MiFID II research costs will disproportionately impact smaller managers
Requirements under the Markets in Financial Instruments Directive II (MiFID II) stipulating fund managers must pay for research through their management fee as opposed to equity commissions will adversely impact smaller firms.
A consultation published by the European Securities and Markets Authority (ESMA) in summer proposed a ban on dealing commissions to pay for access to research analysts, bespoke reports, corporate access and even market data services such as Bloomberg. This goes further than the rules introduced in June 2014 by the UK’s Financial Conduct Authority (FCA), which stated fund managers could only charge underlying clients for research through trading commissions if that research was original and had a meaningful impact on trading decisions.
“MiFID II’s stance on research commissions will have a number of unintended consequences. There will be a decrease in the flow of information coming from brokers to managers in the form of research. For start-up managers, this will be problematic. Many of these institutions do not possess the critical mass to pay for up front research out of their management fee, and therefore need to offset the costs to their investors. This added expense of research could make it prohibitively difficult for small or emerging fund managers to break-even. I believe most investors in start-up funds are sympathetic to paying 20 basis points or so for research providing the costs are transparent and the research itself serves a useful purpose,” said Dominic Johnson, chairman of the New City Initiative, an industry association, and partner and chief executive officer at Somerset Capital Management, a $5.6 billion emerging markets focused fund manager in London.
Some reports suggest MiFID II’s clampdown on research practices at fund managers could facilitate a drag on returns. Berenberg, a German bank, warned UK asset managers could see 20 per-cent to 30 per-cent of their profits wiped out if the £1 billion and £1.5 billion approximately spent annually by firms on research were absorbed into the profit and loss (P&L).
There is speculation as to what will happen to brokerage research. A sizeable chunk of the research provided by brokers is rarely read by asset managers, and there have been criticisms within the industry about the lack of transparency from brokers about how they price research into their commissions. “The challenge is that brokers are not entirely transparent about the costs of research and how it is packaged. It might be an idea for regulators to require brokers to itemise the costs they charge asset managers. If that were to occur, asset managers would be able to be more transparent about their own costs to their end clients,” said Johnson.
A likely consequence of these changes could result in fund managers porting more business towards brokers in exchange for cut-price or even free research. Such an outcome would certainly lead to greater opacity. Alternatively, some fund managers might simply charge a higher management fee. Either outcome is unlikely to be well-received by the investor community.
There is also debate about the future of independent, specialist research providers. “The future for specialist providers is interesting. I believe these outfits stand to benefit because their research is genuinely bespoke. Utilising specialist research providers can be a cost saving as well, because it means resources can be freed up internally,” commented Johnson.
It is not just regulators that are taking note of research costs but institutional investors. “As a firm, we are phasing out soft dollars for any research. But we do get queries from institutional allocators such as sovereign wealth funds and public sector pension plans about how we pay for research,” said Johnson.
Regulatory interest towards research costs began in November 2012, when the then Financial Services Authority (FSA), the precursor to the FCA, wrote to all of the CEOs at major asset management houses in London asking them to explain by no later than February 2013 on how they managed conflicts of interest, with a particular emphasis on the use of client commissions to pay for equity research.
In a speech at the FCA’s annual asset management conference in October 2013, Martin Wheatley, CEO at the FCA, criticised managers for stretching the definition of what constituted research to cover non-eligible services and then charging these costs to investors instead of paying for it themselves through their management fees. Wheatley made it no secret at the time that he wanted the EU to replicate what the UK was doing on research costs on a pan-European basis through MiFID II. However, some wonder whether ESMA’s tough stance on research costs slightly wrong-footed the FCA, which has been praised throughout the industry for its proportional approach on the issue.