The investment research industry might look entirely different in a few years. Or it might not. Regulators are pushing hard for a severing between research and trade execution that could succeed. But several market forces are pushing back.
Regulators want the way investors pay for research to change dramatically. Instead of bundling it in with the commissions they pay brokers to execute trades, fees for research will be separate from the fees for execution. While there is still some debate about just who ends up paying them, the general idea is that the end-clients in managed funds should bear the burden of execution, but the fund managers themselves should bear the cost of research. Research is seen as a benefit to the fund manager, while execution is part of the portfolio.
The changes fall under the European Union’s Markets in Financial Instruments Directive, commonly called MiFID 2. The directive imposes various changes to the way asset management works in Europe and it will have a wide impact — from the advice intermediaries give to the way over-the-counter derivatives are sold.
Armies of lawyers are still figuring out the details and implementation has already been delayed for a year. But asset managers are increasingly waking up to the changes. While SA’s regulators have not yet adopted it, it is likely to become the more stringent standard. As most professional codes compel managers to always comply with the more stringent code, it will become the de facto standard, particularly for those competing with other global firms for mandates.
If the regulatory vision comes to pass it will have several dramatic effects, some surely unintended. If fund managers have to incur research costs against their own income statements, the case for them to internalise research will grow. That will have several other consequences including:
Barriers to entry for new fund managers will rise as they will not be able to access an existing pool of research. Given SA’s transformation imperative, this could be harmful. Larger managers would have a greater competitive advantage in having a wider pool of assets against which to defray research costs.
If brokers have to cut back on the costs of research, it is likely they will focus on high-volume stocks, which will mean less coverage of small-and mid-cap stocks, leading to lower trading volumes and a higher cost of capital for small companies.
Costs could be pushed out of commissions and into wider share price spreads.
Active management could be discouraged, pushing more funds into passive portfolios which effectively get a free ride on the active decision makers left in the market. The result could be less market efficiency.
The hoped-for positive impact is that greater economic efficiencies should arise in asset management and therefore potentially lower costs to the end-client. Asset managers, forced to actively decide what research to buy, may be choosier about what really adds value to them.
They will also have to think harder about how to recover the costs from clients, which may lead to lower costs for end-clients. These are consequences of the enhanced transparency around costs that is the regulators’ main intention. Another potentially positive impact, from an overall market point of view, could be that non-broking research houses are able to enter the market and drive innovation in research. Asset managers may also find the process of analysing what research they consume enlightening, helping to gain insight as to how they generate alpha.
The challenge will be to convince clients that research is worth it. Clients are interested in returns and, sometimes, risk management. Research is merely a means to that end. Research teams will have to demonstrate that they can have an impact on both.
It is hard to believe that firms will price their research at the true economic cost. Research may continue to be a loss leader, a form of marketing, especially when it comes to trying to attract new clients. MiFID 2 really imposes regulations on the buy side to ensure that they separate out what they pay for. There is less obligation on the sell side to fully separate costs.
That is where the push-back against the changes may come from. Workarounds will become common as brokers find ways to keep their research costs covered without actually making clients pay them directly.
Innovation is hard to predict. Already various firms are entering the market to try to intermediate between research teams and fund managers, with complex value-determining mechanisms. Nonbroker research firms may find ways into the market too. Whether end-clients will be better off, it will be some time before we will be able to tell.
* Theobald is chairman of research house Intellidex, which conducted the research for the survey