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Decades ago when I was a sellside analyst in the City of London doing the rounds of my firm’s fund management clients, I would regularly ask them a simple question: what did they want in research?
The answer back then was: every conceivable option. The fund managers’ desks were often overflowing with mounting stacks of unread research and their phones besieged by brokers brimming with ideas. But the investors still wanted more. Why? Because there was little direct cost to them. It was all largely paid for with commissions on trades. In turn, these were paid out of the pockets of fund manager’s clients — pensions funds and the like.
Eventually, regulators thought this was not such a great idea and in came Europe’s much heralded Markets in Financial Instruments Directive II — or Mifid II — from 2018. This aimed to shine a light on research expenses, unbundling research fees from trading commissions and making the costs explicit.
Now, though, regulators are carrying out what is known in my current trade as a “reverse ferret”. Pushed by the UK Treasury that is seeking to take advantage of its post-Brexit freedom from EU rule-setting, regulators at the Financial Conduct Authority have begun to rethink this unbundling of research and trading expenses. The European Securities Management Authority is carrying out a similar exercise.
The main driver of this extraordinary turnaround is the realisation of the unintended consequences that Mifid II has wrought. The directive undoubtedly brought more transparency. But there also have been complaints that the changes have damaged the financial ecosystem and diminished the supply of equity research, particularly for smaller companies.
Initially, Mifid II unbundling promised a means of promoting higher quality analysis and reducing any redundant reports. But it also began a period of vicious price cutting on research by the largest brokerage firms.
As small, independent research houses watched with horror, prices for their services plummeted. Asset managers, who found they had to pay more explicitly for research costs, happily grasped at any chance for discounts. Bulge-bracket brokers tackled any competition from independents head on with all-inclusive research packages at very low prices.
And even for large investment banks, there were downsides to Mifid II. It added layers of administration to win the research battle. Regardless of any subsidies provided by other parts of investment banks, research became even larger cost centres than they had been previously.
“I would think that quite a few research heads will be happy to see the previous system go,” says Steve Kelly, an adviser to the European Association of Independent Research Providers.
Research remains a big business. Last year, global cash equities research was estimated to cost around $11bn annually, according to Kelly’s analysis of Integrity Research data. About $6bn comes from the US, with Europe and the UK providing $3bn or so. But research clients have become more careful with their budgets, even in the US. “When you go from an all-you-can-eat model to à la carte, you think more carefully about what you consume,” says one senior executive at a large US fund manager.
In the US, the investment community has long bundled research costs with trading commissions. Under the US Investment Act of 1940, professional investors cannot pay for research directly. Local concerns that US brokerages would have to create special investment advisers to accept direct payments under Mifid II were put to rest recently. A workaround will leave any UK and European research money paid sequestered in that region.
In Europe, things will not return to pre-Mifid II days. Even in the UK, a government-commissioned review by financial services lawyer Rachel Kent did not recommend a mandatory return to the commission-sharing agreements (via trading) of the past. But Kent did suggest more payment flexibility is needed. And even independent research groups are not expecting business will suddenly improve radically. “I expect an uplift of perhaps 5 to 6 per cent in our global revenues,” says Iain Johnston, chair at New Street Research.
Having seen the backtracking by the government on Mifid II for research, many investment managers will want to delay having any cost discussions until confirmation of changes. Those discussions will no doubt be tricky. If their clients expect their asset managers to do in-depth analysis, shouldn’t this cost be shared?
When seen as part of trading expenses the cost may be only a few hundredths of a per cent. Not so fast, asset owners may say. Mike Carrodus at Substantive Research quips that pension fund bosses ask, “If it’s so little, why don’t you pay for it?” Who forks out for research, not just how much, is the real issue.