By Chris Tiscornia (pictured), CEO, Cowen’s Westminster Research Associates – MiFID II 1 is right around the corner and many asset managers are still scrambling to implement processes that will be compliant with its research unbundling requirements.
As the buy-side and sell-side explicitly negotiate the price of research, many of the largest asset managers have publicly announced that they plan to fund external research from their own resources for their MiFID II entities. While some of these managers are analysing whether to extend this practice to other jurisdictions, the majority of their assets will continue to be funded alongside trading commissions outside of the EU.
In the first half of 2015, there was a genuine concern throughout the industry that the forthcoming MiFID II guidelines could be interpreted to view investment research as an inducement, thereby driving investment managers to pay for research directly. During the second half of 2015, many industry constituents – regulators, politicians, buy-side and sell-side participants, independent research providers – cautioned that such a dramatic overhaul would trigger a set of unintended consequences within the industry and beyond. Taking these concerns into consideration, the European Commission (EC) allowed for commission sharing arrangements (CSAs) to survive as one of the available funding mechanisms for research payment accounts (RPAs) when the Delegated Directive was released in April of 2016.2
Whether the recent trend towards absorbing the cost of research in Europe by asset managers is being driven by perceived operational complexities or competitive opportunities, for some asset managers, it is important to reconsider some of the potential repercussions that come into play if direct funding becomes prevalent in the industry.
Regulatory
The primary objective of MiFID II’s unbundling requirements is to improve transparency over the cost and value of research for underlying asset owners. For asset managers that fund research via a RPA, the establishment of a more rigorous research valuation and budgeting process, coupled with enhanced reporting requirements, creates an increased level of accountability for managers in the research acquisition process.
Asset managers that fund research directly will not be subject to the same set of research budgeting and client reporting requirements as firms that fund research through a RPA. Ironically, this creates a more opaque structure where investors will likely still incur the costs of research in the form of embedded management fees or higher execution costs, but will not have visibility into their managers’ research costs.
Asset management
The largest asset managers have a distinct competitive advantage because they are more likely to have adequate scale and internal resources to absorb the cost of funding their research budgets directly. If direct funding becomes more prevalent in the industry, small and mid-size asset managers will be left in the unenviable position of having to raise their fees (good luck) or trying to generate alpha with less information, thereby impacting their performance. Smaller asset managers that go down the direct funding path will be faced with an enormous amount of pressure on their business operations – in particular, their ability to attract investment talent and access a broad range of research will be significantly challenged.
In an environment that is already extremely demanding for active asset managers, these pressures will accelerate the shift to passive strategies and inevitably lead to further consolidation in the asset management industry. Needless to say, lack of diversity and fewer choices amongst asset managers and their products is one of the potential consequences of the movement towards direct funding.
Performance
The recent public debate in London has largely focused on cost and the source and methodology for funding research. Only recently have a minority of asset managers come out publicly to highlight two other important considerations for investors – value and performance.
While they have been less vocal in the public debate, this is something that has not been lost on the hedge fund managers with whom we speak. While some long-only managers will use this dynamic period to lower their spend with their research providers, there is a recognition in the hedge fund space that their ability to source unique, proprietary information will put them in a position to outperform. Additionally, the adaptation of direct payments for research has not translated in the hedge fund space. Most hedge funds recognise that the RPA model provides them with a mechanism to acquire an array of research while still affording them with a platform that addresses MiFID II’s reporting requirements.
Research coverage/IPO market
MiFID II reporting requirements should create a transparent and increasingly efficient marketplace that will allow clients to focus their research expenditures on truly differentiated research that helps them perform.
However, another potential consequence for the industry and the economy more broadly could be a decline in research coverage of smaller and mid-tier companies, which would subsequently put added pressure on the IPO market. As buy-side firms become more particular about the research they consume and the research providers with whom they contract, it will inevitably put pressure on sell-side business models.
While the largest sell-side firms will offer waterfront coverage to their buy-side clients, pricing pressure will force boutique firms to run cost-benefit analyses to inform decisions about whether they should continue to provide research services, and, if so, which sectors and regions they should cover. Research providers will likely elect to cover sectors and companies that are the most profitable – either based on revenues generated directly from their research offerings or because of the potential to generate fees in other areas of the firm such as banking or trading.
This dynamic potentially creates a research vacuum in industries or companies that are currently out of favor and less profitable for the research providers. This may be particularly true for small cap research coverage, which, by nature, is a less liquid market. An absence in coverage will mean that newly public companies will have a hard time attracting investor interest and may incentivise companies to stay private longer to ensure that they get research coverage.
Operations and reporting
Asset managers that choose to fund a RPA with transaction based charges can feel comfortable that they will be well equipped to provide their asset owners with the requisite reporting beginning in January 2018 based on industry response to MiFID II. Third-party providers, including software firms and broker-dealers that offer RPA administration, have designed and enhanced their offerings to help clients respond to the regulations. As an example, our Westminster RPA business provides tools that allow asset managers to create budgets at the firm, fund and strategy levels; allocate research payments against these budgets; and generate MiFID II compliant reports for their investors and regulators.
Final thoughts
When the EC issued its Delegated Directive in April 2016, it effectively provided asset managers with a degree of flexibility in terms of funding for research payments. While some managers with adequate scale and internal resources will choose to absorb the costs of research, other firms will recognise that alternative funding models are more suitable for their size, strategy and ability to perform for their clients and will choose to fund RPAs with direct charges or with enhanced CSAs. We are hopeful that national regulators – throughout Europe and in the US – recognise the need for flexibility in terms of funding and foster an environment that creates a level playing field for asset managers of all sizes to acquire research from many different sources and to ultimately provide value and better performance for their investors.
1 Directive 2014/65/EU and Regulation (EU) No. 600/2014, collectively, “MiFID II.”
2 Commission Delegated Directive (EU) 2017/593 (Official Journal version published 31 March 2017; adopted by Commission 7 April 2016).
