How are hedge funds changing their research methods in the wake of MiFID II? Joe McGrath investigates…
The introduction of the second Markets in Financial Instruments Directive (MiFID II) in January 2018 heralded fundamental changes in the market, specifically when it comes to research.
Buy-side firms have had to scrutinise the amount they spend on research and evaluate the quality of sell-side and third-party materials.
The consensus is that MiFID has led to a reduction in research consumption by hedge funds, with a further fall possible.
Fabrice Bouland, chief executive officer at research management platform, Alphamety, says: “Consumers are increasingly moving to, or willing to pay more for, direct ‘organic’ information instead of paying for to many analysts processing the information for them. Interactions like corporate meetings, seminars or calls to top analysts are priced more than written research; expert networks for investment professionals are already a USD1 billion industry and expected to grow to USD5 billion in the next few years, compared to the USD10 billion research industry.”
He adds that fund managers are investing directly in data processing capabilities, alongside additional skillsets such as fundamental analysts, data scientists, coders and quants to ‘re-internalise’ the investment function.
When it comes to alternative methods of research, Tyler Tebb, executive director at event driven group Olivetree Financial, sees an “iTunes for research” style platform as key for the industry.
He says: “This is in its early days, but houses research from different sources that have all passed through a compliance element – that is the hurdle for managers with new research formats. By using a platform or marketplace, you can get access to some of the more routine research and then use independent consultants that are perhaps a little more niche in what they do.”
At Bluebay Asset Management, social media is used as an initial input for macroeconomic trends, but on the ground research also sees teams meeting with multiple stakeholders or policy makers to get a broad view.
Simon Chennell, institutional portfolio manager at BlueBay Asset Management, explains: “The more successful active managers will not be relying on paid for research. While it is useful to be aware of what is being written and read by others (given that it can drive consensus for a time), actually it is not the kind of research that allows you to position ahead of the market.
“It’s our belief that successful investment idea generation requires a forensic approach to proprietary research. In today’s markets this applies as much to the area of policy and politics, as to the more traditional research area of corporate analysis. It is also important to be smart in how you gather your inputs, with increased use of social media and building of relationships with policymakers, politicians and think-tanks to try to better understand the factors that will drive future market moves.”
Concentrated market
Matteo Basso, a vice president at financial consultancy group Duff & Phelps, is among those expecting third party research consumption to fall further. “We have also seen a number of managers expanding their internal research capabilities by hiring more analysts and investing in technology to make their processes more data-driven.”
The 2018 Global Alternative Fund Survey published by EY echoes this position revealing that the use of artificial intelligence among hedge fund managers grew 200 per cent during the year, with almost 100 per cent growth in the proportion of managers expecting to make use of AI tech in the near future.
Ammad Ahmad, co-founder and managing director of global intelligence platform, Atheneum, explains that MiFID II requires more transparency in research spending than ever before.
This ‘unbundling’ of the cost of research, separate from brokers’ trading commissions has made hedge funds keener to isolate the value they get from research, and clients more interested in understanding what they get for their money, he says.
Tebbs confirms that value for money is a priority, but argues that while a lot of the initial research can be done in-house, value still exists in specialist knowledge that is otherwise difficult to access.
Chennell agrees: “We believe in adopting a forensic approach, to your own research, rather than rely on paid for research. This focus allows you to know when paid for research is right or wrong, which can either affirm that an idea is good, or equally importantly if it is driving conventional wisdom, also allows you to take advantage of mis-pricings that come from what Mr Trump would call ‘fake news’.”
The fund management industry as a whole, Ahmad says, has reduced its overall research budget, on average, by around 15 per cent.
“The spending cut varies from a lower percentage for smaller asset managers with assets under management of between EUR1 billion-EUR20 billion, to more aggressive cuts for the larger managers, with assets greater than EUR200 billion.”
At the same time as spending has been cut, the EY report suggests the use of ‘next generation’ data has increased materially.
In 2018, 70 per cent of hedge fund managers used it as part of their investment process, with 30 per cent admitting they did not expect to do so. Two years ago, 50 per cent of hedge fund managers didn’t expect to use next-gen data.
“The explosion in the volume of data that is available and the number of market participants utilising it has begun to change how many hedge funds think of this information,” the report found. “For many firms in the industry, what next-gen data was a few years ago is now just data.”
Regulatory prelude
This change in the approach to research methods, while enhanced by MiFID II, stems from a regulatory focus by the Financial Conduct Authority.
“The fundamental point about the legislative changes brought by MiFID II, but also by an FCA regulatory focus prior to that, is the perceived potential conflict of interest that existed in the relationship dynamic,” says Bobby Johal, managing director at ACA Compliance. “In a post-MiFID II environment, the value of the entire proposition (best execution factors and research quality) must be considered separately and demonstrably so.”
While most mangers may be opting to conduct their own research and have implemented robust procedures that allow them to do so, they may, however, need to retain the services of prime brokers.
“From our experience, most fund managers have implemented robust enough procedures, which allow them to manage this conflict and treat their prime brokers and other research providers in the same way,” says Bose. “However, there is a perception that for sell-side firms, clients are still valued, and treated accordingly, by the overall volume of business they bring, and this does generate conduct concerns.”
Under pressure
Bose says that smaller managers could feel pressure from prime brokers to direct sufficient business to them and, due to their size, may not have the bargaining power to negotiate on cost.
“We will need to see how the market and the culture of firms evolves as these are still early days,” he says.
The Financial Conduct Authority started looking into these practices in the summer of 2018, in a multi-firm industry review and is expected to continue this supervisory work throughout 2019.
Ahmad says: “Given the increased transparency and scrutiny for both the asset managers and sell side research providers – managers need to make decisions on research quality and value for money rather than share of wallet for their prime brokers.”
Other options
The past 18-months have shown that striking the balance with robust, independent research and getting value for money isn’t as simple as it perhaps should be.
For Bouland the conclusions drawn so far paint a gloomy picture.
“Bulge brackets dominate still, or even more, in terms of market shares; with very few exceptions,” he says, adding that independents are increasingly complaining about business conditions.
However, Bouland suggests that research budgets could increase in 2019, having perhaps fallen as low as they can. “Will independents benefit fully from it? It is really a matter of value for money now that the price of written research has hit the bottom, led by JP Morgan.”
While there could be a case for managers to use alternative data providers for fresh insights, Johal says no meaningful trend has emerged and the market hasn’t seen a storm of new entrants.
“One might suggest that the buy-side has seen a flight to safety and concentrated the number of providers that they use. In part, this is a natural response to the need to ensure strict controls on the research flows and the attendant administrative burdens,” he says.
“With traditional research providers also adjusting their pricing to remain competitive, the opening in the market for alternative providers is perhaps not as enticing as regulators and competition authorities may have hoped.”
He adds that this concentration of providers, not to mention the increased compliance challenge of using alternative providers, also means a narrowing of coverage, which carries with it fresh implications for managers.
Chennel says: “Less competition can make for less variety of view but can also make research lazier.”
Bouland agrees, adding: “Upcoming sell-side consolidation or disappearance in the research space will facilitate the concentration of quality. The USD1 billion question remains: will the independents play an economically sustainable role in that new landscape?”
