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Mifid II’s unbundling framework has already had a transformative effect on the way research is bought, sold and consumed globally. Less than a year after implementation fund houses have overhauled their budgets, reports of banks slashing their research teams have been steadily working their way through the press, and clients are asking their managers increasingly difficult questions on where their money is going and why.
All of this was known ahead of time and, in fairness, the impact perhaps hasn’t been quite as dramatic as some predicted. But while other elements of Mifid II are viewed more as technical overnight changes with little wider effect, research unbundling is more fundamental and long-term, with the true effects continuing to develop over the coming years.
As with all regulation, different approaches to implementation have emerged. Here the top banks, asset managers and independent research providers reveal how they’re getting to grips with the new rules.
Read more: Research unbundling goes global
Payments & budgets: swallow the cost
Mifid II’s article 24 requires asset managers to explicitly separate commissions, such as research and execution, into their component parts.
Two options emerged: either create a research payment account (RPA) with an absolute research budget funded by client money, or pay for the research yourself.
Absorbing the cost of research into your own P&L quickly emerged as the preferred option towards the end of 2017, for reasons centred on both reputation and simplicity. As time has gone on very, very few houses have opted to pass on the cost, and they have paid the price in more ways than one: according to Frost Consulting, those that pass on the cost spend up to 7.5x on it. Sources say that’s likely because if the same manager runs more than one fund and uses the same piece of research for both, it’s incredibly difficult to establish how to split that bill.
The majority are small boutique firms, who feel they’re already losing out on new business to those that shoulder the cost. Initially Janus Henderson, Schroders, Invesco and Union Investment said they would pass the cost on, but they quickly u-turned last year when it became clear this was out of step with market practice.
According to sources, research fees are quickly becoming a similar concept to performance fees among investors. Cynics may argue that costs are passed on to clients elsewhere regardless; fund managers fire back that their fees have not increased over the past year. That could still change.
Regardless of firms’ choice from the above options, asset managers report a sharp increase in questions from clients on exactly what their money is being used for. While it’s natural that passing on the cost would result in the need to justify it, such questioning is becoming standard practice regardless. “When pitching for new business, we’re now seeing the buyside needing to demonstrate to clients that the prices are appropriate and that they’re getting value for money,” says John Halloran, director of trading services at IHS Markit in New York.
That’s forcing everyone to scrutinise what they’re consuming. Overall, it’s seen spending fall dramatically. This year brokers will earn approximately 20% less – or around $300 million – on European equity research as a result of buyside budget cuts, according to Greenwich Associates. Halloran has seen clients reduce their annual spend by as much as 40% already. Funds also plan to slash prices further by around five or six percent next year. As Greenwich says, ‘success [for the sellside] will be defined as ‘almost’ capturing the same revenue as in pre-Mifid II times’.
One somewhat unexpected result is the international pickup of research unbundling. While it’s not a regulatory requirement anywhere but the EU – and the US for example has granted no-action relief on certain elements – clients based everywhere from Seattle to Sydney have taken an interest in the rules. Research unbundling itself is rapidly becoming global best practice, with implications for sellside analyst departments everywhere.
Read more: US market explains resistance to Mifid II
The US’ no-action has helped stateside firms exponentially, so much so that some feel it gives them an unfair advantage over their EU counterparts. It covers several areas, including relieving them of the need to register as investment advisors in addition to holding a broker-dealer licence – which comes with its own complications.
A ‘couple’ of US firms have gone a step further and registered as advisors anyway, but the vast majority have taken full advantage of the regulatory relief. “That allows them to continue doing business without making any real change to practices with their Mifid-regulated counterparties,” says one US-based source. “In the meantime it gives them the additional benefit of economies of scale, which creates this feeling of an uneven playing field.”
Most US firms continue to use client money to fund research payments though, mainly because they can. That too could change. The no-action letter will expire after 900 days, and while some in the industry are lobbying for it to become permanent, others expect regulators to get rid, having taken stock of how the market has already shifted.
SPECIAL REPORT: MIFID II & MARKET STRUCTURE
Consumption & coverage: reassess your needs
Internal broker votes, already an entrenched practice in many asset managers, have now become more formal, as fund houses ask their managers to consider both the quality and quantity of what they’re consuming. They typically take place every six months.
Asset managers have introduced all sorts of technology to improve research discovery and minimise costs, as well as readership tracking, broker vote, and commission management tools. Regtech firms have reaped the benefit of asset managers seeking a full-service research management package. So-called research marketplaces have sprung, with new initiatives from Thomson Reuters, RSRCHXchange, Alphametry and Smartkarma, to name a few. As the market becomes more comfortable with the new environment, sources expect these platforms to prompt a rise in ad hoc arrangements over comprehensive packages.
Day-to-day interactions have also changed, with the buyside being more particular about who attends analyst meetings. Face-to-face time with analysts has remained highly valuable – and lucrative for those flogging it – but one Singapore-based manager now asks his bank not to send an economist because he’s too expensive.
Read more: Market searching for Mifid II best practice
Many fund houses have ramped up their own internal research departments; a trend sources expect to continue in the coming years. Others have taken a different approach: in November 2018 AllianceBernstein announced it had made an offer for independent provider Autonomous Research. An alternative is to snap up a smaller competitor: in late November it emerged that Macquarie is in early talks to acquire City broker Liberum for £100 million. Similar deals are expected to follow.
Practically all, though, have drastically slashed the number of external providers they use. A typical medium-sized investment firm will now have between five and 10 all-in subscriptions with large banks, and a similar number of contracts with independent providers. That’s down from around 100 just a few years ago.
Most would agree that consolidation – at least as far as the content itself is concerned – is necessary. For decades now investment banks have flooded clients’ inboxes with free reports in an effort to secure execution mandates. Larger managers were receiving such reports in their millions every year; the vast majority of which went straight in the trash. In 2017, JPMorgan alone published 131,000 reports.
Coverage is also changing as analysts chase the lower-hanging fruit – and not just within the EU. Again this might be sensible since pre-January 3, there were 43 analysts publishing reports on Apple alone.
Meanwhile small and midcap stocks in the UK and Italy in particular have suffered in terms of both coverage and liquidity: 85% of UK-based respondents to a Practice Insight survey said that Mifid II would have a more significant impact on the research market than FCA reforms. But a New York-based regulatory change manager has noticed the same trend among US companies.
“Once corporates have done an IPO we’re seeing some really struggling for analyst attention,” he says. “At the extreme end it could be locking them in capital structures for years.” Many say this is already damaging secondary market liquidity for these companies’ securities, exacerbating the problem.
“Mifid favours large asset managers and large sellside providers, and neither of those like to do small caps, because small cap funds can’t scale up,” says a senior risk officer at a large EU asset manager. “Now it’s priced explicitly it’s harder to subsidise that small cap work, so those companies are suffering.”
To fix the issue he suggests creating a blind pool for larger asset managers – the biggest beneficiaries of the rules, in his eyes – to fund coverage for smaller companies. “I just don’t think the regulator cares that much, because this outcome was so predictable,” he adds.
Sellside pricing: cheap at twice the price
A common thread at conferences throughout the year has been the sellside’s embrace of peppercorn pricing. JPMorgan charges some clients as little as $10,000 for access to its written notes, while other banks are asking for an average portal access fee of around $25,000.
Meetings are far more expensive, but considering one late 2017 survey put the estimated cost of research at approximately $10 million for every $10 billion of equity assets, those prices are astonishingly low.
Whether or not these practices will continue is not yet clear. At an industry event earlier this year, the Financial Conduct Authority’s Mhairi Jackson said the UK regulator would be keeping a close eye on ‘all-you-can-eat’ pricing models.
Smaller brokers and independent research providers (IRPs) argue that these tactics push them out of the market, since bulge bracket firms benefit from economies of scale, and can continue to fund internal analyst departments via execution commissions. They also make the point that there’s so little difference between cut-price research and outright free research that it’s technically still an inducement.
IRPs may still feel aggrieved, but some, including US-based StockViews, have admitted to benefiting from the buyside’s more discerning appetite. The change in landscape is slowly but surely prompting a flight to quality, with IRPs – generally more specialised in the sectors or companies they cover – snapping up some of that business.
But the overall feeling is that banks’ predatory pricing is squeezing IRPs, who are reliant on research commissions only. The rules have made it more difficult for managers to use them in general, because they’re often only relevant on particular trades, yet the budget must be set ahead of time. In summer 2018 more than 50% of European research allocation was still being directed towards global investment banks.
Industry group EuroIRP has asked European regulators to grant them an exemption on the grounds that current levels of competitiveness are detrimental to the end-investor. It is also requesting that regulators clarify their position on peppercorn pricing.
It may succeed, but managers’ decision to absorb the costs into their own P&L accounts has appeased the regulator insofar as it’s not client money at stake here.
Read more: UK IPO reforms damage research volumes
Other non-monetary benefits: as you were
While reams of written notes are widely accepted to have little value in the new marketplace, one area many are clinging on to is corporate access.
Typically, meetings with companies themselves were arranged by the bank on the deal, ‘free’ of charge. Now that’s considered a non-monetary benefit – or an inducement to trade – and must come with a price tag. Where the practice has continued, sometimes the corporate will now pay the bank for it.
Pricing has been all over the place. In January the risk manager’s firm paid £100 for a conference meeting with the CEO and CFO of a company it was considering investing in – yet the same bank was charging many multiples of that for a call with an analyst. Other sources say prices vary significantly depending on who requested the meeting.
But other corporates, afraid of either footing the bill or losing valuable exposure among investors, have taken matters into their own hands and rapidly ramped up their internal investor relations departments. Providing direct access to investors is no small feat – sources say it’s an incredibly high-maintenance, pampered process for the asset manager – but cutting out the middleman has already saved them a few cents.
Read more: Mifid II shrinks sellside use