly applies to only asset managers operating in Europe, many global buyside institutions headquartered in the US could end up complying for all of their clients. The administrative costs of ring-fencing different clients could otherwise be far too high.

Prioritizing the Shopping List

When it comes to what kind of research asset managers are willing to pay for, fundamental analysis may not be on the top of the list. “[Sellside] firms incorporating research offerings must thoroughly understand the specifics of demand,” writes Matt Samelson, chief executive of Woodbine Associates. “Over and above coverage, providers must assess both the types of offerings and delivery channels for services.” Complicating the issue for broker-dealers, the research finds that the operational area controlling the choice of broker-dealer at fund management shops varies depending on the size of the fund manager’s assets. (FinOps Report was provided a copy of the entire report entitled “Research Services: Value and Opportunity Among Asset Managers in the US Equity Market,” which must be purchased).

Samelson divides research offerings into eight broad categories: access to company management, access to analysts, conferences and seminars, individual company reports, actionable research, macroeconomic analysis, custom research and expert networks. Based on his study of 49 US investment advisors and pension plans, he concludes that interest in specific offerings and willingness to pay for it varies significantly, depending on asset size. The study only looked at traditional or “long-only” strategies.

The largest fund managers and owners — those with more than US$100 billion in assets– heavily rely on their head traders to decide which brokerage to use. These large shops are especially looking for customized research on specific companies as well as macroeconomic analysis and access to third-party experts. At medium-sized fund management firms with between US$10 billion and US$100 billion in assets under their belts, portfolio managers are more likely to call the shots and are looking for access to company management, traditional analyst services, and conferences. The smallest asset management shops — those with less than US$10 billion in assets — differ widely in their demand for research and depend on a combination of the head trader, portfolio manager and others to decide on their research budget.

The disparity in research needs among asset managers appears to boil down what they think they can do on their own and what they need to fill the gaps. The largest asset managers already do much of their own fundamental research. The fact that their head traders play such a great role in how commission dollars are allocated indicates that best trade execution is the deciding factor in choosing among the bulge-bracket firms. For their research needs, these firms are likely to turn instead to the independent providers — research shops that don’t also offer trade execution.

However, because the largest asset managers also have the most money to spend, they are the ones bulge-bracket firms can’t afford to lose as clients. Holding onto them in the new environment may not be easy, as they are the most fickle consumers of services with little hesitation about jumping ship, according to Samelson. By contrast, the portfolio managers at medium-sized fund shops who make the decisions are clearly research-oriented and have traditional had more loyalty to their bulge-bracket broker dealers who offer access to corporate management they could not win on their own. Broker-dealers that aim to attract a higher number of smaller asset managers may find it harder to make the group profitable. They will be looking for the most up-market services for their relatively smaller research budgets.

What’s Useful, What’s Not

Although Samelson’s report relies on a small set of asset managers and owners, his findings struck a cord with several buy-side shops contacted by FinOps Report who fit the category of large asset management firms. They tell FinOps that their investment teams don’t read all the research reports they now receive from the bulge-bracket firms they use for trade execution. “Of course we get the full research package, but a lot of it duplicates what we already have in house. To be frank, we find bespoke and macro research far more useful,” says a US asset management firm’s operations manager.

If broker-dealers know that asset managers are already in the habit of picking and choosing what is useful from the broker-dealers’ value-add packages and the offerings of independent researchers, it would seem logical that they start now to customize the research packages they offer users of their execution services. Alternatively, they could even allow their buyside clients to choose from a research menu, perhaps linked in some way to the fund manager’s anticipated transaction volume.

Some broker-dealers appear to be already preparing for the new regime, based on what two bulge-bracket firms tell FinOps. “We will are looking at a two-tiered approach with clients getting the basic research as a premium for using the execution services, but add charges for open-door access to analysts, invitations to company presentations and free research events,” says the research director of one brokerage.

Versions of the two-tiered model are beginning to show up in the offerings of several investment banks including Barclays, Credit Suisse, Citi, and Deutsche Bank. The price differential between the tiers could be substantial: US$50,000 for standard research and over US$1 million for the deluxe package in one case. Other investment banks, such as UBS, have said they will explicitly charge for services that cost them money — like using their analyst’s time. They will market-price that time based on the analyst’s popularity and fluctuating demand.

Will this tiering model address the challenges faced by the fund managers to assign price and value to all research charged to investors? Not necessarily, but until the final regulation and technical standards are published, it is too early to say. The potential exemption of  basic equities research from the unbundling requirement would appear to leave that research unpriced, though still with value and cost that has to be assumed and budgeted by the asset manager.

Would bulge-bracket brokerages help their fund manager place a value on what they provide without explicit charges? One director of research at a New York brokerage said it wan’t likely, adding “The value of research is a bit subjective, so we will let them do the talking to their investors.”